It consists of many parts, including guaranteed income to the retired, disabled, and qualified survivors, insurance in the form of Medicare, unemployment benefits, and other programs. Today, we’ll specifically look at what it takes to qualify for retirement and disability benefits.

Social Security Work Requirements

Your ability to receive disability and/or retirement payments primarily depends on your work history. For you and your dependents/survivors to qualify for full benefits under each program, you need to be “fully insured.” You and/or your dependents may also qualify for limited benefits if you are “currently insured.”

Each status requires a certain number of social security quarters of employment earnings. This number changes from year to year. In 2010, a quarter of earnings is $1,120. You can earn up to 4 quarters per calendar year, regardless of when the earnings were actually earned – once you make $4,480 in a year, you have 4 quarters for that year, whether you earned that money in January or December. Current requirements are as follows:

• Fully Insured means that you have 40 quarters of qualified earnings after the age of 21.
• Currently Insured workers have at least six quarters of coverage out of the previous 13 calendar quarters.
• Disability Insured varies based on age. Those between 21 and 24 have to have 6 quarters of coverage in the last 12 quarters. If you are 24-30, you have to be covered for half of the available quarters after age 21. If you are over 31, you have to be fully insured (40 quarters of coverage) AND have earned 20 of those quarters in the last 40 calendar quarters.

Other Social Security Requirements

In addition to a certain number of quarters/years of work experience, you have to meet additional qualifications to actually claim and receive your benefits:

• Retirement: To claim your social security retirement benefits, you have to be fully insured and reach full retirement age, which varies from 65 (for those born before 1938) to 67 (for those born after 1960). You may receive reduced benefits before full retirement age or increased benefits if you defer receipt past retirement age. Your spouse and dependents may also claim benefits based on your work history.
• Survivor: When you die, your survivors (spouse and dependents) may be able to claim social security death benefits based on your retirement benefits. Amounts and eligibility will vary depending on whether you were fully or currently insured at death. This benefit applies regardless of your age at death.
• Disability: To receive social security disability benefits, which are notoriously hard to qualify for, you must meet the definition of disability insured above AND prove that you meet the government’s definition of disabled. Because this definition is so hard to meet, most people should carry supplemental disability insurance.

Social Security Benefits

If you have met all requirements, you will receive a percentage of your highest years of income, based on many very complicated calculations completed by the Social Security Administration. You can see an estimate of your benefits using the social security calculator. The system is calibrated so that lower-paid workers receive a higher percentage of their income than higher-paid workers.

As mentioned earlier, your spouse and dependents may also receive benefits based on your work history. Your Social Security Statement, received annually about 3 months before your birthday, will provide personalized details about your potential benefits.

As we all know, Social Security will have to undergo major changes to stay solvent in the future. So while you should be aware of this information, you should also make sure you are using retirement accounts to plan for the future on your own!

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But to really supercharge your savings and make sure you are extra-prepared for retirement, you should also take advantage of catch up contributions. Catch-up contributions are special provisions that allow you to contribute additional funds to your retirement accounts as you get closer to retirement. This has the double benefit of helping beef up your retirement savings while deferring taxes.

Why Catch Up Contributions Matter

Someone maxing out a 401k with an 8% earnings rate would save just over $500,000 between ages 50 and 65. Someone taking full advantage of catch-up contributions would save over $667,000 in that same time period:

If you withdraw 4% of your nest egg annually in retirement, that additional savings would mean an additional $6,000 of income per year.

Over 50 Catch up Contribution Limits

Most retirement accounts allow for additional contributions for account holders over 50:

• 401(k), 403(b), 457: May contribute $5,500 above the limit of $16,500, for a total of $22,000. Remember that the 401k catch up limit applies to the total of all 401k and 403b accounts held by one employee, even across multiple employers. 457 accounts have a separate $22,000 limit.
• Traditional IRA/Roth IRA: Up to $1,000 above the standard $5,000 maximum Roth contribution.
• SIMPLE IRA: Up to $2,500 above the standard $11,500.

403b 15-year Catch-up

If you have 15 years of service with a public school system, hospital, home health service agency, church, or certain other organizations, you can increase your 403(b) contributions by the lesser of:

• $3,000
• $15,000 reduced by previous catch-up contributions under this rule
• $5,000 times the number of years of service minus total contributions made in earlier years

The IRS explains further. Note that this applies to all employees with 15 years of service at a qualified organization, regardless of age. If you are over 50 you may take this AND the over-50 catch-up noted above.

