There's still enough time to stash away some of your 1990
self-employment earnings in a tax-deferred retirement account, that
great perquisite of the independent business person.
Gary Lesser, a New York City attorney who specializes in benefits consulting for small- to medium-size businesses, points out that Keogh and simplified employee pension (SEP) retirement accounts can provide great advantages for people who own corporations or partnerships, or are sole proprietors (even if only part-time), but that too many entrepreneurs are turned off by the legal jargon and administrative burdens and complexities that accompany those plans. There's no need to be. Let's cut through the jargon to get at what you need to know.
SEPs and Keoghs are the best financial perks available. It's very profitable to build your nest egg with pretax dollars. In the 28 percent bracket, you'll save $280 in federal taxes alone for every $1,000 you invest in a retirement plan. And as the money builds up tax-deferred, it really makes a difference: T. Rowe Price, a Baltimore mutual-fund company, estimates that if you save $2,000 a year in a tax-deferred account earning 8 percent, you'll have $12,671 in five years and $244,691 in 30 years. If you had been taxed on the interest at the 28 percent margin, you would have only $8,079 after five years and just $109,148 after 30 years.
Keoghs and SEPs are typically better than IRAs. After the Tax Reform Act of 1986, most Americans lost their eligibility for tax-defeffed individual retirement accounts. Even if you still qualify for a tax-deferred IRA (which means you are covered by no other pension plan, even through a spouse, and that you earn less than $25,000 as a single taxpayer or $40,000 as a couple), you can shelter more retirement savings in a Keogh or SEP, also called a SEP-IRA.
A SEP plan is simpler than a Keogh. A SEP works just like an
individual retirement account, except that its eligibility requirements
aren't restricted the way standard IRAs' are. There are no requirements
that you continue contributing to a SEP or that you contribute at all
during lean years. You can establish a SEP even if your spouse is
covered by a pension plan. Even if you have your own pension plan from a
regular job, you can set up a SEP for your self-employed earnings. You
can't do that with a regular IRA. You can set up a SEP-IRA simply by
going to a bank, mutual-fund company, or brokerage house and filling out
one form.
Here's where the government requirements come in: Every year, you are allowed to deduct SEP-IRA deposits of up to 15 percent of your taxable business income after adding back in half of your self-employment tax, but after subtracting the SEP deposit. That means you have to know how much you're going to contribute before you can calculate your contribution. There's a basic calculation that will handle that for you, and it comes down to this: You can deduct contributions of up to 13.0434 percent of your taxable business income every year, after you add back in half of your self-employment tax. If the bottom line on your schedule C is $50,000, your self-employment tax is $7,650 in 1990. Add half of that back in, for a total of $53,825, and multiply it by 0.130434. The result, $7,020, is your allowable SEP-IRA contribution. Your yearly contribution cannot exceed $30,000.
Keoghs are more complicated than SEPs, but potentially more profitable. Keoghs are established under different IRS standards that require a higher level of setup documentation than for SEPs and thus are more complicated. Still, any good bank, brokerage, or mutual-fund company should be able to guide you through the forms if you decide to establish a Keogh. And last year the IRS eased the annual reporting requirement on Keoghs-now you have to report on your plan annually only if it has amassed more than $100,000.
One advantage of Keoghs over SEPs is an income-averaging provision for withdrawal of the funds at retirement. If you retire at 59 1/2 and withdraw a sum from your Keogh account, you don't have to pay tax on it all at once-you can average it as income over five years (or 10 years if you were 50 years old before January 1986), which reduces your tax liabilities. With a SEP, you would have to pay tax on the entire withdrawal in the year you took the money out. However, with either plan you can spread out the tax burden by making withdrawals gradually throughout your retirement.
There are two types of Keogh plans--one's more flexible, the other allows bigger deductions. When you open your Keogh account, you need to decide which type of plan you want: profit-sharing or money-purchase. Profit-sharing Keogh plans give you flexibility. You can contribute as much or as little as you want every year, as long as you stay below the maximums, which are the same as the SEP limits: 13.0434 percent of your taxable business income, after adding to your income half of your self-employment tax, with contributions not to exceed $30,000. With a profit-sharing Keogh, you don't have to put anything at all into the plan if you don't want to.
