Retirement Planning for Independent Consultants

By Patricia E. Mohr, February 2005

[From SHRM's Consultants Forum]

If you're an independent consultant who operates as a sole proprietor and haven't yet set up a tax-preferred retirement account, you’re missing a great opportunity. As your own boss, you have an advantage in that the IRS treats you as both the employer and the employee—which allows you to deduct the contributions you make to your own retirement. The tax-sheltered savings can add up quickly.

However, the process of choosing the right retirement plan can be daunting. If you don’t make the right selection, you could wind up paying more than you bargained for in management fees and taxes.

The good news: Once you understand your options, it's relatively easy to set up a business retirement account.

Getting Started: Choose a Plan

Many investment advisers have a limited set of products they can offer clients, which do not always meet everyone’s individual needs, says Fred Payne, president of the Retirement Plan Service Corp., in Portland, Ore. He recommends starting with a certified public accountant or a third-party administrator who can help tailor a retirement plan to your business strategy.

Your options are an array of acronyms, including:

The Old Standby: IRAs

To choose the right plan, first determine how much money you want to deduct from your annual salary. Traditional IRAs are best for those who only want to contribute $5,000 or $6,000 per year, since the costs of establishing a more complicated employer-provided plan can outweigh the benefits. And an individual IRA can subsequently be rolled into another structure later.

Stepping Up to SIMPLEs and SEPs

For some people, employer-sponsored SIMPLE and SEP IRAs offer good options for saving without a lot of cost and complexity. Note that:

“I would recommend the SEP to someone who is making a fairly high income, never wants to have any administrative costs and is never likely to ever have employees,” Payne said.

The deadline to establish a SEP IRA is the same as your company’s tax-filing deadline, generally April 15 unless you have filed for an extension. The deadline to establish a SIMPLE IRA is Oct. 1.

Going Solo with a 401(k): A Hype or a Help?

Proprietors nearing retirement age who haven't set aside enough savings to provide for a comfortable retirement will want to choose a plan that will allow them to contribute more tax-deductible dollars per year, such as a solo 401(k).

Once exclusive to corporations, the 401(k) structure became available to sole proprietors beginning in 2002 with the passage of the Economic Growth and Tax Relief Reconciliation Act. Since then, a growing number of investment firms have designed 401(k) plans for the individual market.

How is a solo 401(k) different from a SEP or SIMPLE IRA?

The numbers add up. Consider a consultant, age 50 or older, making $100,000 this year with no employees other than a spouse. She could contribute as much as $25,000 to her solo 401(k), defer an additional $12,000 from her income and make a “catch-up” contribution of $4,000.

You can estimate your own contribution limits using the 401khelpcenter’s online calculator. The site will help you compare the 401(k) contribution limits with those of SIMPLE or SEP IRA plans.

“We recommend the solo 401(k) to the business owner who wants to maximize the amount of money he wants to put in his plan,” Payne said. “It is a very easy plan to set up and administer.”

Because they are not locked into contributing a set dollar amount per year, it is a good plan for businesses with unpredictable streams of income. The structure also gives owners more choices in investment options—investing with more than one mutual fund family or opting for alternative investments such as real estate. Condominiums, single-family rentals, mobile homes, undeveloped land and second mortgages all qualify as long as no family member lives on the property.

You can even borrow from your plan. Like corporate plans, the solo 401(k) offers the self-employed protection against unforeseeable expenses. A business owner can borrow up to 50 percent of the account balance or $50,000. The IRS will treat the transfer as a loan as long as the owner repays the balance with interest within five years.

Hiring Workers? Find a Safe Harbor

The risk in setting up any retirement plan is that it will cost you more money if your business expands and you hire staff. The tax law [section 401(a)(4)] says business owners cannot have a plan that discriminates in favor of highly compensated employees (such as themselves). The law requires companies with existing retirement plans to make nondiscriminatory contributions to their employees’ accounts.

“All plans are subject to discrimination testing,” Payne said, adding that it can be the highest hidden cost of setting up a retirement plan. But, he says, there are ways to limit your liability when it comes to financing workers’ retirements. Employees generally need not be enrolled in a company’s retirement plan until they have worked at least 1,000 hours in a 12-month period. “At that point, you would convert the plan to a safe harbor 401(k) plan,” Payne said. “They are not difficult to set up at all.”

Safe harbor 401(k) plans give the employer the option of making contributions to employees’ retirement accounts under an alternative method that does not require extensive discrimination testing. Employers can contribute either matching funds or non-elective amounts to the plan on behalf of eligible employees.

Employers must notify employees they are converting the company plan to a safe harbor plan 30 days in advance, and they must make contributions on behalf of all eligible employees once they change it. Also, all safe harbor contributions are immediately 100 percent vested.

50 or Older? Try a Keogh

Martin Nissenbaum, national director of retirement planning at Ernst & Young, recommends Keogh defined benefit plans to many of his clients who want to shelter higher amounts of retirement savings from their taxable income. The plan is ideal for business owners age 50 and over who are maximizing their earning potential, have few or no employees and want to quickly increase their savings for retirement.

The plan offers many tax advantages:

Consultants can set up a defined benefit plan even if they already receive benefit distributions from a previous employer. “As of now, there is no limitation on what can be put away for you as long as they are unrelated companies,” Nissenbaum said. But setting up a defined benefit plan takes a little more leg work than traditional contribution plans.

“It’s not difficult, but you cannot do it yourself,” Nissenbaum said. An ERISA or pension attorney can help design a plan and draft the legal documents for a fee of about $2,000 to $3,000. You’ll also need to pay an actuary about $300 upfront and $1,000 per year to run the needed computations. The actuary will look at your annual income, target retirement benefit, the number of years you have before you reach retirement, life expectancy and the expected investment return to determine money you will need for retirement—and how much you'll need to set aside each year to reach that goal.

The downside is that the plan locks the business owner into contributing the same amount per year. If your income fluctuates on a yearly basis, this might not be the plan for you. It's possible for you to terminate the plan, but you will need to hire an attorney and actuary to help you through the process.

Nissenbaum also pointed out that a retiree could face a 50 percent excise tax on the benefit if investment returns end up exceeding the actuarial expectations. But he noted, “that’s a problem most people would like to have.”

Patricia E. Mohr, a freelance writer covering public policy issues, is the former senior Capitol Hill reporter for Tax Analysts in Washington, D.C.

Related Reading

Retirement Plan Comparison Chart, Perquest Inc.

SIMPLE IRAs, SEPs, and Similar Retirement Plans, Internal Revenue Service

Small Business Retirement Plans, Smart Money

Solo Retirement, Forbes

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