457 Double Limit Catch-up Contribution

In the three years before normal retirement age (as defined in plan document), government and certain non-government employees may take what’s known as the “double limit catch-up.” If you did not contribute the maximum possible amount in previous years, you can contribute the lesser of double the current year’s maximum amount ($16,500) OR the sum of “missed” contributions in previous years. For example:

• If you have $10,000 of unused contributions, you can take an additional $10,000 in any one of the three years before retirement.
• If you have $30,000 of unused contributions, you can take an additional $10,000 in each of the three years before retirement.
• If you have $100,000 of unused contributions, you can double maximum contributions for three years before retirement, but won’t ever be able to make up that $100,000 completely.

If you always maxed out your contributions, this rule does not apply to you. If you take this catch-up you cannot take the over-50 catch-up for 457s.

Note that current tax and catch-up rules allow you to contribute up to $25,000 to a $403b and $33,000 to a 457 in one year – not to mention another $6,000 to an IRA!

Take Action

If you want to increase your retirement savings, log in to your online account or contact your benefits coordinator at work.

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If you’re considering a traditional IRA conversion to Roth IRA this year, here’s a guide of Roth conversion articles to help you navigate conversion rules and the pros and cons of Roth IRA conversions.

Roth IRA Conversion Rules

2010 Roth Conversion Rules. Roth conversion rules and guidance about Roth conversions in 2010.

Tax treatment of Roth Conversions. Pro rata distribution rules for the Roth IRA and the 60 day rule for Roth conversions.

How to Make a Roth IRA Conversion. Once you decide if you want to make a Roth IRA conversion, here’s how to do it!

Roth IRA Conversion Strategies

Roth Conversion Strategy to Minimize Tax. Minimize the taxes on your conversions by implementing a multiple conversion strategy.

Roth Conversion Strategies. How to increase your basis in your IRA and avoid some of the taxes with Roth conversions.

Pros and Cons of Roth Conversions

Roth IRA Conversion Considerations. Pros and cons of Roth conversions and things to consider before you make a Roth conversion.

Roth IRA Conversion Calculators. A list of Roth conversion calculators to help you with your analysis.

Roth IRA Extras

Roth IRA for Kids. Want to help your kids save for the future tax free? An excellent opportunity is a Roth IRA for kids.

2010 Roth IRA Limits. In addition to your Roth IRA conversion, you can still make a regular Roth IRA contribution if you meet the income limits. Beware though, a large Roth conversion could make you ineligible to make a contribution if you elect to include the income in the current year.

Roth IRA penalty free withdrawals. Once you make your Roth conversion, you can withdraw your money tax free and penalty free after five years.

Worksheet to track Roth IRA contributions and conversions. You’re in charge of tracking your own contributions and conversions for tax purposes. Make sure you do so!

Phew! Everything you need to know about Roth IRA conversions!

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We previously explored roth conversion strategies like increasing your basis to avoid taxes, but if you’re ready to convert the taxable portion of your traditional IRA, this one might be for you!

Roth IRA Conversion Strategy

Here’s the plan to execute the Roth IRA conversion strategy:

Create multiple traditional IRAs. For example, if you have a $100,000 traditional IRA to convert, separate it into 4 $25,000 traditional IRAs.

Convert each IRA. For each account, make a traditional IRA conversion to a Roth IRA. You’ll want to keep each new Roth IRA separate.

Invest differently. In your new Roth IRAs, you’ll want to take a separate investment approach. Separating by each asset class would probably make the most sense and gives the most flexibility.

Monitor Returns. Since each Roth IRA holds a different asset class, the returns will vary. If the value goes up, leave it alone.

Recharacterize. Select the accounts where the value went down, which could be all, some, or none, of the new Roth IRAs. Reverse the conversions with a recharacterization by October 15, 2011 (with an extension), for 2010 Roth IRA conversions.

Tax Savings. With this strategy you’ll avoid paying taxes on money you lost, without having to recharacterize the entire conversion, allowing you to keep the conversions on the winners!

Tips and Tricks

Reconvert. You can later reconvert the money that you recharacterized, but there is a waiting period of at least 30 days and at least until the next year. You’ll be able to reconvert at a lower value, which means lower taxes.

Rebalance and Consolidate. After you’re done converting, you can put the Roth IRAs back together for a more simplified record keeping.

Keep Good Records. The paperwork on this one could get very complicated if you take it to the extreme. Be sure to keep good records so you don’t make tax time next year a real headache!

