David, a music producer, knows his business is beginning to hit its stride because he is now able to save more than the maximum IRA contribution of $5,000. As larger record contracts come in, he also must now pay quarterly estimated tax payments. “Uncle Sam is killing me” is a line he’s been sharing regularly with his friends.
At this point, David should look into “employer-sponsored” retirement plan options. These retirement savings accounts offer tax preferences not available elsewhere. The SEP IRA and solo/individual 401(k) are the two most common retirement plans chosen by successful self-employed people due to their high contribution limits.
David expects his business income for the next several years to be at least $100,000. Because David’s business is unincorporated, he can contribute up to a limit of 20% of adjusted business income into a SEP IRA, or approximately $20,000.
The solo 401(k) offers greater contribution potential. SEP IRAs only offer employer contributions, but a solo 401(k) allows a business owner to split a retirement contribution into two parts: employee and employer contributions. In David’s case, he can count the first $17,000 of his contribution as an employee contribution, plus he can then contribute an additional $20,000, accounted for as an employer contribution, for a total of $37,000. If David’s goal is to maximize his retirement contributions, clearly the 401(k) is the way to go.
Saving the maximum amount will reduce David’s taxable business income down to $63,000. Before the deduction, this $37,000 was taxed at 15% (federal income taxes) and 5.75% (state taxes). This means David can reduce his current tax payments by $7,677.50 by making a $37,000 retirement plan contribution. Take that, Uncle Sam!
David’s wife also helps run the business, which makes her eligible to contribute as well. However, any additional employees will make David’s business ineligible for the solo 401(k).
The solo 401(k) has the added advantage of being able to contribute the employee contributions into a Roth account that will never be taxed again. However, with added flexibility comes some added paperwork to set up and maintain the plan. Plan updates need to be recorded each year. Once the plan balance reaches over $250,000, tax form 5500 must be filed annually. And if any employees are hired, a transition must be made to a full-fledged 401(k) plan once they have completed one year of service.
In order to stay on track with his retirement goals, David plans to save 12% of his income every year. Because he does not expect to save any more than 20% of his adjusted business income, I recommend the SEP IRA because it’s easier to set up and maintain.
Numerous mutual fund, brokerage, and discount brokerage firms offer packaged solo 401(k) and SEP IRA plans. Vanguard is one of the best because of its low costs and superior fund options. And knowing that his retirement savings is on track will be music to David’s ears.