Money-purchase plans eliminate that flexibility but let you deduct a larger percentage of your earnings-up to 25 percent of your net business income after including half the self-employment tax and, again, after subtracting your Keogh contribution. That comes to 20 percent of your taxable income plus half of your self-employment tax. With a $50,000 net business income, your money-purchase contribution would be $10,765. You still can't exceed $30,000, so if your income is approaching the $230,000 mark, there's no advantage to the money-purchase plan; you'll hit the $30,000 limit at 13.02 percent.
Money-purchase plans make you decide up front what percentage your contribution will be and stick with it during fat and lean years. If you set up a money-purchase plan, you can't decide to skip a year, or the account could lose its eligibility as a tax-deferred plan, and you would suffer hefty penalties by the IRS.
Combining plans often increases flexibility and ids you make a larger contribution. Set up a money-purchase Keogh with a regular 10 percent contribution and you are still free to set up a SEP-IRA or Keogh profit-sharing plan (or both) for up to an additional 15 percent of your income. Of course, those figures are also subject to the same convoluted calculation-where you have to reduce your qualifying income by the intended contribution to figure out the maximum allowable contribution-so the two plans together would come out to 20 percent of your net income after you've reduced it by half of your self-employment tax. Attorney Gary Lesser calculates that the maximum contribution for a year in which you earned $50,000 would be $3,694 for the money-purchase Keogh and $5,541 for the profit-sharing plan.
That combination of plans gives you the maximum leeway to contribute as much as possible but still refrain from locking into a money-purchase plan at a 25 percent contribution.
You can make contributions (and even set up a SEP) after the tax year is over. You have to establish a Keogh before the end of the fiscal year-for most small businesses, that means the end of the calendar year. However, you have until your tax-return due date-April 15 if you are unincorporated and don't file for extensions-to set up your SEP-IRA for 1990. If you are incorporated and on a calendar-year basis, your tax-return due date is March 15.
If you already have a retirement plan, remember: You can make 1990 contributions to your Keogh or SEP until the date your tax return is due.
If you hire employees, you'll have to cover them with your Keogh or SEP. Now your financial life gets much more complicated, because you may find that your new employees are eligible for a plan you thought you were setting up just for yourself.
If your company grows from a one-person shop to a business with employees, it's unlikely that the same retirement plan that worked for you in the past will work in the future. If you established a plan when you were your company's sole employee and then began hiring others, it is often best to terminate your current plan and draw up a new one with employees in mind.
SEPs let you defer coverage on new employees until they have worked in three of the preceding five years, but then the employees are fully vested, and you must contribute to their plans just as you do your own. Under a Keogh, you can defer employees' participation until they have completed 1,000 hours of service in one year (about 20 hours a week) and then phase in a graduated vesting schedule. These are considerations that must be checked off on the plan contract when the plan is established.
There are a few ways to get at your money. Once you hit age 59 1/2, you can begin taking money out of your retirement account without paying a penalty, even if you are still working. But you will be taxed on the withdrawal as part of your income tax. Once you've turned 70 1/2, you must start to withdraw the money and pay tax on it, even if you aren't retired, don't need it, and would rather keep it socked away in its tax-deferred account.
Since Keoghs and SEPs are legally established retirement accounts, you usually can't withdraw your money before you are 59 1/2 without paying a 10 percent penalty as well as the income tax due that year on the amount of the withdrawal. You can take the money out before then and avoid the penalty if you withdraw it in small, regular amounts calculated to last your lifetime (like an annuity). In that case, you still pay the income tax on the withdrawal annually.
The compounding benefits of saving money tax-deferred are so great that even if you build up your account for 10 years or so and then decide to pull the money out to send your kids to college or for some other reason, you cab end up with more money after paying taxes and a 10 percent penalty than you would have had before.