Communicate Clearly. If you have multiple accounts, you’ll need to work closely with your broker to make sure the correct conversions and recharacterizations take place. I’ve done Roth IRA conversions and recharacterizations at both Scottrade and Vanguard before without any issues.

More Helpful Roth IRA information:

• 2010 Roth conversion
• Aggressive Roth IRA conversion strategy case study
• Tax treatment of Roth conversion
• How to Make Early Roth IRA Withdrawals

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We’ve been talking about Roth IRA conversions all week. To recap, the 2010 Roth conversion rules mark the first year that there is no income limit for Roth IRA conversion eligibility. Because of that, many people have access to a Roth IRA for the first time.

While you shouldn’t rush into a Roth IRA conversion, there are many instances where a conversion will leave you in a better financial situation over the long term. When deciding whether a Roth conversion is right for you, there are two main things to consider: the effect on your finances during the year of Roth conversion, and the effect at retirement.

Consider a Roth Conversion if:

• You believe you will be in a higher tax bracket during retirement. When you convert, the conversion amount will count as income and you will pay taxes on pre-tax contributions plus growth using today’s tax brackets. You’ll get hit with a larger bill up front because you’re paying on all of it, but if you anticipate a rise in overall tax rates or your own personal bracket, you’ll pay less per dollar of withdrawals by converting today. Plus, paying taxes now and converting means you never have to pay on future earnings. However remember that many people find themselves in lower brackets come retirement age.
• You cannot contribute new funds to a Roth IRA. If you are over the Roth IRA contribution limits, you can now contribute to a traditional IRA and convert each year – but you never know if the rules will change. Converting what you have now is your best chance to take advantage of the tax breaks offered by a Roth.
• You are over 70 ½ and do not need access to your rollover-eligible funds. IRA account owners must take taxable minimum distributions each year after attaining the age of 70 ½, but Roth IRAs do not have the same requirement. Roth funds can sit in the account untouched until the owner’s death. If you do not need the income in future years, you can preserve the funds for your heirs by paying taxes on the rollover and letting your funds continue to grow tax free. If you believe your children or grandchildren will be in a lower tax bracket after your death, you may want to skip conversion and let them pay (lower) taxes later instead.
• Your IRA contributions have dropped in value. If you convert funds that have dropped in value, you only have to pay taxes on what you actually convert – even if it’s less than you originally contribute. If we continue to experience a rebound from the stock market lows, you’ll enjoy tax-free growth after conversion. And if by chance your funds continue to drop, you can do a recharacterization back to a traditional IRA and get some of your tax payment back.

Hold Off or Only do a Partial Roth Conversion if:

• You would tap the conversion amount to pay taxes. In order for a conversion to make sense at all, you must be able to pay the taxes on the conversion amount from outside your retirement funds. Using funds to pay the tax bill lowers the amount of money you have available to grow tax free and withdraw in retirement. Plus, you may face a penalty if you’re under 59 ½. If you want to convert only your nondeductible IRA contributions, you can do so using a special Roth IRA conversion strategy.
• Your conversion amount would place you in a higher tax bracket. If doing a full conversion will place you in a new tax bracket, you may wish to convert over a few years. For example, say you have $10,000 before moving into the 28% bracket, and you have $25,000 to convert. If you convert all now, you’ll pay 25% on $10,000 and 28% on the remaining $15,000. Alternatively, you can convert $10,000 this year (at 25%) and another $10,000 next year, also at 25%. Remember that the special provisions for spreading out your tax bill only apply to conversions done in 2010.
• You expect to be in a lower tax bracket at retirement. If you expect to be in a much lower tax bracket at retirement, it may not make sense to convert now. The final decision depends on how many years you have until retirement and how much growth you expect. If you are relatively young and expect high appreciation, it might make sense to pay a high tax rate on a lower amount. But if you have only a few years until retirement, chances are the math for conversion doesn’t quite work out.
• You want to avoid increased taxation of your Social Security Benefits and/or Medicare premiums. IRA conversions basically count as income for tax purposes – and for purposes of calculating Medicare premiums and the taxation of your Social Security Benefits. Of course these adjustments will only matter for one year, so this shouldn’t be a huge factor in your decision.

Additional Resources

Converting to a Roth IRA is a good idea for many people, but figuring out all the possibilities and implications can be an intense process! Jeff over at Good Financial Cents has an excellent post detailing the calculations, considerations and tax consequences of a few sample rollovers. He pays attention to some intricate details that are a big help to anyone seriously considering a rollover. You can also check out this roundup of conversion calculators over at ConsumerBoomer. If you’re over 70, read about some special considerations over at Vanguard. And of course, don’t forget that it’s always a good idea to check with a tax professional and/or financial planner to make sure that your plan is the absolute best for your personal circumstances.

