We’ve discussed retirement savings opportunities available to employees. However, many taxpayers are self-employed small business owners who do not have access to employer- sponsored plans.29 Moreover, individually managed retirement plans such as traditional and Roth IRAs are not particularly attractive to self-employed taxpayers due to the rela- tively low contribution limits on these plans. What retirement savings options, then, are available to the self-employed?
Congress has created a number of retirement savings plans for self-employed taxpayers.
Two of the more popular are simplified employee pension (SEP) IRAs and individual (or
“self-employed”) 401(k) plans. These are defined contribution plans that generally work the same way as employer-provided plans. That is, amounts set aside in these plans are deducted from income, earnings are free of tax until distributed, and distributions from the plans are fully taxable.30 As we discuss below, these plans differ in terms of their annual contribution limits. They also have different nontax characteristics, including their suitability for busi- nesses with employees other than the owner and their administration costs. As you might expect, these factors should be considered when self-employed small business owners choose a retirement plan.31 We describe SEP IRAs and individual 401(k) plans below.32
Simplified Employee Pension (SEP) IRA
A simplified employee pension (SEP) can be administered through an individual retire- ment account (IRA) called a SEP IRA.33 The owner of a sole proprietorship can make
LO 13-5 TAXES IN THE REAL WORLD Roth or Traditional Retirement
Savings Vehicle?
With increasing budgetary deficits and the gov- ernment’s increasing need for revenues, one can reasonably anticipate that future tax rates will ex- ceed current tax rates. With increasing tax rates, taxpayers should favor Roth 401(k) plans and Roth IRAs over traditional retirement savings ve- hicles. Yet, less than 10 percent of employees who could contribute to Roth 401(k) plans choose to do so and more than 15 times more taxpayers use traditional IRAs than use Roth IRAs. Why are so many more taxpayers choosing traditional re- tirement savings options when Roth accounts may theoretically provide a greater after-tax sum at retirement? It could be that there are not a lot of taxpayers who expect their marginal tax rates to be higher at retirement than they are now, it could
be that taxpayers prefer deductible retirement savings contributions for the current tax savings, or it could be that taxpayers believe that in the future Congress may change the tax laws so that distributions from Roth accounts will become tax- able. A sound response to the tax law uncertainty would be to hedge your bets and include some retirement savings in traditional accounts and some in Roth accounts so that you can adapt to changing tax laws over time.
It remains to be seen what effect recent tax rate cuts have on taxpayers’ choice to invest in traditional versus Roth-type retirement plans.
Source: Carolyn T. Geer, “Bad Math: Taxes Rise as Savings Fall,” The Wall Street Journal, January 20, 2013.
THE KEY FACTS Self-Employed Retirement Accounts
• Popular plans include SEP IRAs and individual 401(k)s.
• Similar to (non-Roth) quali- fied defined contribution plans.
• Contributions are de- ductible and distribu- tions are taxable.
29Because sole proprietorships with self-employment income are very common, we assume in our examples and explanations here that any self-employment income originates from a sole proprietorship. In some cases, however, partners and LLC members may also have self-employment income from a partnership or LLC.
30“Keogh” self-employed defined benefit plans are also an option. Generally, defined benefit plans are attrac- tive to older, self-employed individuals with profitable businesses because they allow for greater deductible contributions. However, they are usually more costly to maintain than the defined contribution plans we mention here.
31Many investment firms provide comparisons to help taxpayers select self-employed retirement plans. One par- ticularly good comparison is provided by Fidelity Investments at www.fidelity.com/retirement/small-business/
compare-plans-chart.
32A Savings Incentive Match Plans for Employees (SIMPLE) IRA is another popular form of retirement plan for the self-employed. For those earning lower amounts of self-employment income, the contribution limits for a SIMPLE IRA are generally higher than contribution limits for SEP IRAs.
