Taxation of Self Employment Retirement Plans

(NOTE: This is a continuation of a case study looking into tax implications of starting up a small business. This particular article deals with tax deductions for small business. Click here to go back to the start of the case study.)

Before I begin, I want to note that I am a tax professional, not a retirement specialist. The following information is about the tax benefits only of self employment retirement plans. For a full understanding of retirement plans, you should consult with an investment specialist.

In the continuation of our case study, Amy is looking to set up a retirement plan for her nail wrap business, but is having a hard time figuring out how to apply it on the Schedule C. She calls up her accountant to figure out how self employment retirement plans work in her particular situation.

“First of all,” her accountant explains, “you’re not going to find your contribution on the Schedule C. For both self employed individuals and partnerships, your retirement information is going to be reported on page 1 of your 1040” (between lines 23 and 35 for the 2013 forms).

While there are a variety of plans out there, the most common self employment retirement plans are the Simplified Employee Pensions (SEPs) and IRAs. Each option has pros and cons.

Sunset on the beach

I know how boring retirement planning can be, so I’m going to put this picture here and pretend like this is what you’ll see every day once you retire

Simplified Employee Pensions

If you’re the only person in your company, the SEP is your best bet from a tax perspective. Also known as a SEP IRA, this plan allows you to contribute up to the lesser of 25% of your income, or $51k for 2013 (52k for 2014. Updated numbers can be found on the IRS’s website). What this means is that, after setting up the plan with an investment advisor, you can contribute up to $51,000 every year tax deferred. Like all traditional IRAs, you’ll have to pay taxes on the amount when you withdraw from it, but it a great way to potentially push your income into retirement, which, for most people, ends up being in a lower tax bracket.

Along with the big tax deferral, the SEP also allows contributions past age 70 1/2, unlike the IRA. This might not be relevant for many people, but it could help out a few.

The biggest downside to a SEP is that you must contribute an equal amount to all of your employees. If you’re the only one in your company, that’s clearly not an issue. But if you have a teenager helping you stock shelves for minimum wage, you’ll only get a $51k deduction if you give that teenage employee a similar $51k contribution. While the employee might appreciate the money, it most likely isn’t your intention.

Another downside to the SEP is you can’t have been separately eligible for a 401(k). This shouldn’t be a problem for most people, but if you’re running a business and working a night job on the side while sales pick up, that night job’s 401(k) could prohibit you from having a SEP in your business.

If you do choose to have a SEP, contributions to the plan must be made by the earlier of when you file your tax return, or the tax return due date including extensions.

IRA

The IRA is the traditional investment vehicle, and doesn’t really change for self employment retirement plans. As an employer, you can set up a SIMPLE IRA, which allows you to match your employees’ contributions if they have over $5,000 a year in wages and you have fewer than 100 employees.

In our case, though, as a self employed individual, it’s fairly straight forward. Once you set up a traditional IRA, you can contribute up to $5,500 tax deferred per year (for both 2013 & 2014). If you’re over 50, you get to contribute an extra $1,000 tax deferred.

Note that you can also set up a SIMPLE 401(k), but this would be an unlikely choice if you have no employees.

IRA contributions are fairly straight forward, and you’re able to make them even if you have another 401(k)  for that night job you’ve been forced to take, though that other retirement plan might limit the amount you can contribute.

Roth IRA

You can always contribute to a Roth IRA. The advantage is that you won’t have to pay taxes on any of the proceeds during your retirement. Unfortunately, that means you have to pay taxes on all your money now before you contribute it. Whether or not this is a good idea really depends on your particular situation. But if the other two options above don’t work out, it’s certainly something to consider.

 

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Picture by Jeff Turner