By: Frank Armstrong
*As seen on Forbes.
I’m amazed by the number of successful self employed people that don’t take advantage of available tax favored retirement plans.
Like many people, more than a few self employed haven’t saved enough for retirement. But, unlike most corporate types, self-employed with no employees can design almost any kind of pension that they want. (And if they have employees they can still design the plan to richly reward themselves.)
The advantages of pension plans are obvious: forced savings, tax deductions, tax deferral of gains, and the ability to pass on tax-deferred assets to future generations. You may think pension plans are only for employees of large corporations. Wrong! A single-participant plan is very easy, economical, and effective to set up. If you don’t take care of your own retirement, who do you think is going to do it for you?
In the distant past, when it came to retirement plan options, the self-employed or members of a partnership were at a distinct disadvantage relative to corporations. Although over time, those restrictions have been removed, the perception of limited choices still lingers. That’s unfortunate because now you have plan flexibility that would make the average corporate employee turn green with envy.
It’s great being the sole decider. You can design a plan that meets your needs exactly without negotiating with others who have different objectives and financial situations. And with no employees, there are no pesky top heavy or cross testing issues to complicate plan design and administration. Best of all, 100% of the pension deposit goes directly to your own account.
Designing and maintaining your own plan doesn’t have to be time consuming or expensive. All the major discount brokerages have a full spectrum of pre-approved plans that you can adopt with just a few check marks. Pre-approval means that the IRS has already accepted the plan, so the hassle of filing for a “determination” letter is not required. Opening an account for most pension plans shouldn’t take more than a few minutes.
Unless you have complex needs, retirement plans can be very economical. For instance, Vanguard will set up a profit sharing plan for you with their funds that will allow you to defer up to 25% of your net income (with a limit of $51,000 in 2013, or $56,500 if over age 50) for no additional administration or custody fees. At the end of the year, they will send you all the information you need to file the required IRS form 5500. Alternatively, you can use TD Ameritrade or Schwab to open up the entire universe of investment choices.
The variety of plans to choose from is mind-numbing and includes IRA, Roth IRA, SEP-IRA, Simple IRA, 401(k), Roth 401(k), profit sharing, money purchase pension plan, and defined benefit plan. If you find the benefits and features of the options confusing, the Department of Labor publishes a concise table comparing plans at: www.dol.gov/elaws/pwba/plans/final.asp.
The 401(k) has two neat properties that are certainly worth considering: First, when you are more than 50 years old, you can make an additional $5500 a year “catch up” contribution to your plan.
Don’t forget the Roth 401(k) option. While these get no current deductions, the funds can later be withdrawn tax free, and they are never subject to the minimum distribution rules. If you expect to be in a higher income bracket later, or if you predict tax rates in general will go up, this is an especially good way to leverage the tax code.
With all those choices available, how should you decide which one to select? A good starting point is to determine how much you can save comfortably for your retirement goal, and then pick the least cumbersome plan that allows for that level of savings. As in many other facets of life, simple is best.
If you are older, behind in your retirement savings, and would like to sock away lots of your income, consider defined benefit plans. While large corporations are terminating their plans en mass, small employers are taking advantage of the ability to shelter significant amounts of income for their highly compensated principals. For instance, we just designed a single-participant plan for a self-employed 55-year old physician/consultant that allowed him to defer just over $162,000 a year for the next ten years.
Don’t get bogged down in minutia. The overwhelming issue is not the fine points of difference between pension plans, but whether or not you are saving enough so that you can live with a certain amount of class and comfort later in life.
Unless you are very confident of your investment skills, it makes sense to utilize an investment advisor to tend your nest egg. The small additional cost will be well worth it. Just make sure you avoid commission-based brokers and stick with professional-fee-only advisors so that you get objective advice. For a match to qualified professional-fee-only advisors, check www.napfa.org or www.paladinregistry.com.
Note: The deadline for establishing these plans is December 31. So hurry if you want to do it this year. But after the paperwork is done you can fund it next year when you determine your income for tax purposes.
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