33§408(k).
annual contributions directly to her SEP IRA. For 2018, the annual contribution is limited to the lesser of:
∙ $55,000 or
∙ 20 percent of Schedule C net income, after reducing Schedule C net income by the deduction for the employer’s portion of self-employment taxes paid (50 percent of the self-employment taxes paid).34
Contributions can be made up to the extended due date of the tax return.35
34The Individual Income Tax Computation and Tax Credits chapter addresses self-employment taxes in more detail. Also note that for SEP IRAs no catch-up contributions are allowed for taxpayers 50 years and older.
35§404(h). This is October 15 for a calendar-year taxpayer.
What if: Dave (assume age 64) reports Schedule C net income of $40,000 during the current year. If he sets up a SEP IRA for himself, what is the maximum contribution he may make to the plan (assuming he has no other source of employee or self-employment income)?
Answer: $7,435, computed as follows:
Description Amount Explanation
(1) First limit on contribution $55,000
(2) Schedule C net income minus the self- 37,174 $40,000 − ($40,000 ×
employment tax deduction .9235 × 15.3% × 50%)
(3) Percentage for limitation based on (2) 20%
(4) Second limit on contribution 7,435 (2) × (3)
Maximum contribution $ 7,435 Lesser of (1) or (4) What if: Assume Dave is 48 years old at the end of the year. What is his maximum deductible contribution?
Answer: $7,435. Dave’s maximum deductible contribution for a SEP IRA does not depend on his age.
What if: Suppose Dave reports $310,000 of Schedule C net income rather than $40,000. What is his maximum deductible contribution to his SEP IRA account?
Answer: $55,000, the lesser of (1) $55,000 or (2) $59,578 {20% × [$310,000 − ({(310,000 × .9235 − $128,400} × 2.9% × 50%) + ($128,400 × 15.3% × 50%))]}.
Example 13-19
Nontax Considerations If a sole proprietor has hired employees, the sole propri- etor must contribute to the employees’ respective SEP IRAs based on their compensa- tion. Because owners may view this requirement as being too favorable to employees, the SEP IRA is best suited for sole proprietors who do not have employees or who are willing to provide generous benefits to their employees. From an administrative per- spective, SEP IRAs are easy to set up and have relatively low administrative costs from year to year.
Individual 401(k) Plans
Individual 401(k) plans are strictly for sole proprietors (and their spouses) who do not have employees. Under this type of plan, for 2018 the sole proprietor can contribute the lesser of:
∙ $55,000 or
∙ 20 percent of Schedule C net income, after reducing Schedule C net income by the deduction for the employer’s portion of self-employment taxes paid (50 percent of self-employment taxes paid) (employer’s contribution) plus an additional $18,500 (employee’s contribution).
THE KEY FACTS Self-Employed Retirement Accounts
• SEP IRA 2018 contribution limit.
• Lesser of (1) $55,000 or (2) 20 percent of Schedule C net income (after reducing Sched- ule C net income by the deduction for the employer’s portion of self-employment taxes paid).
Further, if the sole proprietor is at least 50 years of age by the end of the tax year, she may contribute an additional $6,000 as a catch-up contribution. Thus, a self- employed taxpayer with sufficient self-employment earnings who is at least 50 years of age at year-end could contribute up to $61,000 to an individual 401(k) for 2018 ($55,000 + $6,000).
Finally, even though the individual 401(k) contribution limits provide for taxpay- ers to contribute an additional $18,500 or $24,500 (this includes the additional $6,000 for taxpayers at least 50 years of age at year-end) relative to a SEP IRA, a taxpayer’s individual 401(k) contributions for the year are not allowed to exceed the taxpayer’s Schedule C net income minus the self-employment tax deduction. Consequently, a taxpayer with limited self-employment income may not be able to take advantage of the additional $18,500 ($24,500) of contributions that individual 401(k)s allow relative to SEP IRAs.
Example 13-20
Example 13-21
What if: Suppose that Dave is 64 years old at the end of the year, reports $40,000 of Schedule C net income, and has no other sources of income. What is the maximum amount he can contribute to an individual 401(k) account?
