Traditional IRA vs. SEP IRA for the self-employed

For the self-employed, a solid retirement plan means more than wishful thinking. A sure path to disappointment is hoping for a big inheritance or a winning lottery ticket.

In reality, the basics of retirement savings are simple enough. Save, save, and save some more. The more you save, and the earlier you begin saving, the bigger your retirement nest egg will be. One of the first steps is to set up an IRA.

A definition of retirement acronyms

At its most basic, an IRA is an individual retirement account. A small business owner puts money into it each year to have income in retirement. The more you put into your account, the more money you should have upon retirement.

There are several types of IRAs. You might ask, What's a SEP-IRA? The three most common IRAs are as follows:

• A traditional pre-tax IRA. This is the most common IRA and has been around the longest. You put money into this account from your job and do not pay taxes on that amount. When you withdraw the money, though, you must pay taxes.
• A Roth IRA. This works in much the same way, only the money you contribute to your account is taxed as ordinary income. The big advantage is when you withdraw the money it is all tax-free. Even what you have earned on the money is tax-free.
• A SEP-IRA. This is also known as the Simplified Employee Pension plan. In many ways, it is set up as a regular IRA, but there are some differences.

In most cases, the first two IRAs above are only available through employer work plans. The important question for small business owners is, what's better for the self-employed?

The advantages of a SEP-IRA for the self-employed

A few important rules apply to a person or small business owner setting up a SEP-IRA. The biggest is that employers must contribute the same amount to each employee's account. So, if the business owner has 15 employees, each one must get a retirement contribution. This plan works best for a person who is self-employed with his or her own business.

The benefits of this plan are many, and include the following:

• The plan is easy to set up and administer
• It allows for much higher contribution limits than a traditional IRA
• It offers greater flexibility than a traditional IRA because yearly contributions are not required
• Contributions are tax-deductible

There are a few disadvantages to this program. There is no option for a Roth version of this plan. This limits your ability to control your tax load in retirement. Most of the other negatives of the plan are the same as those of a traditional IRA. These include the inability to withdraw funds before age 59 without a penalty, and required minimum distributions at age 70 .

Once you have begun to fund your SEP-IRA, you need to come up with a plan for your money. In other words, you must decide how to invest the money in your account. This will depend upon your personality and how far away you are from retirement.

At one extreme is the person who puts all their money into stocks. When the market is up, the account will grow quickly. When the market is down, though, large losses could occur. Most people go for a mix of stocks, bonds and cash, which tempers market fluctuations.

Other retirement options for the self-employed

If you don't love the SEP-IRA option, you might wonder what other options exist for the self-employed. The most appealing of these other options might be the individual 401(k) plan. It is also known as the solo 401(k). This plan actually allows you to contribute more money to the account. It also allows for catch-up contributions for those over age 50.

A final consideration is how you handle Social Security. If you can defer taking monthly payments until age 70 you will get a larger amount each month. In most cases, this can result in a larger benefit for those who live over 80 years of age.

To get the most out of Social Security, the self-employed should report all earned income. Failure to do so may result in a reduced Social Security benefit.

The importance of financial planning

A retirement plan is one of the financial foundations for the successful self-employed. It can mean the difference between a difficult retirement and one where you are soaking up the sun on the beach.