Retirement Plans for Independent Contractors

If you are an independent contractor, you are on your own for your retirement plan. You don't get the benefit of an employer's human resources department setting everything up for you. You are solely responsible for your own retirement security. Fortunately, Congress recognizes this and has created a number of tax-advantaged retirement plans that work well for independent contractors and owners of small businesses.

Simplified Employer Pension

Remember, as an independent contractor, you are your own employer. As your employer, the Simplified Employer Pension, or SEP, allows you to contribute up to $49,000 per year, or 25 percent of your total compensation, whichever is higher, into a pension plan for yourself, though these limits are also subject to a deduction limit for self-employed individuals. You can also do the same for your employees or a spouse who works for you. Contributions are deductible as a business expense on your Schedule C. Amounts in the plan grow tax deferred, and withdrawals are generally taxed as income. A 10 percent penalty usually applies for withdrawals prior to age 59 and a half except in certain cases of hardship.

Deduction Limit for the Self-Employed

If you are self-employed, you must account for your own Social Security tax, or self-employment tax contributions when figuring your total income. Use the rate table for self-employed individuals published by the IRS to figure your allowable contribution, net of Social Security tax. The worksheet and tables are published in Chapter 5 of IRS Publication 560 — Retirement Plans for Small Business.

Solo 401k Plans

A solo 401k plan is a special kind of 401k plan designed for sole proprietors and independent contractors. The administrative requirements for these plans are streamlined, and costs are lower than they generally are for conventional 401k plans. These plans are taxed similarly to SEP plans, but provide additional protection from creditors. Sole proprietors can contribute up to $16,500 plus 20 percent of business income, capped at $49,000 per year. If you are the owner-employee of your own corporation, the limit is 25 percent of yearly salary. Taxpayers over age 50 can contribute up to $22,000, plus 20 percent of their earnings, capped at $54,500.

Defined Benefit Plans

A defined benefit plan, such as a Section 412i plan, is designed to provide a specific retirement income benefit — often calculated as a percentage of your final year's income. The disadvantages of these plans is that they involve significant set-up costs. You must hire an actuary to help you figure required contributions — contributions are mandatory once you set up the plan. However, for those contractors making significant income, with steady, reliable streams of income, these plans allow them to take large tax deductions and set aside substantial amounts of money on a tax-advantaged basis. 412i plans can only be established with a life insurance company, and provide a guaranteed retirement benefit, provided the plan sponsor makes the required contributions.