The Advisor

RETIREMENT PLANS FOR THE SELF-EMPLOYED
by James E. Cheeks, Esq
Copyright 2003, James E. Cheeks

The Keogh or self-employed retirement plan is a government-recognized tax and investment program, for those who qualify. Many millions of people qualify, whether they are self-employed as a career, or as a moonlighting sideline from their day job. Keoghs have been greatly enriched through major rules changes in 2001 and 2002. Here we'll consider the benefits available in 2003 and after.

If you're in a Keogh plan, you can do all these things:

• Put money in the plan each year toward retirement or investment goals
• Take a tax deduction for that amount
• Postpone tax on your investment earnings until you withdraw them
• Have complete personal control of your investment assets

Tax deduction can free up more funds for investment, and investment earnings compound tax-free. The result, for almost every long-term participant, is greater personal wealth than could be had through investing outside the plan.

Types of Keogh plan

The defined benefit type. Here you commit to build towards a specific level of retirement benefit. This type works best for those within, say, 20 years of retirement. It can produce a larger Keogh fund, from larger tax-deductible investment contributions, than the other types. The annual investment and deduction ceiling depends on the retirement benefit level chosen.

Defined contribution plans work best for those starting their Keoghs relatively early in life-meaning when they are more than 20 years away from retirement. There are these three leading types of defined contribution plan:

The 401(k) plan. Here the self-employed person is allowed to make deductible contribution/investments for himself or herself in two capacities: a contribution as employer, to a profit-sharing plan, and another as employee in a form called an "elective deferral". The contribution ceiling as employer is, effectively, 20% of self-employment earnings. The elective deferral ceiling is $12,000 in 2003, rising annually in $1,000 increments to $15,000 in 2006. Thus, one earning $100,000 could put in and deduct up to $32,000 in 2003-that is, $20,000 (20% of $100,000) plus $12,000. Such a move would reduce federal income taxes in a typical case by $9,600. No more than $40,000 can go in for any one year, unless the self-employed person is age 50 or over (see below).

The profit-sharing plan. These are simpler to set up and operate than other Keogh plans (if they don't have elective deferral features). The contribution ceiling is, effectively, 20% of self-employment earnings, up to a maximum contribution of $40,000. A self-employed person with earnings below $200,000 can shelter more earnings-that is, contribute and deduct more-with a 401(k) plan than with a profit-sharing plan alone.

The money purchase plan. This has the same contribution and deduction limits (20% of self-employment earnings up to a maximum contribution of $40,000) as the profit-sharing plan, but imposes restrictions which many self-employeds find onerous. Participants generally can't withdraw funds from the plan before retirement age, absent such major events as disability or termination of the plan. Also, the self-employed person is generally obliged to make annual contributions. Defined benefit plans are also subject to these conditions, but 401(k) plans and other profit-sharing plans are not.

Many self-employeds with money purchase plans are currently considering switching to 401(k)s or other profit-sharing plans.

Any of these plans can let you make additional nondeductible investment contributions, along with the deductible kind. Investment earnings on such contributions build tax-free while in the plan. Amounts you put in come out tax-free, but the earnings become taxable when withdrawn.

If you have employees, you usually will have to include them in your Keogh plan, at some cost (tax-deductible, of course) to yourself. For this reason, you may decide on a type of plan that's less than the best for you, in order to keep down the cost of including your employees. A 401(k) is sometimes chosen as a way to keep these costs down.

Plans with some Keogh-like features

Simplified employee plans--SEPs or SEP-IRAs. SEPs or SEP-IRAs are a variant of the widely known and widely used IRA concept. Unlike Keoghs, they aren't designed exclusively for self-employeds, though self-employeds can use them. For 2003 and after, SEP-IRAs let self-employeds deduct investment contributions for themselves up to--but not more than--the ceiling for profit-sharing Keoghs.

As the name suggests, SEP-IRAs are simpler to set up and operate than most Keoghs. A unique advantage is the opportunity to set up a SEP-IRA early in a year and take a tax deduction on the return for the preceding year--set up in 2004 and tax-deduct on the 2003 return, for example.

As with Keoghs, if you have employees, you generally must include them in your SEP-IRA. SEP-IRAs lack the Keogh's options to keep down costs for employees.

The SIMPLE plan. The overworked word "simple", already exploited in the SEP-IRA acronym, is now itself a distorted acronym for Savings Incentive Match Plan for Employees. SIMPLEs, which first became available in January 1997, can be used by self-employeds, though not designed for them alone.

SIMPLEs work best for those with relatively modest self-employment earnings, including employees moonlighting in a self-employment sideline. With a SIMPLE, for 2003 you can invest and deduct all your self-employment earnings up to $8,000--less than that, of course, if you prefer.

Where earnings exceed $8,000 a year, SIMPLE allows further deductible investments in modest amounts, generally 3% of self-employment earnings. Here Keogh plans, and even SEP-IRAs, can do better, often much better. The $8,000 SIMPLE limit (for 2003) rises annually in $1,000 increments to $10,000 in 2005 and after.

SIMPLEs are easier to set up and operate than Keoghs. The money goes into your IRA.

If you have employees, they usually must be given the option to let a part of their pay each year (up to $8,000 for 2003, $9,000 for 2004, and so on) go into their IRA account. You as employer must match this, up to 3% of their pay, with some exceptions.

SIMPLE 401(k)s. Self-employeds without employees should have no interest in this type. For those with employees, it's somewhat simpler than the standard (profit-sharing) type of 401(k), but administrative difficulties remain. SIMPLE 401(k)s are subject to a special version of the dollar amount ceiling ($8,000 for 2003) and 3% ceiling of SIMPLE plans.

If age 50 or over, self-employeds in a 401(k) or a SIMPLE can make additional deductible contribution/investments on their own behalf. In a 401(k), this additional amount is $2,000 in 2003, rising thereafter in $1,000 annual increments to $5,000. For SIMPLES the 2003 ceiling is $1,000, rising thereafter in $500 annual increments to $2,500.

Cashing in

Withdrawal from any of these plans usually is taxable, with a special tax penalty for most nonretirement withdrawals before age 59 1/2.

A self-employed's withdrawals must begin not later than age 70 1/2 (or April 1 of the year after that age is reached).

Withdrawal in the form of a retirement annuity is common but not required. You can take it all at once or in large chunks at various times of your own choosing. Investments continue tax-sheltered until withdrawn. By legally minimizing the amount you withdraw, you prolong the tax shelter for yourself and your heirs.

Getting started

All too many self-employeds let the wealth-building opportunities of self-employed retirement plans slip away through inaction. This is unfortunate, since many of those who have taken the trouble to look seriously at tax-favored retirement planning have acted on the knowledge, and are glad they did.

James E. Cheeks, Esq. Is the author of "Self-Employed Retirement Planning" published by Poseidon Publishing LLC at http://www.poseidonpublishing.com.

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