More older people than ever are working for themselves these days, according to the Bureau of Labor Statistics, and self-employment rises steadily with age. The group with the most self-employed? Men 55 to 64 years old.
That means they have to take the initiative to save for their retirement—and that is far trickier than simply signing up for a company 401(k) plan.
It includes sifting through an alphabet soup of options—individual retirement accounts, individual 401(k)s, simplified employee pensions and more—and dodging the come-ons from brokers and others eager to push complex retirement plans that might be little more than life-insurance products that will suck away a good chunk of your savings in commissions and fees.
The good news is, whether you are self-employed or just have income from free-lance work outside your regular job, there are savings plans for individuals that are simple to set up and run—and they can save you thousands of dollars in taxes while boosting your nest egg.
When all the weeds are cleared away, there are two real choices: individual 401(k)s and SEP-IRAs, both of which let you set aside and deduct some of your income, which then rises tax-free until withdrawal. And that is one benefit that will become only more valuable—especially if tax rates rise sharply in the years ahead.
Individual 401(k)s. These are the most flexible option and let you make the largest contributions, or “deferrals.”
Also called “solo” or “one-participant” 401(k)s, they are available to free-lancers, independent contractors and sole proprietors. as well as business owners with no employees other than a spouse.
You also can set up an individual 401(k) if you have a regular job but also have self-employment income on the side.
Since you are both the employer and the employee, you can contribute to the plan in two ways. As an employee, you can contribute up to 100% of your compensation, up to a limit of $17,000 in 2012, plus a catch-up contribution of $5,500 if you are at least 50 years old, for a total of $22,500.
As the employer, you can contribute up to 20% of your self-employment earnings—or 25% if your business is incorporated, says John Heywood, a principal at Vanguard Group’s retail-investor unit.
In 2012, total contributions from both employer and employee can’t exceed $50,000, or $55,500 if you are 50 or older.
For the purposes of determining the amount you can contribute, “compensation” is defined as your gross income minus business expenses, minus one-half of your self-employment taxes—that is, Social Security and Medicare taxes, which in 2012 total 13.3% of the first $110,000 of income. (Social Security taxes are capped at that level this year.)
So, for example, if you are over 50 and have net self-employment income of $50,000, you could contribute a maximum of $22,500 as an employee, plus the maximum employer contribution of $9,294, for a total of $31,794, says Mr. Heywood.
You can generally deduct your contributions from your net business income, which is the amount you report on Schedule C. If your business is incorporated, you can deduct the salary deferral from W-2 earnings and the employer contribution as a business expense.
The limits on elective deferrals are calculated by person, not by plan. So, if you have contributed $10,000 to another employer’s 401(k), you can defer only $7,000 in your individual 401(k).
SEP-IRAs. Simplified employee pensions are often called SEP-IRAs, because your contributions go into an IRA. You can contribute up to 25% of your net self-employment income, up to a maximum of $50,000 in 2012. Contributions are deductible as a business expense.
You can set up SEPs at mutual-fund companies, brokerage firms or banks. Fewer providers offer individual 401(k) accounts; some of the larger ones include Vanguard, T. Rowe Price Group TROW +0.48% and Fidelity Investments, which have no setup fees, and nominal or zero annual fees.
Individual 401(k)s must be established by Dec. 31, but you can contribute as late as the tax-filing deadline (generally April 15, or Oct. 15 if you file for an extension). The deadline to set up and contribute to a SEP-IRA is the tax-filing deadline.