Pension Plans for the Self-Employed are tax-sheltered savings plans for owners (and employees) of unincorporated businesses.  A self-employed individual is a sole proprietor or partner who works in his or her own unincorporated business.  The most well known pension plans for the self-employed are Keogh plans and Individual Retirement Accounts (IRAs).  However, the self-employed can also take advantage of recent changes in the law to save for retirement using other options.  Self-employed individuals can take advantage of Keogh plans, SEPs (Simplified Employee Pensions), SIMPLE plans (Savings Incentive Match Plan for Employees), Solo 401(k)s, deductible (traditional) IRAs and Roth IRAs – sometimes in combination.

Keogh Plans. 

When originally enacted in the early 1960s, Keogh plans, also known as HR-10 plans, were limited but at least offered self-employed people an opportunity to save for retirement on a tax-favored basis similar to that enjoyed by corporate owners and employees.  Over the years, the distinctions between Keoghs and plans for regular corporations have been eroded.  Now although some Internal Revenue Service (IRS) forms, such as the Form 5500 for pension reporting, still refer to Keogh plans, most financial and investment firms simply refer to the specific type of plan: defined benefit or defined contribution.

A Keogh plan is a qualified retirement plan that covers one or more self-employed individuals.  For example, a typical Keogh plan might cover the self-employed person, the spouse of the self-employed person, and a few employees.  If a self-employed person, such as a sole proprietor, has employees, they must be included in the plan.

Keogh plan contributions are deducted from gross income, and tax is deferred until funds are withdrawn from the plan at a later date.  Income generated by the investments in a Keogh plan is also tax-deferred until it is withdrawn from the plan.

An advantage of Keogh plans is that the limits on contributions are significantly more liberal than those applied to IRAs.  In 2003, the maximum contribution to a defined contribution Keogh plan is the lesser of $40,000 and 100% of net earnings from the business.  The maximum contribution to a self-employed defined benefit pension plan depends on actuarial calculations for what is required to fund a benefit that, in 2003, may not be greater than $160,000 per year.  The calculation depends on the self-employed individual’s income, the target benefit, years until normal retirement age, and anticipated investment returns.  The defined benefit plan will usually provide the greatest deductible contribution for high earners over age 50 or thereabouts, but it is also the most complicated to set up and the most expensive to maintain.  Generally, benefit payments from a Keogh plan to a self-employed individual must begin by April 1 of the year after he or she reaches age 70 ½.  Beginning in 2003, the owner-employee (a self-employed person or a partner owning more than 10% of the business) is able to take a loan from the Keogh plan (generally up to the lesser of $50,000, or half of the vested benefit).  Prior to 2002, such loans were “prohibited transactions” subject to penalty.

An individual who works for a regular employer and is covered under that employer’s qualified plan can establish a separate Keogh plan for an additional business carried on separately as a self-employed individual.

SEPs (Simplified Employee Pensions) 

SEPs, sometimes known as SEP IRAs, are traditional IRAs that can take expanded contributions from one or more employees, including a self-employed person.  The contribution limits are significantly higher than a traditional IRA:  in 2003, the lesser of $40,000 or 100% of net earnings.  SEPs are very simple to set up, very flexible in terms of contributions year to year, and a great benefit to procrastinators because they can be opened as late as the due date of the tax return on which the deduction is being claimed, including extensions.  For self-employed persons with employees, there are stringent rules about treating all employees (including owner-employees) in a nondiscriminatory manner with regard to employer contributions.

SIMPLE Plans

SIMPLE plans may be thought of as the middle ground of pension plans for the self-employed.  Employers with no more than 100 employees (anyone earning at least $5,000 per year) may set up a SIMPLE plan for employees, but it must be the only plan in the enterprise.  SIMPLE plans have been available since the 1996 Small Business Job Protection Act and were enhanced in the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA 2001).  In exchange for very simple administration – no annual reporting – self-employed people, partners, and small companies accept lower (but perhaps more realistic) annual contribution limits than are available in some other forms of retirement plans.

