Disclaimer: Information contained below was accurate as of the date of publication. Due to frequent tax law changes, information may no longer be accurate. For the latest tax information, please contact a member CPA.

RETIREMENT PLANS FOR THE SELF-EMPLOYED

by Andrew D. Schwartz, CPA

Contributing to a retirement plan is one of the best tax shelters available to you during your working years.  The money contributed generally saves you taxes today and always grows tax deferred. 

Plus, with the future of social security up in the air and traditional corporate pension plans on the path towards extinction, contributing to a retirement plan provides some peace of mind that you'll be able to retire comfortably.

Self-Employed Retirement Plans

When you're an employee at a company, you have two options.  Start by taking advantage of whatever retirement plan your employer offers, such as a 401k or 403b plan.  You also have the option of contributing to a traditional IRA or Roth IRA each year that you or your spouse has "earned income", subject to certain limitations. 

When you're self-employed, it's up to you to establish and fund a retirement plan for your business.  The three most popular plans are SEP IRAs, SIMPLE IRAs, and Solo 401ks.  Contributions into all these plans (except the new Roth 401k) reduce your Adjusted Gross Income (AGI) and grow tax-deferred.

What if you work for a business that provides you with access to a retirement plan, and then you do some moonlighting or consulting on the side?  Each year, you're allowed to make tax deductible contributions into a SEP, SIMPLE or Sole 401k based on your net self-employment income, even if you're covered under another employer's retirement plan.

Let's compare these three self-employed retirement plans, assuming your business is an unincorporated entity.

Maximum Contribution For Self-Employed Individuals Under the Age of 50

SEP IRA

SEPs are a very user friendly retirement savings option.  Each year that you have self-employment income, you can contribute as much as 20% of your net self-employment income into your SEP.  On $50,000 of income, you could make pre-tax contributions of up to $10,000 into your SEP.

The due date for establishing a SEP is the due date of your tax return, including extensions.   So if you filed an extension request on April 15th, you have until October 15th to establish and fund a SEP for 2005.

Establishing and maintaining a SEP requires very little paperwork.  The only costs associated with these plans are the fees charged by the mutual fund company or the plan's financial advisor.  And with a SEP, there is never a requirement to file a tax form for the plan with the IRS.

SIMPLE IRA

SIMPLE IRAs are a scaled down version of a 401k plan.  With a SIMPLE, your contribution consists of two components.  First, you can make "deferral" contributions of the lesser of your net self-employment income or $10,000 ($12,500 if 50 or older).  You'll also contribute either 2% or 3% of your net income, not to exceed the amount of your deferral.  On $50,000 of income, you can contribute up to $11,500 into your SIMPLE.

The due date for establishing a SIMPLE is October 1st of the first year of the plan.  And like SEPs, there is very little paperwork required to set up or maintain the plan, no fees except those charged by the fund company or your financial advisor, and no annual filing requirements with the IRS.

Keep in mind that the amount you can contribute into your SIMPLE may be limited if you participate in a 401k or 403b plan through another employer.  For 2006, your total "deferrals" through all your plans generally can't exceed $15,000 ($20,000 if 50 or older).  So if you contribute $12,000 into your employer's 401k plan, your SIMPLE contribution would be limited to $6,000 - $3,000 in deferrals plus 3% of your income, not to exceed your $3,000 deferral.

Solo 401k

Solo 401k's gained popularity thanks to the 2001 Tax Act.  Under the current rules, you can contribute up to $15,000 ($20,000 if 50 or older) plus 20% of your net self-employment earnings into these pre-tax accounts.  On $50,000 of self-employment income, you could sock away a whopping $25,000 into your Solo 401k.

You're only eligible to take advantage of this type plan if you have no employees who work for you more than 1,000 hours per year besides your spouse.  The due date for establishing a Solo 401k is December 31st of the plan's first year.   And like the SIMPLE, the $15,000 of deferrals is reduced if you contribute to another employer's 401k or 403b plan.

Expect the administrative burden and fees associated with Solo 401k's to exceed those of the other plans.  And once plan assets exceed $100,000, you're required to file a Form 5500EZ annually with the IRS.

What If You Have Employees?

When you have staff, if you contribute to your own retirement account, you're generally required to make equivalent contributions on behalf of your eligible employees.  What determines eligibility?

• For a SEP, an eligible employee is someone who earns more than $450 from you in three successive years. 

• For a SIMPLE, an employee who earned at least $5,000 from you during either of the prior two years, and is reasonably expected to earn $5,000 from you in this calendar year, becomes eligible.

• For the 401k, eligibility begins once someone works for you at least 1,000 hours and for a period of twelve months.

With a SEP, if you want to max out your annual contributions, expect to contribute 25% of your eligible employees' W-2 wages into their SEP accounts as well. 

With a SIMPLE or a 401k plan, the salary deferrals come out of your employees' pocket.  Your only requirement is to make the matching contributions and any additional profit sharing plan contributions on behalf of your staff.  Many self-employed individuals with staff end up migrating towards either of these two plans.

One drawback of SEPs and SIMPLEs is that they don't allow for "vesting schedules".  With a more sophisticated plan like the 401k plan, your employees forfeit a portion of the profit sharing plan contributions made on their behalf if they stop working for you.  For most plans, an employee won't be fully vested until after completing six years of service.

