Which Options Should I Consider First?
The most popular plan and the easiest to run (and, therefore, the one you'll likely consider right off the bat) is the SEP-IRA. It's run on an IRA platform, which means the application is often the same as a Traditional or Roth IRA application and is easy to complete. The plan can be used for one-person operations or for businesses with multiple employees. You can set up a SEP at virtually any financial institution that offers an IRA. As far as contribution limits go, you can jam 25% of your compensation, up to $42,000 for 2005 and $44,000 for 2006, in a SEP. The contributions are tax-deductible for the business owner, but not for employees. All accounts (employer and employee) are tax-deferred and function like other IRAs, with mandatory distributions beginning at age 70 1/2.
Second, if you're a one-person business (or one-person plus your spouse), you'll also want to consider the "self-employed" 401(k), because it could potentially allow you to contribute more than the SEP. Like the SEP-IRA, the self-employed 401(k) enables a business owner to make contributions on his or her own behalf and on behalf of a spouse. But the self-employed 401(k) also includes a salary deferral component, allowing a self-employed person and a spouse to each defer up to $15,000 of his or her salary in addition to employer contributions. Although you cannot stash more than $44,000 in a Self-Employed 401(k) for 2006, the salary deferral component of this plan can allow you to save significantly more money in a tax-deferred account than you would with the SEP. For example, if $20,000 represents 25% of your profits (or your maximum contribution limit both for this plan and the SEP-IRA), you can add $15,000 to that in salary deferral, making your total employer's contribution and salary deferral a total of $35,000. This is more than you'd be able to save on a tax-deferred basis with a SEP-IRA on the same income. All contributions are tax-deductible either personally or to the business, depending on whether the business is incorporated or not.
Additionally, if you're age 50 or older, a Self-Employed 401(k) boosts the contribution limit from $44,000 to $49,000 and the salary deferral limit from $15,000 to $20,000. This can be helpful if you've gotten a late start on retirement savings and need to start socking away as much as possible.
As is the case with SEP-IRAs, self-employed 401(k)s are also generally inexpensive to maintain, relatively easy to administer, and you can invest your assets across a broad array of different options. However, they do require filing the IRS Form 5500 when plan assets exceed $100,000.
We should also note that the deadline for opening a self-employed 401(k) and making a contribution for 2005 was Dec. 31, 2005. So if you started your business in 2005, and haven't started a retirement plan yet, you may want to open a SEP-IRA for 2005, and then consider whether a 401(k) would be more advantageous in the future.
The third plan you'll want to consider is the Simple IRA, which is appropriate if you have fewer than 100 employees, each earning at least $5,000 the previous year. The Simple IRA will give you greater tax benefits as a business owner than the SEP would, because you can deduct contributions to your personal IRA account and those you make to your employees' IRAs. Additionally, your employees enjoy a deduction with the Simple IRA--something that they don't get with the SEP. The drawback of this plan is that it won't allow you to sock away as much as the SEP-IRA.
Finally, as your business expands, you may find a full-blown 401(k) more appropriate. As Sue mentioned, the Fidelity e401(k)
might be a good place to start exploring that option.Where Can I Set Up These Plans?
Speaking of Fidelity's e401(k), it just so happens that the discount brokerage/fund supermarkets, such as Fidelity, Schwab, TD Waterhouse, E-Trade, Vanguard, and T. Rowe Price, are good places to establish all of these plans. We made some quick calls to many of the boutique fund families that we like, such as Oakmark, Ariel, Royce, Fairholme, and Mosaic, and we discovered that most can only accommodate SEP-IRAs, not the other vehicles for the self-employed. Generally, you cannot establish self-employed 401(k)s or Simple IRAs at the boutique fund families. The brokerage/supermarkets, on the other hand, typically have all the options available and even dedicated teams of retirement specialists who can guide you through the set-up process and help you weigh the advantages and disadvantages of each plan. Though they can't offer formal tax advice, their assistance in helping you weigh each plan can be helpful.What About Investing the Money?
The other great advantage of using a brokerage/supermarket to handle your retirement assets if you're self-employed is the panoply of investment options these institutions make available to you. Starting your own business with a new retirement account at a supermarket can help you correct allocation problems that might exist in your current retirement savings plan.
Before you begin selecting investments for your retirement plan, you should know what you already own in all your retirement accounts. Morningstar.com's Instant X-Ray tool
can help you assess your current holdings in terms of the all-important asset-allocation question (how much you have in the three major asset classes: stocks, bonds, and cash). Beyond the allocation question, the X-Ray tool will also show you your style-box positioning and sector weightings, indicating whether you're overweighted or deficient in a particular part of the market (such as small-cap stocks or high-yield bonds) or a sector (such as industrials or health-care).
Second, look for any holes you might have in your current holdings. Do you have too much bond exposure? Then add stock funds to your new SEP-IRA or 401(k). Do you have too much small-cap value exposure? Then add some large-cap exposure to your new account, as long as it doesn't inordinately elevate your overall stock exposure. The style box and sector questions are important, but the basic allocation question (how much stocks/bonds/cash) is arguably the most important or fundamental one.
Third, consider upgrading and consolidating. For example, most of your other retirement savings may be in a previous employer's 401(k) plan that lacked good funds in a particular category. Perhaps you are in a plan that didn't have a good international fund. In that case, take the opportunity to add a good one now. In fact, while we're on the subject of mediocre 401(k) plans, consider rolling a mediocre previous plan into your new SEP-IRA or 401(k), if you're confident that you have better fund selections at the institution you've chosen. Keep in mind that you will likely have to liquidate funds in the previous plan and rollover cash, so don't do it if there are good funds there (especially if they are closed), and you want to keep them. You may also roll other IRAs into your new retirement plan, as long as they're not Roth IRAs.
Finally, after you've decided where your current plan might be deficient, consider filling the gaps with Morningstar's Fund Analyst Picks
, available to Premium subscribers of Morningstar.com.