The funding mechanism can be either an individual account for each participant (SIMPLE IRA) or a single pool of money in which everyone participates SIMPLE 401(k).  Employee contributions are limited to $8,000 annually in 2003, except that those who will be 50 or older at the end of the year can contribute an additional $1,000.  Each participating employee’s contribution must be matched up to 3% of the employee’s pay (with some limited flexibility year to year to allow for a bad year), or the employer must make a nonelective contribution of 2% of compensation for all eligible employees, regardless of their contribution.

SIMPLE plans are more democratic than some other plans.  In SIMPLE IRAs the “top- heavy” and nondiscrimination rules that apply to Keogh and SEP plans to assure that benefits are not weighted toward the owners and highly compensated individuals do not

Table 1

Important Features of Traditional and Roth Individual Retirement Accounts

Apply.  In a SIMPLE 401(k), the special nondiscrimination rules and top-heavy rules do not apply, but regular nondiscrimination and coverage rules do.

Solo 401(k) Plans

Solo 401(k) plans are newly attractive since the passage of EGTRRA 2001 but, as a practical matter, are only attractive to self-employed people with no employees except a spouse.  If incorporated, the maximum contribution between employer and employee is the lesser of $40,000 or 100% of compensation, plus an overage-50 catch-up amount twice that available in SIMPLE plans ($2,000 in 2003).  They also offer great flexibility in terms of stopping and starting; there doesn’t have to be a contribution to the plan in any given year.  Should business falter badly, loans are available from the plan up to $50,000 without taxes or penalty.

Individual Retirement Account

IRAs were originally developed as a tax-deferred savings plan for workers without access to an employer pension.  Over the years IRAs have been modified several times.  Now there are two primary types of IRAs: traditional and Roth IRAs.  Under the traditional IRA, contributions (up to certain limits) are deductible and investment earnings are tax-deferred.  Contributions to a Roth IRA are made with after-tax earned income.  Because traditional and Roth IRAs have some restrictions, a potential participant is advised to investigate the restrictions carefully (see http://www.irs.gov/). Table 1 provides a comparison of some of the features of traditional and Roth IRAs.

Other Options for Saving for Retirement 

Many self-employed individuals depend on a spouse’s employment for access to health care benefits and pension plan coverage.  Doing this allows the self-employed person to reinvest earnings and profits or to invest in other savings options.  A study of women business owners (De Vaney et al. 1997) showed that the owners saved the most by investing in stocks.  The amount saved in other retirement savings options was (in order from second largest amount to the smallest amount): equity in their own business; savings accounts, bonds or certificates of deposit; mutual funds; IRAs; 401(k) or 403(b) tax-deferred accounts; Employee Stock Option Plans; Simplified Employee Pensions; and Keogh plans.  At the time the study was conducted, loans to the employer from a Keogh plan were a “prohibited transaction.”  However, the results could be taken as an indication that the self-employed prefer to save in options that are more readily accessible (such as stocks, mutual funds, savings accounts, etc.) than tax-deferred retirement accounts.

In a study comparing retirement plan participation by the self-employed and wage-and-salary earners, De Vaney and Chien (2000) found that an advanced degree, high income, and Caucasian heritage were the major factors that predicted participation by the self-employed in formal retirement plans.  In contrast, wage-and-salary workers tended to be participants in formal retirement plans if they were older, if they had some college education or a degree, and if they worked full time and for a larger firm.  Another study showed that the self-employed tend to retire later than wage-and-salary workers; this may influence their participation in retirement savings plans and the options used for retirement savings (De Vaney and Kim 2003).  (See also DEFINED BENEFIT PENSION PLAN; DEFINED CONTRIBUTION PLAN; FINANCIAL ADVISORS; INDIVIDUAL RETIREMENT ACCOUNT (IRA); KEOGH PLANS; RETIREMENT PLANS – 401(k); SOCIAL SECURITY PROGRAM OF THE UNITED STATES.)

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