Let's look at another T. Rowe Price estimate: If you save $2,000 every year for 20 years in a tax-deferred 8 percent account, you will accumulate $98,844. Subtract the 28 percent income tax (which you would have paid anyway) and the 10 percent early-withdrawal penalty, and you're left with $61,283. That's still several thousand dollars better than the $54,598 you would have built up in a taxable account at the same 8 percent interest rate.
Gary Lesser, a New York City attorney who specializes in benefits consulting for small- to medium-size businesses, points out that Keogh and simplified employee pension (SEP) retirement accounts can provide great advantages for people who own corporations or partnerships, or are sole proprietors (even if only part-time), but that too many entrepreneurs are turned off by the legal jargon and administrative burdens and complexities that accompany those plans. There's no need to be. Let's cut through the jargon to get at what you need to know.
SEPs and Keoghs are the best financial perks available. It's very profitable to build your nest egg with pretax dollars. In the 28 percent bracket, you'll save $280 in federal taxes alone for every $1,000 you invest in a retirement plan. And as the money builds up tax-deferred, it really makes a difference: T. Rowe Price, a Baltimore mutual-fund company, estimates that if you save $2,000 a year in a tax-deferred account earning 8 percent, you'll have $12,671 in five years and $244,691 in 30 years. If you had been taxed on the interest at the 28 percent margin, you would have only $8,079 after five years and just $109,148 after 30 years.
Keoghs and SEPs are typically better than IRAs. After the Tax Reform Act of 1986, most Americans lost their eligibility for tax-defeffed individual retirement accounts. Even if you still qualify for a tax-deferred IRA (which means you are covered by no other pension plan, even through a spouse, and that you earn less than $25,000 as a single taxpayer or $40,000 as a couple), you can shelter more retirement savings in a Keogh or SEP, also called a SEP-IRA.
Here's where the government requirements come in: Every year, you are allowed to deduct SEP-IRA deposits of up to 15 percent of your taxable business income after adding back in half of your self-employment tax, but after subtracting the SEP deposit. That means you have to know how much you're going to contribute before you can calculate your contribution. There's a basic calculation that will handle that for you, and it comes down to this: You can deduct contributions of up to 13.0434 percent of your taxable business income every year, after you add back in half of your self-employment tax. If the bottom line on your schedule C is $50,000, your self-employment tax is $7,650 in 1990. Add half of that back in, for a total of $53,825, and multiply it by 0.130434. The result, $7,020, is your allowable SEP-IRA contribution. Your yearly contribution cannot exceed $30,000.
Keoghs are more complicated than SEPs, but potentially more profitable. Keoghs are established under different IRS standards that require a higher level of setup documentation than for SEPs and thus are more complicated. Still, any good bank, brokerage, or mutual-fund company should be able to guide you through the forms if you decide to establish a Keogh. And last year the IRS eased the annual reporting requirement on Keoghs-now you have to report on your plan annually only if it has amassed more than $100,000.
One advantage of Keoghs over SEPs is an income-averaging provision for withdrawal of the funds at retirement. If you retire at 59 1/2 and withdraw a sum from your Keogh account, you don't have to pay tax on it all at once-you can average it as income over five years (or 10 years if you were 50 years old before January 1986), which reduces your tax liabilities. With a SEP, you would have to pay tax on the entire withdrawal in the year you took the money out. However, with either plan you can spread out the tax burden by making withdrawals gradually throughout your retirement.
There are two types of Keogh plans--one's more flexible, the other allows bigger deductions. When you open your Keogh account, you need to decide which type of plan you want: profit-sharing or money-purchase. Profit-sharing Keogh plans give you flexibility. You can contribute as much or as little as you want every year, as long as you stay below the maximums, which are the same as the SEP limits: 13.0434 percent of your taxable business income, after adding to your income half of your self-employment tax, with contributions not to exceed $30,000. With a profit-sharing Keogh, you don't have to put anything at all into the plan if you don't want to.
