Investment Guide: Self-Employment
A Plan of One's Own

Brigid McMenamin and Janet Novack,

Here's a great reason to be self-employed: The tax breaks you get to save for retirement.

When Congress sweetened the tax breaks for retirement saving in 2001 some of the juiciest benefits went to the self-employed. If you work for yourself, by day or by moonlight, take a new look at your retirement plan choices. If you don't, try to generate some self-employment income. You may be able to shelter a large chunk of it from current income taxes and rebuild your battered retirement accounts.

Deborah C. Canada, 53, retired in April as vice president of human resources for Union Acceptance Corp., a car financing company. She now works part time for the sales force research and training business her husband, Richard, an Indiana University faculty member, runs on the side. "I would have thought long and hard before I retired had it not been for what we could save for retirement through Dick's business," she says.

This year Deborah and Richard, 57, are each putting $12,000 pretax in the 401(k) plan of their firm, the Dartmouth Group. Dartmouth will contribute another $8,000 for her and $29,000 for him to a profit-sharing plan. The Canadas won't be taxed on that either until they (or their children) draw it down some day.

The Canadas have lots of company: 30% of families with adjusted gross income of $200,000 or more had self-employment earnings in 2000. And a higher percentage work for themselves at some point, since Americans use self-employment as a bridge between jobs and as a way to combine careers and kids or stay productive after 65. The fattened savings breaks provide yet another good reason to work for yourself.

"There's no question the retirement rules are slanted in favor of the self-employed,'' says David R. Marcus, a partner with Marks Paneth & Shron in New York. One of his self-employed clients in the entertainment business is putting $320,000 pretax into his defined-benefit pension plan this year.

To save that much, you'll need an accountant, an actuary, a custom-designed plan and a big income. If your earnings are more modest, you may be able to use an off-the-shelf "defined contribution" plan from a mutual fund company, broker, bank or insurance company. To pick the right type of plan for you, first narrow your options based on the amount you can save each year. Then factor in whether you have a pension at a regular job; whether you have employees or might hire some one day; and whether you want to borrow from your plan.

UNDER $3,000

If you have no other pension plan and little cash to spare, open a traditional deductible individual retirement account. You can shelter up to $3,000 ($3,500 if you're 50 or older) of your self-employment earnings. But if you have another pension plan, eligibility for a deductible IRA starts to phase out when adjusted gross income hits $34,000 for a single, or $54,000 for a couple. If you don't have a plan, but your spouse does, phase-out begins at $150,000.

UP TO $10,000

In this savings range a Simple IRA might suffice. Paperwork is minimal (relatively speaking). A self-employed person can shelter up to $7,000 of earnings, pretax, in 2002, as an "employee" contributionand put away another 3% of earnings, up to $7,000, as an "employer" contribution. Allowed employee contributions will rise $1,000 a year to $10,000 in 2005. If you're 50 or older, you can put away an extra $500 as an employee "catch-up" contribution in 2002. That bonus rises $500 a year to $2,500 in 2006. It's too late to set up a Simple for 2002--the deadline is Oct. 1.

Nevertheless, if you have, or might hire, an employee, a Simple can be a good choice: You have to contribute only 1%to 3%of salary for each worker and don't have to worry about dog-in-the-manger nondiscrimination tests that (in other plans) limit what you can save if your employees don't save.

A Simple won't work for some moonlighters who have 401(k) plans at work. If you've made the legal maximum allowed employee contributions to a 401(k)--$11,000 for 2002 or $12,000 if you're 50 or older--you can't make additional employee contributions to a Simple IRA or another 401(k). But because of nondiscrimination tests, many big company plans prohibit better-paid workers from contributing the full $11,000. If you work for state or local government and have a 401(k)-like plan known as a 457, you can double dip, putting the maximum in both the 457 and a Simple or 401(k). That's what Richard Canada does.

UP TO $40,000

If you want to save more or can't use a Simple, consider a SEP-IRA or a profit-sharing plan. The maximum that can be put in these for 2002 is $40,000, or $41,000 if you're 50 or older and use a profit-sharing plan with a 401(k). You can set up and fund a SEP for 2002 until the due date for your 2002 tax return, including extensions. A profit-sharing plan, also called a profit-sharing Keogh, must be set up by Dec. 31, but need not be funded until you file your return. Both plans are funded by employer contributions of up to 25% of "modified net" earnings. (Translation: If you're an unincorporated sole proprietor, that's 20% of your net after subtracting one-half of your self-employment Social Security and Medicare taxes.)

The long-popular paired Keogh, which combines a profit-sharing plan and a money-purchase plan is now obsolete. If you've got a money-purchase plan, roll it into a profit-sharing plan or a SEP--contributions to both are totally discretionary each year.

Which one is better? A SEP is simpler and doesn't require annual filing of a Form 5500 with the IRS. If a profit-sharing plan has more than $100,000 in assets, or you have employees (other than your spouse), you must file the form. But if you do have employees, the SEP has disadvantages: More part-timers must be covered and there's less flexibility to design the plan to suit your needs. Moreover, in some states a SEP has less protection from creditors.

The key difference, however, is that you can add a 401(k) allowing employee contributions to a profit-sharing plan, but not to a SEP. The new law exempts employee contributions from the 25% of earnings limit applied to employer contributions, making a 401(k) ideal for a self-employed person who doesn't earn a lot, but can save a lot. Using a 401(k) you can defer $40,000 (or $41,000 if you're 50 or older) with only $116,000 in salary if you're incorporated, or $152,300 in earnings if you're not. Without a 401(k) you'll need $160,000 if incorporated and $208,050 as a sole proprietor to reach $40,000. The 401(k)'s advantage is about to grow: The maximum pretax employee contribution will rise $1,000 a year from $11,000 in 2002 to $15,000 in 2006, while the 50-and-up catch-up contribution will rise $1,000 a year from $1,000 in 2002 to $5,000 in 2006. Remember, if you're moonlighting and have a 401(k) at work too, your employee contributions are counted together for that limit.

The 401(k) has another new benefit: You can roll money from deductible IRAs, other 401(k)s or a lump sum pension distribution into your self-employed 401(k) and later borrow up to $50,000 from it, whereas you can't borrow from an IRA. The self-employed 401(k)s in the table can cover your spouse or a partner, and generally must be set up by Dec. 31 and funded by Dec. 31 if you're incorporated, or by the time you file your taxes, if you're not. If you have employees who qualify to be included, you'll need a plan that will cost a bit more in fees. Note: Fidelity's plan doesn't allow loans and uses special "safe harbor" rules that require you to contribute 3% of earnings and, in most cases, to open the account by Oct. 1.

$40,000-PLUS

If you can put away more than $40,000 and are 45 or older, consider a defined-benefit plan. The law allows pretax contributions to these plans sufficient to fund a specific retirement benefit, so the older you are when you start the plan, the more you can put away each year. In 2002 a plan can pay a retiring 62-year-old a pension equivalent to a lump sum of $1.9 million, up from $1.3 million in 2001, calculates Frederick Rumack of Buck Consultants. Equally important for folks who have been funding a defined-contribution plan for years: You can ignore the defined-contribution plan's existing balance in accumulating your $1.9 million.