Individual 401(k) seems to be the most promising choice for our family, who has a chunk of sideline self-employed income from family buinesses with no other employees. Still, I had considered other major retirement plan options for the self-employed, namely SEP IRA and SIMPLE Plans. Here are my notes:
SEP IRA (Simplified Employee Pension Plan)
• SEP IRA can be adopted for almost all forms of doing business: sole proprietor, in a partnership, or a business owner (of either an unincorporated or incorporated business, including Subchapter S corporations).
• Under SEP IRA, employer can contribute up to 25% of employee's compensaton, up to $42,000 for 2005. (While the upper limit of the contribution is similar to individual 401(k), one will need to earn, and get taxed on, an income of $210,000 before the contribution can be maxed out.) Employer can deduct the whole amount in tax returns.
• Employer also needs to maintain a written allocation formula that does not discriminate in favor of "highly compensated employees." (This usually does not work well for businesses hiring non-family member employees.)
• Employer has no obligation to contribute to the plan every year.
• SEP IRA does not provide means for employee to shield his/her own income though.
• Conclusion: SEP IRA is not an attractive option compared to individual 401(k). For an annual sidelne income of $40,000, we can only expect to shield $8,000 from income tax va SEP IRA, compared to more than $35,000 under individual 401(k).
SIMPLE Plans (Savings Incentive Match Plan or Employees of Small Employers)
• SIMPLE Plans are not really engineered to a one/two-people businesses like my case. It is more a simplified plan for businesses with less than 100 employees. To quality, the business has to have 100 or fewer employees earning $5,000 or more in compensation for the preceding year, and the business should not maintain another qualified plan.
• Both employee and employer can contribution. For 2005, employee can defer up to 100% of the compensation with an annual cap of $10,000), and another $2,000 in catch-up contributions for people over 50. Employer can either 1) match employee's contribution on a dollar-to-dollar basis for up to 3% of the compensation, up to $10,000 in 2005, or 2) make non-elective contriution of 2% of compensation on each eligible employee, up to $4,200 in 2005.
• Employer can deduct the contributions from business's tax return. Some startup costs can be deducted as well.
• Conclusion: Another no-go for my family. The deferred amount is barely over $20,000 -- still way behind that of individual 401(k)'s.
So, it appears that we will need to stick to individual 401(k) plans. On the other hand, as we mentioned in part 3, the form of doing business may also play a role in tax strategy. Therefore, we are going to find out whether we should incorporate, or stay solo in order to minimize our tax bill.
This post is part of the Tax Strategy for Self-Employment Income Series, please also read the rest of the series:
Part 1: The Tax Exposure
Part 2: The Framework
Part 3: The Major Options
Part 4: Individual 401(k) Introduction
Part 5: Individual 401(k) Analysis & Resources
Part 6: SEP IRA and SIMPLE Plans
Part 7: Forms of Doing Business
Part 8: LLC and S Corporation
Part 9: C Corporation
Part 10: The Conclusion
