It's not uncommon for the self-employed to delay retirement planning. As they manage and build their businesses in challenging economic circumstances, they face complicated choices. On the one hand, traditional 401(k) plans may seem expensive and too complex. On the other hand, standard IRA accounts may seem insufficient, especially if the participant is not disciplined about making contributions, or if he or she is relying solely on an old IRA or 401(k) from a previous job. In most cases, in fact, sole proprietors and small-business owners with a handful of employees need a retirement plan that's more rigorous than a payroll-deduction IRA, but less complicated and costly than a typical 401(k).
Luckily, there are plenty of options, including the Simplified Employee Pension (SEP) IRA plan, the Savings Incentive Match Plan for Employees (SIMPLE) IRA and the individual 401(k). All are designed specifically to help self-employed and small-business taxpayers save for retirement, but your specific needs and the nature of your business will determine which one is right for you.
SEP IRA: Offering flexibility for a variety of needs
Perhaps the most popular of the three plans is the SEP IRA. According to IRS rules, employers can contribute up to 25% of employees' compensation, while sole proprietors can generally contribute a maximum of 20% of their "net earnings from self-employment" per year, up to a $50,000 cap. (The IRS reconsiders its monetary cap annually. In 2012, for example, the IRS raised the maximum SEP contribution to $50,000 from 2011's $49,000 cap.)
SEP assets can be invested in a broad range of investments—stocks, bonds, mutual funds and more. Though SEP IRAs are more popular among sole proprietors, business owners can also set them up for themselves and their employees, making contributions on their employees' behalf, which can then be deducted as a business expense.
One of the SEP IRA's chief advantages is its flexibility: It allows you to vary your contribution level from year to year, or even forgo contributions completely, to accommodate fluctuating income and business liquidity needs. Unlike other types of retirement plans, the SEP IRA doesn't require you to make matching contributions. Employers have the additional flexibility of making contributions for 2011 up to the business tax filing deadline, plus extensions.
SIMPLE IRA: A tax-advantaged plan for you and your employees
With the SIMPLE IRA, contributions are mandatory. Intended for small businesses with 100 employees or fewer, or for sole proprietors who know they'll be hiring employees in the near future, the SIMPLE IRA has plenty of advantages. But before committing to this plan, you must feel comfortable making obligatory employee contributions year in and year out. If the cash flow of your business varies, for instance, this might not be the right plan for you.
Pretax salary deferrals, which the SEP IRA doesn't allow, are arguably the SIMPLE IRA's biggest selling point. In 2012, business owners and employees alike can defer as much as $11,500 of their pre-tax annual salary. Those who are 50 and older can contribute an additional $2,500. (Like the SEP cap, these maximums are revisited each year and are subject to change.)
SIMPLE IRAs have advantages over traditional 401(k) plans. SIMPLE IRAs are generally easier and less costly to manage than traditional 401(k)s because they don't require compliance testing or the additional paperwork that comes with annual IRS Form 5500 filing. A traditional 401(k) plan generally requires compliance testing to make sure lower-income workers have access to the same retirement plan savings opportunities as top-level employees. While employer contributions are mandatory, SIMPLE IRAs have fewer administrative requirements than traditional 401(k)s.
Individual 401(k): Helping you save while maintaining liquidity
The individual 401(k) is designed for sole proprietors and is not available to businesses with nonowner employees. It offers the same contribution limits as the SEP: as of 2012, a maximum deductible contribution of 25% of compensation, not to exceed $50,000—with the exception that people age 50 or older can make an additional $5,500 "catch-up" contribution.
The individual 401(k) offers a key advantage: the ability to take out loans against the plan, which are not permitted in SEP or SIMPLE IRA plans.
These choices—SEP, SIMPLE and individual 401(k)—provide additional options for the small-business owner. As you can see, they each offer unique benefits, so it's important that you take time to review them with your Financial Advisor and tax professional to determine which plan is best suited for you. Saving for retirement, after all, is no less crucial to you than it is to those who work for someone else.
Any tax statements contained herein were not intended or written to be used, and cannot be used for the purpose of avoiding U.S. federal, state or local tax penalties. Neither Merrill Lynch nor its Financial Advisors provide tax, accounting or legal advice. Clients should review any planned financial transactions or arrangements that may have tax, accounting or legal implications with their personal professional advisors.