The retirement plan you select depends on several factors. (Photo: Shutterstock)

A defined contribution plan such as a 401(k) is a straightforward way to save for retirement for most employees. However, it's not so simple for self-employed individuals who face a number of different retirement plan options and strategies.

For self-employed individuals with no employees, establishing a retirement plan for your business may sound like a daunting process, but a review of each option will help make the decision on the right retirement plan for you much easier.

The Internal Revenue Service offers a variety of retirement savings plan options. The plan you select depends on several factors, including how your business is structured, the amount you can afford to contribute per year, and how much income you generate annually.

Self-employed individuals with no employees have the benefit of being treated as both employer and employee, which can be beneficial when contributing to certain retirement plans.

Each situation must be looked at individually. In order to make the most suitable choice, it is important to review the options available.

SEP IRA: A simple solution

A Simplified Employee Pension (SEP) Individual Retirement Account (IRA) is one type of retirement plan to consider when comparing plan options for self-employed individuals. No lengthy plan document or annual 5500 filing is required, and there is typically minimal paperwork needed to establish a SEP IRA.

The contribution rules for SEP IRAs are simple and straightforward. You can contribute up to 25% of your net compensation up to $56,000 (in 2019). Contributions to a SEP IRA are discretionary and are not required each year. If you currently have a Traditional IRA, it can be converted to a SEP IRA using Form 5305-SEP.

There is no need to fund the account until you file your tax return, which provides some flexibility. For example, if your income turns out to be higher than expected, you can make a larger contribution and thereby reduce your tax bill. If your income is lower than expected, you can make a smaller contribution.

Example: Mark is a 30-year-old new business owner with compensation of $100,000 and is interested in saving $25,000 a year. A SEP IRA may be a good fit for Mark, as it is easy to set up and administer, and his SEP IRA contributions can increase as his income grows.

Solo 401(k): Greater contribution levels

A solo 401(k) retirement plan, sometimes known as a One Participant 401(k) Plan, may be a good retirement savings plan to consider for business owners who want to maximize their contributions each year beyond SEP IRA limits (see above).

However, it requires the adoption of a formal plan document and the annual filing of form 5500, and you must adhere to the terms of the plan document. Depending on the complexity of your business structure and/or the possibility of adding an employee in the future, you should consider working with a qualified third-party administrator or accountant to administer your plan.

The solo 401(k) retirement plan allows the highest possible contribution among defined contribution retirement plans. Contributions consist of both an employee and a discretionary employer contribution. Since you represent both the employee and employer, your total contribution is the sum of those components. You can contribute up to 100% of your W2 compensation into the plan up to $19,000 (in 2019), plus an additional $6,000 if you are 50 or older, for a total of $25,000.

In addition, an employer contribution of up to 25% of compensation is permitted. Combined, the total limits are: $56,000 if under age 50 and $62,000 if over age 50. If you are interested in even greater contribution levels, there is the option to establish a defined benefit plan as well.

Generally, if your compensation is below $225,000 or you are over age 50, your maximum contribution is higher with a Solo 401(k). The level of difference will vary based on your income and type of entity. Consult your accountant to assist you with the calculations so you can select the plan most suitable for you.

Example: Maureen, 52, is a self-employed computer programmer with compensation of $165,000 a year. She would like to contribute $50,000 – $60,000 into a retirement plan. A SEP IRA would only permit her to contribute 25% of her compensation, which would equate to roughly $37,500. A solo 401(k) would allow her to defer $25,000 of her income and also an additional profit sharing contribution of $37,000 for a total of $62,000.

Defined benefit/cash balance plans: Maximize your contributions

Traditional defined benefit and cash balance plans are also options to consider when comparing retirement savings plans for self-employed individuals, as you can potentially contribute up to $200,000 or more annually.

A defined benefit plan guarantees a certain benefit when you retire. How much you receive generally depends on factors such as your salary, age, and retirement age. Each year, actuaries calculate the future benefits that are projected to be paid from the plan, and ultimately determine what amount needs to be contributed to the plan to fund that projected benefit.

Contributions are also tax deductible as a business expense, which helps to reduce your taxable income. A cash balance plan combines the features of a traditional DB plan features, such as higher contribution levels and guaranteed benefits, with the flexibility and portability of a defined contribution plan.

These plans generally have a minimum intended commitment of at least 3-5 years, with typical plans existing much longer. They are often combined with a solo 401(k) to maximize the amount you can save for retirement each year. They also require the services of a third party administrator and an actuary. Businesses with older owners and stable year-to-year income are generally good candidates to implement a defined benefit or cash balance plan.

Example: Rick, 48, is a self-employed attorney with no employees and compensation of $330,000. He currently does not have a retirement plan and is looking to start contributing large amounts of at least $100,000 a year to reduce his taxable income and save for retirement. Based on Rick's age, income, projected retirement age of 65, and his business being in existence for 5 years, he could make a maximum contribution of $230,000, but also has the option to set that amount much lower as desired.

Self-employed individuals with no employees should meet with a retirement plan specialist before choosing any of these options.

Joe McDonald is a Senior Retirement Plan Specialist with Janney Montgomery Scott, LLC. He has more than 10 years of experience in the retirement plan arena. Janney's Retirement Plan Services team supports Janney's Financial Advisors and their valued clients with business retirement planning services.