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As mentioned yesterday in How to Make a Roth IRA Conversion, some special rules went into effect on January 1 that make 2010 Roth IRA conversions more attractive than ever.

If you haven’t yet, you should really consider converting to a Roth IRA this year. This is especially true if you do not qualify to contribute to a Roth IRA and have been unable to reap its benefits.

2010 Roth Conversion Rules

Rules specific to 2010 roth conversions include the following:

• No income limits: For the first time ever, all taxpayers can rollover a traditional IRA to a Roth IRA, regardless of income. So if you’ve had too high of an income to contribute to a Roth, and took advantage of a deductible or non-deductible traditional IRA instead, you can convert all contributions plus growth to a Roth – paying taxes on the converted amount but then enjoying tax-free growth forever. As of now, this provision is permanent.
• Extension of tax payment: Ordinarily, taxes are due on all IRA account growth as well as any deductible contributions. In 2010, you can actually defer paying taxes on the converted amount by completing the conversion in 2010 but claiming half the income in 2011 and half in 2012 – meaning half of the actual tax payment could be deferred to spring of 2013! You can also elect to pay all taxes in 2010. Be aware that you will pay taxes at your rates in those years, so you should pay now if you expect your personal bracket to increase. Spouses can make different elections, but each taxpayer has to apply the same election to all accounts – you can’t choose to pay taxes on one IRA but defer them on another. This election is special for 2010 and will expire in 2011.  

Other Roth Conversion Rules

Other than the two mentioned above, Roth conversion rules remain the same. So remember:

• Contribution limits remain the same. 2010 Roth IRA limits haven’t changed. If you are over the income limits for Roth IRA contributions, you cannot contribute new funds to a Roth. However, as long as the special 2010 roth conversion rule above exists, you can contribute to a traditional IRA and immediately convert.
• Pro-rata rules apply. If you do choose to go the conversion route, you don’t have to convert all your funds. One reason to do it in pieces is to spread your tax bill over many years. However, if you have made both deductible and nondeductible IRA contributions, any partial conversion will be deemed to come from both pools, in a ratio equal to your original contributions. What this means is, you can’t avoid taxes by choosing to convert only nondeductible contributions. However, if you’re willing to put in some work, there is a Roth conversion workaround strategy.
• Regardless of the timing, taxes will be due. At some point, you will owe taxes on your Roth conversion, whether you choose to defer them or not. You should only convert if you can afford to shoulder the tax bill with non-retirement funds. If you use part of the converted amount to pay taxes, you miss out on the compounding growth and may face an early withdrawal penalty.

Check back tomorrow to find out Should You Do a Roth Conversion?

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As you probably know, there are no longer income limits for future retirees hoping to convert traditional IRAs to Roth IRAs.

Previously, only those with income under $100,000 could take advantage of the superior tax treatment of a Roth. Today, the Roth IRA conversion rules allow anyone to convert existing funds, even if you make too much to contribute new savings to a Roth IRA.

Why a Roth IRA is Good for You

A Roth IRA is the Cadillac of retirement plans. It is funded with after-tax dollars and allows you to:

• Withdraw your contributions tax- and penalty-free.
• Withdraw growth on your contributions tax-free after age 59.5.
• Keep your contributions and earnings in the account as long as you want, with no requirement for minimum contributions.

Roth IRA Conversions

If you are the owner of a traditional IRA, you may want to convert all or part of the funds to a Roth. The Pension Protection Act of 2006 also allows you to convert assets from 401(k)s or similar employer plans directly to a Roth IRA. You will have to pay tax on any deductible contributions. However, once the conversion is done you will never pay taxes on any eligible withdrawals!

If you are under 59.5, Roth IRA contributions generally have to remain in the account for 5 years after conversion before they can be withdrawn. So you should not convert any amount you might need in the next 5 years.