Money-purchase plans eliminate that flexibility but let you deduct a larger percentage of your earnings-up to 25 percent of your net business income after including half the self-employment tax and, again, after subtracting your Keogh contribution. That comes to 20 percent of your taxable income plus half of your self-employment tax. With a $50,000 net business income, your money-purchase contribution would be $10,765. You still can't exceed $30,000, so if your income is approaching the $230,000 mark, there's no advantage to the money-purchase plan; you'll hit the $30,000 limit at 13.02 percent.
Money-purchase plans make you decide up front what percentage your contribution will be and stick with it during fat and lean years. If you set up a money-purchase plan, you can't decide to skip a year, or the account could lose its eligibility as a tax-deferred plan, and you would suffer hefty penalties by the IRS.
Combining plans often increases flexibility and ids you make a larger contribution. Set up a money-purchase Keogh with a regular 10 percent contribution and you are still free to set up a SEP-IRA or Keogh profit-sharing plan (or both) for up to an additional 15 percent of your income. Of course, those figures are also subject to the same convoluted calculation-where you have to reduce your qualifying income by the intended contribution to figure out the maximum allowable contribution-so the two plans together would come out to 20 percent of your net income after you've reduced it by half of your self-employment tax. Attorney Gary Lesser calculates that the maximum contribution for a year in which you earned $50,000 would be $3,694 for the money-purchase Keogh and $5,541 for the profit-sharing plan.
That combination of plans gives you the maximum leeway to contribute as much as possible but still refrain from locking into a money-purchase plan at a 25 percent contribution.
You can make contributions (and even set up a SEP) after the tax year is over. You have to establish a Keogh before the end of the fiscal year-for most small businesses, that means the end of the calendar year. However, you have until your tax-return due date-April 15 if you are unincorporated and don't file for extensions-to set up your SEP-IRA for 1990. If you are incorporated and on a calendar-year basis, your tax-return due date is March 15.
If you already have a retirement plan, remember: You can make 1990 contributions to your Keogh or SEP until the date your tax return is due.
If you hire employees, you'll have to cover them with your Keogh or SEP. Now your financial life gets much more complicated, because you may find that your new employees are eligible for a plan you thought you were setting up just for yourself.
If your company grows from a one-person shop to a business with employees, it's unlikely that the same retirement plan that worked for you in the past will work in the future. If you established a plan when you were your company's sole employee and then began hiring others, it is often best to terminate your current plan and draw up a new one with employees in mind.
SEPs let you defer coverage on new employees until they have worked in three of the preceding five years, but then the employees are fully vested, and you must contribute to their plans just as you do your own. Under a Keogh, you can defer employees' participation until they have completed 1,000 hours of service in one year (about 20 hours a week) and then phase in a graduated vesting schedule. These are considerations that must be checked off on the plan contract when the plan is established.
There are a few ways to get at your money. Once you hit age 59 1/2, you can begin taking money out of your retirement account without paying a penalty, even if you are still working. But you will be taxed on the withdrawal as part of your income tax. Once you've turned 70 1/2, you must start to withdraw the money and pay tax on it, even if you aren't retired, don't need it, and would rather keep it socked away in its tax-deferred account.
Since Keoghs and SEPs are legally established retirement accounts, you usually can't withdraw your money before you are 59 1/2 without paying a 10 percent penalty as well as the income tax due that year on the amount of the withdrawal. You can take the money out before then and avoid the penalty if you withdraw it in small, regular amounts calculated to last your lifetime (like an annuity). In that case, you still pay the income tax on the withdrawal annually.
The compounding benefits of saving money tax-deferred are so great that even if you build up your account for 10 years or so and then decide to pull the money out to send your kids to college or for some other reason, you cab end up with more money after paying taxes and a 10 percent penalty than you would have had before.
Let's look at another T. Rowe Price estimate: If you save $2,000 every year for 20 years in a tax-deferred 8 percent account, you will accumulate $98,844. Subtract the 28 percent income tax (which you would have paid anyway) and the 10 percent early-withdrawal penalty, and you're left with $61,283. That's still several thousand dollars better than the $54,598 you would have built up in a taxable account at the same 8 percent interest rate.
No comments:
Post a Comment