Once you have staff, choosing the correct plan for your business becomes much more difficult.  Make sure to seek the advice of your CPA or financial advisor, or contact one our affiliated CPAs.

Summary of Self-Employed Retirement Plans- 2006 Rules

Other Options

Here are a few other pre-tax retirement savings plans available to self-employed individuals.

With a Defined Benefit Plan (DB), the annual contribution is significantly larger than most other plans since it is based on how much money you need to set aside today to fund an income stream when you retire.  While these plans allow for very substantial contributions, be aware that they lock you into making large contributions each year you have self-employment income.  Plus, DBs are expensive to set up and maintain, and may require substantial contributions on behalf of your eligible staff.

Keogh plans are another option available to self-employed individuals.  Keoghs aren't as popular as they once were, since the 2001 Tax Act increased the amount you can now contribute into a SEP.  Even so, Keoghs offer some options not available with SEPs, including vesting schedules for contributions made on behalf of your staff.  And if you have staff, Keoghs may offer more protection from your creditors than a SEP or SIMPLE.

Pick One

Like most decisions in connection with your personal finances, the worst decision you can make is to put off making a decision.  The sooner you start saving for your retirement, the better off you'll be.

Take some time now to determine which plan makes the most sense for you, complete the necessary paperwork to set up that plan, and get on track to max out your allowable contributions for 2006.

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HOW'S YOUR FICO?

by Andrew D. Schwartz, CPA

Blood pressure, pulse, good cholesterol, bad cholesterol, and your weight are all risk factors for heart disease monitored by your doctor.  How come your doctor never takes a look at your FICO score as well?

Your FICO score is what lenders use to determine your creditworthiness.  Potential employers and landlords may also get a hold of your FICO score before deciding to deal with you.  Like your SAT score, the higher your FICO, the more attractive you'll be. 

How Is Your FICO Score Calculated?

According to our friends at www.myFICO.com , the FICO score for most people is calculated on the weighted average of these five attributes:

• Payment History - weight 35%:  Factors in your payment history on various types of accounts (mortgages, installment loans, credit cards, and retail accounts), as well as past due amounts, and adverse public records.

• Amounts Owed - weight 30%:  Factors in the number of your outstanding accounts, the total amount owed on those accounts, and the amounts currently outstanding as compared with either your total available credit or, for installment loans, the initial balance.

• Length of Credit History - weight 15%:  Factors in the how long your accounts have been open, and how long since there has been any activity within those accounts.

• New Credit - weight 10%:  Factors in new accounts that have been opened, as well as the frequency of recent credit inquiries.  

• Types of Credit Used - weight 10%: Factors in the number of mortgages, installment loans, credit cards, and retail accounts you have.

Steps To Improve Your FICO

Since your FICO impacts many aspects of your financial life, what steps can you take to improve your FICO score?

Start by taking a look at your credit report on a regular basis, since the information on your credit report is used to generate your FICO score.  You're now allowed to get three free credit reports per year - one from each of the credit reporting agencies - at www.annualcreditreport.com.  

Here are some other suggestions from www.myFICO.com :

• Stay current with your bills.  If you've fallen behind, get up to date as soon as possible.  Don't forget that your payment history accounts for more than one-third of your FICO score.

• Avoid maxing out your credit cards, since owing a high percentage of your available credit reduces your FICO score.

• Be careful opening new credit cards, since too much available credit impacts your FICO score. 

• When comparing available installment loan opportunities, keep in mind that multiple inquiries in a short period of time are generally grouped together as one inquiry when calculating your FICO.

Manage Your Debt

In today's world, very few people have the savings or the disposable income to be able to "pay as you go". Credit cards, mortgage debt, and installment loans are essential to most young professionals. 

Take the steps now to keep your FICO score healthy.  By doing so, you should have easier access to less expensive credit.

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TAX AND FINANCIAL PLANNING CALENDAR FOR JULY, 2006

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2005 & 2006 TAX FACTS

• For 2005, the standard deduction for a single individual is $5,000 and for a married couple is $10,000. A person will benefit by itemizing once allowable deductions exceed the applicable standard deduction. Itemized deductions include state and local income taxes (or sales taxes), real estate taxes, mortgage interest, charitable contributions, and unreimbursed employee business expenses.
• For 2005, the personal exemption is $3,200. Individuals will claim a personal deduction for themselves, their spouse, and their dependents. 
  
• The maximum earnings subject to social security taxes is $94,200 for 2006, up from $90,000 in 2005.
  
• The standard mileage rate is $.485 per business mile as of September 1, 2005 (after being $.405 per mile through August 31, 2005), and will then be $.445 per mile for 2006.
  
• The maximum annual contribution into a 401(k) plan or a 403(b) plan is $15,000 for 2006.  And if you'll be 50 or older by December 31, 2006, you can contribute an extra $5,000 into your 401(k) or 403(b) account this year.
• The maximum annual contribution to your IRA is $4,000 for 2006.  And if you turn 50 by December 31st, you can contribute an extra $1,000 for 2006.  You have until April 15, 2007 to make your 2006 IRA contributions. 

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