Being self-employed has a lot of benefits. You can set your own hours, work from home in your pajamas, and can give yourself as much vacation time as you want (or can afford). I can think of many more silver linings to promote working for yourself, but there are some drawbacks to think about.
Working for an established employer has a lot of benefits too. Most of which we probably take for granted. An employer that has health benefits pays a large portion of the monthly premium, among add-on’s like dental, vision, and mental health benefits. Not to forget, there are other important benefits like life-insurance, disability insurance, and flexible-spending accounts. To add to the list, sometimes employers have nice fringe benefits like adoption assistance, carpool programs, gym discounts, and wellness programs.
But the most important benefit most of us receive from our employers, besides health insurance, is our retirement benefits. This is especially true if you participate in an ever-rare pension plan. Most people will be concerned with other employer provided retirement plans, like 401k’s, especially when you get matching contributions. However, when you work for yourself, all of these benefits become your own responsibility.
It’s important that before becoming self-employed you consider these benefits when weighing your opportunity costs. It’s easy enough to become a dependent on your spouse’s health plan, but you need to plan for your own retirement account immediately. Besides, funding a retirement account has excellent tax benefits that help offset your taxable income.
Self Employed Retirement Accounts
Simplified Employee Pension (SEP-IRA) – A SEP is an easy way to start a retirement plan for yourself or your employees. With a SEP-IRA, you are contributing to an IRA account set up for yourself or your employee. Since the SEP-IRA account belongs to the employee, all funds contributed belong to them immediately and investments are self-directed. You can contribute 25% of an employee’s compensation or $50,000 (whichever is lower). For someone who is self-employed, with no employees, you can contribute 20% of your net earnings or $50,000 (whichever is lower). Contributions to a SEP-IRA are deductible. Therefore, they cannot be in Roth IRA form. SEP IRA’s do not affect the amount an individual can contribute to a Roth or Traditional IRA.
Savings Incentive Match Plan for Employees (SIMPLE IRA) – A SIMPLE IRA is a self-directed retirement account that is funded by employee salary deferrals and employer contributions. Employees can contribute up to $11,500 in 2012. Those 50 and over can add an additional $2,500 in catch-up contributions. Generally, employers must match contributions dollar-for-dollar up to 3% of the employee’s compensation. Employers can also provide non-elective contributions, instead of matching salary deferrals, at a rate of 2% of an employee’s compensation (up to a maximum of $5,000). Since deferrals are done on a pre-tax basis, SIMPLE IRA’s take on the form of Traditional IRA’s.
Self Employed 401k (Solo 401k) – Solo 401k plans are for business owners with no employees, other than their spouse. This type of retirement account allows up to $17,000 in salary deferrals (an additional $5,500 in catch-up contributions if qualified) and has a profit sharing aspect that can boost contribution limits higher than an SEP-IRA. The business may contribute up to 25% of the business owners compensation into the 401k account, up to a maximum of $50,000. Total contributions cannot exceed $50,000, or $55,500 for those 50 and over.
Defined Benefit – Defined benefit plans are out of vogue, but can provide a self-employed individual with no employees a significant tax shelter if they make an extremely large amount of money. An actuary is required to determine annual contributions and advice from a financial institution would be necessary for investment management and administration. Costs are high and there is no flexibility in regards to contributions. Unlike, the SEP, SIMPLE, and 401k, defined benefit plans cannot reduce contributions in years of low cash flow. Payments begin when a specified event occurs, such as retirement, and is paid in monthly installments. A defined benefit plan can be compared to a deferred annuity in the way it functions.
Next time: Investment Accounts for Education
Photo by: Rebecca Siegal
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