Question: I'm starting my own consulting business. It's slow-going, but I don't want to neglect retirement planning while I'm getting my business off the ground. Do you have any thoughts on where to start? I started to research it but was put off by all of the choices.
Answer: You're right--the retirement-planning landscape for self-employed folks is off-putting, to say the least. Whereas workers usually have one retirement plan to choose from, take or it leave it, self-employed folks have to sort among an array of options, ranging from the ultrasimple and familiar, such as an IRA, to more complicated and customized retirement-funding vehicles, such as pension plans.
Homing in on the right vehicle for you will depend on your answers to a few key questions, including how much you plan to contribute to the plan, how many employees you have, and how much flexibility you need. For example, would you like to have the latitude to contribute more in good years for your business but pull back when business isn't as strong? This article provides an overview of most of the key options, save for pension plans, which have become a lot less popular because of their complexity and costs to administer as well as the availability of viable newer options such as solo 401(k)s.
First Stop: IRA
Assuming you have a fledgling business, you can probably skip over more complicated options like pension plans. Instead, a logical first stop on the road to retirement planning will be to fund an IRA, an option for self-employed and non-self-employed folks alike. The key benefits are flexibility and ease of startup and ongoing maintenance. You can put almost any investment type you choose inside an IRA wrapper, and the paperwork usually consists of just a simple application form.
You can also choose your tax treatment. Assuming your income falls below a certain threshold, you may be able to deduct your contribution on your taxes if you're investing in a traditional (that is, non-Roth) IRA; you'll have to pay taxes when you begin taking distributions, though. If you'd like to be able to take tax-free withdrawals in retirement, you can set up a Roth IRA, though you'll have to contribute aftertax dollars. If your income, and in turn your tax rate, are relatively low right now, choosing to make Roth contributions is probably the way to go. (Income limits put a lid on who can initially contribute to a Roth, but it's possible to get in through the back door by starting a traditional IRA and converting to a Roth. Just stay mindful of any other IRA assets on which you haven't already paid taxes, as this article outlines.)
However, there are a couple of key caveats that accompany IRA contributions. The first is that you must have enough earned income to cover your contribution amount; that could be an impediment if your business isn't kicking off a lot of income just yet. If you're married, however, you can open a spousal IRA, provided your spouse has enough of his or her own earned income to cover your IRA contribution, as outlined in this article.
If you're in a position to contribute larger sums, it's worth noting that IRA contribution limits are pretty low, just $5,000 if you're under 50 years old and $6,000 if you're 50-plus. You can still start your retirement funding with an IRA contribution, but if you're able to contribute more than that, you'll need to invest any additional amounts in another vehicle.
Next Stop: Solo 401(k)
If you're in a position to save even more than you can stash in an IRA, a solo, or individual, 401(k) is a sensible alternative. You can put as much into a solo 401(k) as you can a conventional 401(k)--in 2011, that's $16,500 for those under 50 and $22,000 for the over-50 set. You can also sink a share of your net profits into the plan, up to a total contribution amount of $49,000 for those younger than 50 and $54,500 for 50-somethings on up. Setting up a solo 401(k) is straightforward. Your financial-services provider should be able to walk you through the steps, and you'll have latitude to choose the holdings.
As with IRAs, solo 401(k) contributors can choose to make traditional or Roth contributions. Contributing to a traditional solo 401(k) (that is, funding it with pretax contributions) might be a good idea if your primary goal is to shelter income from taxes in the current year. But if you're in a relatively low income-tax bracket now and expect your income to head higher in the future, a Roth solo 401(k) will be the way to go. There are no income limits on contributions, and solo 401(k) participants can also take loans from their accounts, offering a valuable escape hatch if you've contributed a lot in a good year but find you need access to the money later.
Be aware, however, that the solo 401(k) is geared toward individual, self-employed folks and their spouses. It's therefore a good option for those individuals and couples who are in a position to save a fair amount for retirement but not so much for those who have visions of hiring many employees down the line. Solo 401(k) participants can also contribute more in good years and less money in lean ones, offering another layer of flexibility.
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