Situation: One of your clients wants to make a retirement plan contribution before filing his tax return. He has salary from his job and some self-employment income from a side business.
Situation: One of your clients wants to make a retirement plan contribution before filing his tax return. He has salary from his job and some self-employment income from a side business. His wife also works and has salary income. He has heard about Keogh plans, simplified employee pension plans and even Roth individual retirement accounts but wants some help deciding which one is right for him. He participates in his employer’s 401(k) plan.
Solution: First, let’s determine which plans are appropriate for the client. The most common type of plan for individuals with self-employment income is the SEP (also known as SEP IRA). There are other choices, including individual 401(k), savings incentive match plan for employees (Simple) and qualified plans (Keoghs), but they are more complicated. Generally, if an individual has self-employment income and no employees, the SEP will be the preferred choice of retirement plan.
The SEP can be established and funded anytime before the income tax return is filed. The maximum contribution to the SEP is 25% of self-employment income net of the SEP contribution and income tax deduction for one-half of self-employment tax. This algebraic formula results in a contribution equal to 20% of self-employment income net of the deduction for self-employment tax. The overall maximum contribution to retirement plans is $46,000 for 2008 ($49,000 for 2009). The cap is important since the client will have contributions to a SEP and an employer-provided plan. If the client was at least 50 in 2008, he can add $5,000 as a “catch-up” contribution. For additional information regarding retirement plans for small businesses, see IRS Publication 560 at irs.gov.
The client can establish and fund IRAs for himself and his working spouse in addition to the above contributions. The maximum contribution is $5,000 ($6,000 if 50) for each person. Since the client contributes to his employer’s retirement plan, the contribution will not be deductible unless the married couple’s adjusted gross income is less than $63,000. Assuming that the couple’s income exceeds this amount, and thus the contribution is not deductible, they should consider the Roth IRA alternative. Although the Roth IRA contribution is not deductible, the earnings are not taxable. This is a tremendous benefit. In addition, distributions are not required from a Roth IRA during the owner’s lifetime. Thus, the tax-free growth of a Roth IRA can benefit future generations.
Individuals may contribute to a Roth IRA only if income is below certain limits. For a married couple filing jointly, the limit is $169,000 for 2008. For further information on Roth IRAs and traditional IRAs, see IRS Publication 590.
Which is better?
Let’s assume that your client has a choice of contributing $12,000 to a SEP (based on his self-employment income) or $12,000 to Roth IRAs for his wife and himself. Which is a better choice? If the contribution is made just once, the difference in net worth is not significant over the client’s life expectancy. However, if the client contributes $12,000 annually for six years, net worth in 50 years is about $100,000 higher in the SEP scenario. When income and estate taxes (including the income in respect of the decedent, or IRD, deduction) are considered, the Roth IRA scenario wins by about $65,000. These differences are not substantial over the time period.
The compelling lesson here is that doing something helps. Contributing $12,000 a year to a Roth IRA for six years increased net worth by $200,000 in just 20 years, as compared with doing nothing. Also interesting is that the six contributions of $12,000 into the Roth IRA resulted in an asset worth of over $2 million in 50 years (assuming an 8% rate of return).
Lisa Featherngil is the director of financial and estate planning for the Winston-Salem, N.C., and Palm Beach, Fla., offices of Calibre, a multifamily office of Wachovia Corp. of Charlotte, N.C.