How to Convert to a Roth IRA

Converting to a Roth IRA is simple. It requires a little paperwork with your IRA account manager and reporting to the IRS. Specifically, you should take the following steps if you are interested in a conversion:

1. Decide if a conversion makes sense for you. Remember, you will pay taxes on all earnings in your traditional IRA as well as all non-deductible contributions.
2. Decide where you want to hold your Roth IRA. If you are converting from a traditional IRA, you will probably keep your account at the same financial services company. If you are converting from an employer account, you may need to look into options like Scottrade or Vanguard.
3. Contact the company where you will hold the Roth and request the applicable paperwork. If you are transferring assets from another financial services company you may need to open a traditional IRA first, then complete the conversion. A customer service rep will be able to walk you through the process and provide any necessary paperwork.
4. Complete the paperwork, which should specify how to invest the converted assets and how you intend to pay taxes (withhold from the converted amount or separate payment). Conversions must be done by December 31 of the tax year.
5. Report the conversion at tax time on your 1040 and Form 8606 and pay any applicable taxes.
6. Reap the benefits of your new Roth IRA!

Check back for articles on special 2010 Roth Conversion Rules and Should You Do a Roth Conversion?

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The 401k limits and IRA limits will remain the same in 2010. I highlight the Roth IRA and the Roth 401k because they are my favorite retirement plans; limits for traditional 401ks and IRAs will also remain unchanged in 2010.

2010 Contributions

Here are the contribution limits for each:

You can make your 2010 contributions as early as January 2 for the whole year. If you contribute 2010 Roth IRA money between January 2 and April 15, be sure to designate calendar year 2010 if you have already contributed the maximum for 2009.

If you aren’t eligible for a Roth IRA, you can take advantage of the special 2010 Roth Conversion Rules to convert some of your IRA money to a Roth IRA.

Transfer your IRA to Scottrade and stop paying fees. Whether your account is Traditional, Roth, SEP or Rollover, you won’t pay set-up, annual, custodial, inactivity or closing fees with Scottrade. Open a No-Fee IRA now!

2009 Contributions

You can still make 2009 contributions before the end of the year for your 401k. 2009 IRA contributions can be made until April 15, 2010.

See the 2009 Roth 401k and Roth IRA Limits for eligible contributions.

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When I told you about my struggles with my Solo 401k contribution at Fidelity, Lee suggested I look at the SEP-IRA, which made us take a step back and relook at all the available plans; the Solo 401k, the SEP-IRA, and the SIMPLE IRA.

All three plans are available to sole proprietors, partnerships, and C or S corporations.

I promised to share my perspective after we highlighted each plan. Here’s my take:

When You Want a SEP-IRA

There are a few instances that a SEP-IRA is your obvious choice:

Do you have employees? If the answer is yes, you’re going to want to open a SEP-IRA. You cannot open a Solo 401k if you have employees; it’s only for the business owner and spouse.

Is the calendar year over? If the answer is yes, and you still want to make a contribution for the prior tax year, the SEP-IRA is the way to go. You can open and fund a SEP-IRA until the tax filing deadline, plus extensions. In contrast, a Solo 401k has to be established by December 31, but can be funded until the tax filing deadline, plus extensions. If you are planning for next year, act now, and you can establish either plan.

When You Want a Solo 401k

Are you planning Roth conversions? A benefit of the solo 401k is that you won’t have to include the contributions in the pro rata calculation. However, a SEP-IRA will be included in the Roth IRA Conversion calculation.

If you have any plans to make Roth conversions on non-deductible IRA contributions, steer clear of the SEP-IRA, or you’ll be increasing your tax bill on the conversions.

Do you want to maximize your deferral? The Solo 401k is the big winner. Here are the contribution limits:

• 2009 Solo 401k Limits: $16,500 employee deferrals ($22,00 age 50 or older) plus 25% of compensation; maximum of $49,000($54,500 age 50 or older).
• 2009 SEP-IRA Limits: 25% of compensation; maximum of $49,000.

While the limits appear similar, each having a $49,000 maximum, they actually aren’t. Let’s take a closer look at the calculations.

Calculating Maximum Contributions

To calculate the 25% profit sharing contribution, you need to account for the deduction of the plan contribution in the formula in addition to half the self employment tax. So a 25% contribution rate, looks like this:

(Net income – 1/2 self employment tax – profit sharing) * .25 = profit sharing.

It’s actually the same as a 20% self employed rate, which some people prefer to use:

(Net income – 1/2 self employment tax) *.20 = profit sharing.

Here’s an example:

Let’s say your net income is $20,000. Half of your self employment tax is $1412.96. So your profit sharing contribution is $3717.41.
($20,000 – $1412.96 – $3717.41) * .25 = $3717.41
or ($20,000 – $1412.96) * .20 = $3717.41

For the solo 401k, you can defer 100% of your compensation. To calculate your compensation use the prior formula: (Net income – 1/2 self employment tax – profit sharing). ($20,000 – $1412.96 – $3717.41) = $14869.64. Add the profit sharing contribution to the employee deferral ($14869.64 + $3717.41) = $18587.05.