Answer: $31,935, computed as follows:
Description Amount Explanation
(1) First limit on contribution $ 55,000
(2) Schedule C net income minus the self- 37,174 $40,000 − ($40,000 ×
employment tax deduction .9235 × 15.3% × 50%)
(3) Percentage for limitation based on (2) 20%
(4) Limit on employer’s contribution 7,435 (2) × (3) (5) Limit on employee’s contribution 18,500
(6) Second limitation 25,935 (4) + (5)
(7) Maximum contribution before 25,935 Lesser of (1) or (6) catch-up contribution
(8) Catch-up contribution 6,000 Dave is 64 years old at year-end Maximum contribution $31,935 (7) + (8), not to exceed (2)
What if: Assume Dave is 48 years old at the end of the year, reports $40,000 of Schedule C net income, and has no other sources of income. What is his maximum deductible contribution to his indi- vidual 401(k) account?
Answer: $25,935. This is the same as the amount he could contribute as a 64-year-old (see prior example), minus the $6,000 catch-up adjustment ($31,935 − $6,000).
What if: Assume the same facts as above except that Dave (age 64) earned $10,000 of Schedule C net income rather than $40,000. What is his maximum deductible contribution to his individual 401(k)?
THE KEY FACTS Self-Employed Retirement Accounts
• Individual 401(k) 2018 contribution limit.
• Lesser of (1) $55,000 or (2) 20 percent of Sched- ule C net income (after reducing Schedule C net income by the deduction for the employer’s por- tion of self-employment taxes paid) plus $18,500.
• Taxpayers who are at least 50 years old at the end of the year may contribute an additional
$6,000 per year (maxi- mum of $61,000, if self- employment earnings are sufficient).
• Contribution cannot exceed Schedule C net income minus self- employment tax deduction.
(continued on page 13-30)
Answer: $9,294, computed as follows (Dave’s contribution is limited to his Schedule C net income minus self-employment tax deduction):
Description Amount Explanation
(1) First limit on contribution $55,000
(2) Schedule C net income minus self- 9,294 $10,000 − ($10,000 ×
employment tax deduction .9235 × 15.3% × 50%)
(3) Percentage for limitation based on (2) 20%
(4) Limit on employer’s contribution 1,859 (2) × (3) (5) Limit on employee’s contribution 18,500
(6) Second limitation 20,359 (4) + (5)
(7) Maximum contribution before 20,359 Lesser of (1) or (6) catch-up contribution
(8) Catch-up contribution 6,000 Dave is 72 years old at year-end.
Maximum contribution $ 9,294 (7) + (8), not to exceed (2)
What if: Assume Dave (age 64) earned $400,000 of Schedule C net income. What is his maximum deductible contribution to his individual 401(k)?
Answer: $61,000, computed as follows:
Description Amount Explanation
(1) First limit on contribution $ 55,000
(2) Schedule C net income minus self- $386,683 $400,000 − {[(400,000 × employment tax deduction .9235 − 128,400) × 2.9%
× 50%] + [128,400 × 15.3% × 50%]}
(3) Percentage for limitation based on (2) 20%
(4) Limit on employer’s contribution 77,337 (2) × (3) (5) Limit on employee’s contribution 18,500
(6) Second limitation 95,837 (4) + (5)
(7) Maximum contribution before 55,000 Lesser of (1) or (6) catch-up contribution
(8) Catch-up contribution 6,000 Dave is 64 years old at year-end.
Maximum contribution $ 61,000 (7) + (8), not to exceed (2)
Example 13-22
Nontax Considerations As we mentioned above, the individual 401(k) plan is not available for sole proprietors with employees, so providing benefits to employees un- der the plan is not a concern. However, the administrative burden of establishing, op- erating, and maintaining a 401(k) plan is potentially higher than it is for the other self-employed plans.