Savvy Retirement and Tax Planning for Independent Contractors
Savvy Retirement and Tax Planning for Independent Contractors
Qualified retirements plans are a great way to save for the future and receive a current year tax deduction. Small business owners with employees need to weigh the cost of contributions to their employees vs. the tax benefits they personally recognize. However, independent contractors with no employees, are in a much more favorable position to maximize the tax benefits without having to factor in the cost for employees. The homerun for independent contractors with enough income, who are looking to maximize tax benefits and save for the future is often to pair a solo-401k plan with a defined benefit cash balance plan. Let’s take a look at some of the different retirement plan options through the lens of an independent contractor with no employees.
SEP IRA
A SEP-IRA is the simplest type of plan to set up. With a SEP-IRA you can contribute up to the lesser of 25% of net profit from self-employment or $69,000, which is the 2024 cap. Beginning in 2024, you can choose to make ROTH contributions to a SEP IRA by setting up a ROTH SEP IRA (clever name!). SEP IRAs are individual accounts that can be established with any brokerage firm and can invest in stocks, bonds, mutual funds, exchange-traded funds (ETFs). They are completely “employer” funded, which is an important distinction from the solo 401k below. Unlike, the solo 401k (see below) it’s difficult to combine a SEP IRA with other retirement plans and you are not able to take loans against your account.
Individual (solo) 401k
As the name suggest a solo 401(k), also known as an individual 401(k) is a type of 401k retirement savings plan designed for self-employed individuals or small business owners who do not have any employees other than themselves and, if applicable, their spouse. It operates similarly to a traditional 401(k) plan but is tailored for individuals who are both the employer and the employee (ie. independent contractors).
As both the employer and the employee, you can make contributions to the solo 401(k) in two ways:
- Employee Contributions: You can contribute 100% of your income, up to a yearly limit set by the IRS. For 2024, the employee contribution limit is $23,000 for individuals under 50 years old and $30,500 for those 50 and older.
- Employer Contributions: As the employer, you can also make additional contributions, up to 25% of your net self-employment income (after deducting one-half of your self-employment tax and contributions). These contributions are typically considered “profit sharing contributions”.
The total contribution is subject to a combined maximum limit for both employee and employer contributions. For 2024, the total contribution limit is $69,000 for individuals under 50 years old and $76,500 for those 50 years and older.
Like the SEP IRA, solo 401k plans can be set up with a brokerage firm and can invest in stocks, bonds, mutual funds, exchange-traded funds (ETFs). Unlike the SEP IRA, some solo 401k plans will allow you to borrow against your account value and any plan with assets over $250,000 will have to file Form 5500-EZ with the IRS annually.
Cash Balance Plan
A cash balance plan is a type of IRS qualified plan known as a defined benefit plan that offers significantly higher contribution limits. Rather than defining the amount you can contribute on an annual basis like 401k plans (ie. defined contribution plans), the maximum annual contribution for a cash balance plan is determined based on income, age and a pre-determined interest credit – which is defined in the plan document, and usually ~4%. The annual contribution limits for a cash balance plan are done by an actuary and must be customized to every individual. Here is an example of what the maximum contribution amounts might look like at various ages with the tax benefit based on a 37% Federal income tax rate. Note: the tax savings will be even larger for those who pay a state income tax.
In exchange for the higher contribution rates cash balance plans are more rigid and require more administration. The cash balance plans are permanent, and contributions are not elective so you will want to make sure your income/cash flows are consistent enough to fund them every year. You should plan on keeping the plans open for at least 3 years but you are able to terminate for good cause. An actuary must review the plan and certify the plan each year and like the 401k you will have to file a Form 5500 annually with the IRS.
401k w/Profit Sharing Contribution + Cash Balance Plan
The homerun for independent contractors looking to maximize tax savings and save for their future is often combining a solo 401k and cash balance plan. The combination of “employee” 401k savings, “employer” profit sharing contributions and cash balance contributions optimize the retirement contribution limits. Here is an updated example of what the total contributions and tax savings might look like using 2024 contribution limits.
Conclusion:
Independent contractors are in the fortunate position to save for their future and reduce their current year taxes by exploring all available retirement plan options without the offsetting cost of employee contributions. For those over 50 a solo 401k will allow a higher contribution limit than a SEP IRA and for those consistent cash flows a combination of a solo 401k and cash balance plan will allow for the highest contribution limits and therefore greatest tax benefit.
*credit: FuturePlan