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Saving and the self-employed Featured

9:38am EDT July 22, 2002

Self-employed individuals make up the fastest-growing segment of the business community.

Unfortunately, many self-employed entrepreneurs believe that, because they are on their own, they don't have access to retirement plans. They don't realize they have access to a variety of plans to shelter income for their retirement. Most have limits, but they far exceed the limits for IRAs.

Defined-contribution plans

These plans, known as profit-sharing plans and money purchase pension plans, can cover the self-employed person as well as incorporated businesses. With a profit-sharing plan, you can contribute as much as 15 percent of your first $170,000 of compensation in the year 2000.

For money purchase pension plans, you can contribute as much as 25 percent of your first $170,000 of compensation in 2000. Businesses can have both types of plans, but participants, including owners, can contribute no more than $30,000.

With a money purchase pension plan, you must make contributions every year. With a profit-sharing plan, the contributions are at your discretion. Therefore, many self-employed people establish both types of plans.

However, they typically make maximum contributions to the profit-sharing plan (contributions are optional if the business gets in financial trouble) and minimal contributions to the pension plan -- but enough to maximize the $30,000 contribution.

SEP plans

Under a Simplified Employee Pension (SEP) plan, those of you who employ others can contribute toward your employees' retirement. You simply have each employee establish an IRA wherever he or she would like. SEP rules allow you to make yearly maximum contributions of up to 15 percent of an employee's compensation or $30,000, whichever is lower, to a SEP-IRA for each participating employee. You then can use these contributions as a tax deduction.

As with a profit-sharing plan, it's not mandatory to contribute to your employees' SEP-IRAs, but if there are contributions, they must be based on a written allocation formula and cannot favor highly compensated employees. After the contribution is made to the SEP IRA for each employee, the rules for traditional IRAs apply.

If you're self-employed, you have to consider special rules when calculating the maximum deduction for contributions. According to the IRS, your limit is equal to your net earnings. The IRS provides a worksheet in Pub. 590, chapter 4, that can help you make these calculations.

SIMPLE plans

Savings Incentive Match Plans for Employees (SIMPLE) cover employers with 100 or fewer employees. Retirement accounts under this plan can be set up as a 401(k) SIMPLE plan or a SIMPLE IRA plan.

Under a SIMPLE IRA plan, employees can choose to reduce their pay a certain percentage each pay period and allow the employer to contribute that amount to the IRA. You also can make matching contributions of up to 3 percent of salary to only those employees who participate by reducing their salaries or nonelective contributions of up to 2 percent of salary to all eligible employees, regardless of whether they participate by making elective salary contributions.

To be eligible, employees must earn at least $5,000 during any two years prior to the current year and expect to earn at least that much during the current year. Maximum elective contributions, adjusted for cost-of-living increases, are $6,000 for employee-deductible deferrals. With a matching employer contribution, the total potential contribution to a SIMPLE-IRA could be $12,000 a year for the most highly compensated employees.

A 401(k) SIMPLE plan is merely a qualified 401(k) plan that adopts some of the SIMPLE rules to satisfy annual nondiscrimination tests. Louis P. Stanasolovich, named one of the best financial advisers in America the last four years by Worth magazine, is founder and president of Legend Financial Advisors, Inc., a fee-only financial advisory firm located in the North Hills. Reach him at (412) 635-9210. The firm's Web site is www.legend-financial.com.