Total solo 401k contribution: $18587.05
Total SEP-IRA contribution: $3717.41

As you can see, this is where the solo 401k is the big winner. If you want to skip the hand calculations, you can use a calculator to determine your maximum contribution.

Simple IRA?

What about the SIMPLE IRA? I didn’t include it, since the contribution limits don’t even come close to the Solo 401k or the SEP-IRA. If you have employees, and want to let them make contributions, it might be a good choice, however, at that time, you’ll want to compare the SIMPLE IRA to a 401k.

Action Plan

I decided to stick with the Solo 401k since the plan contributions are so much higher and our goals are to defer the maximum amount of money. In addition, we’re planning Roth conversions in 2010, so I want to minimize our taxes for the conversions.

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Solo 401k Overview

A Solo 401k combines the characteristics of a regular 401k plan with a profit-sharing plan. A Solo 401k can only be established by self employed individuals or small business owners with no other employees or just one employee – the owner’s spouse. For most people with no employees the Solo 401k will maximize the allowable contributions you can make to a retirement plan in a given year.

Solo 401k Basics

• Coverage: A Solo 401k is only established for the business owner and the business owner’s spouse if he is an employee.
• Contributors: Solo 401ks are funded by both the employee and the business. The employee contribution is deferred compensation while the business contribution is a portion of profits.
• Contribution limits: In 2009, an employee can defer up to $16,500 to a Solo 401k. Employees who are 50 or older at the end of the year may make a “catch-up” contribution of an additional $5,500. The total amount allowed is reduced by any contributions to a 401k, 403(b), or 457 at another employer. In addition to the employee deferral limit, the business can make a contribution of up to 20% of your total income (25% of earned income, which is total income reduced by self-employment taxes). The total employee and employer contributions must not exceed $49,000 in 2009, or 100% of your income.
• Deadlines: You must establish the plan by December 31 of the calendar year for which you first want to contribute. Contributions, however, can be delayed until the tax-filing deadline for that year, including extensions. For most people this is October 15 of the following calendar year.
• Taxation: Both individual and business contributions to a Solo 401k are deductible from the employer’s income, and are not included as employee income at the time of the contribution. Taxes on withdrawals are explained below.
• Vesting: There is no vesting period for Solo 401k contributions. Note that this is different from most tradtional 401k plans.
• Withdrawals: Solo 401k withdrawals are subject to the same withdrawal rules as regular 401ks. All withdrawals will be subject to income tax. Penalties may apply if taking withdrawals before the age of 59 1/2. A unique feature of Solo 401ks as opposed to other self-employed retirement options is that loans may be available depending on how the plan is set up.

Special Characteristics

• Once the plan reaches $250,000 in assets, you must complete a Form 5500.
• A Solo 401k can accept rollovers from many other retirement plans, making it easy for you to consolidate accounts in one place before beginning withdrawals in retirment.
• Contributions are discretionary, so you can choose not to contribute in years where your business has low revenue and increase contribution if you want to minimize taxes.

Establishing a Solo 401k

There are no regulations governing the establishment of a Solo 401k. You can open one with most major financial institutions, including Vanguard and Fidelity.

Solo 401k Pros

The biggest advantage of a Solo 401k is that it typically allows for the largest contribution when compared to other self-employed plans.

Solo 401k Cons

You cannot use a Solo 401k if you have any employees other than a spouse.

Stay tuned Madison’s wrap-up of this series: an analysis of which self-employed retirement plan is best, in Solo 401k Versus SEP-IRA.

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SIMPLE IRA Overview

SIMPLE stands for Savings Incentive Match Plan for Employees. SIMPLEs were established to encourage small businesses to open retirement plans without the expense of maintaining a qualified plan.

Only businesses with less than 100 employees are eligible to establish a SIMPLE. A SIMPLE can actually use an IRA or a 401(k) to “hold” the contributions, but we are focusing only on the SIMPLE IRA since the 401(k) is rarely used. SIMPLE IRAs are easy to establish, have no annual filing requirements, and relatively few administrative expenses.

SIMPLE IRA Basics

• Coverage: SIMPLE IRAs must cover all employees who either made $5,000 in two preceding calendar years or are expected to make $5,000 in the current calendar year.
• Contributors: SIMPLE IRAs are funded by both employees and employers. Employees contribute by deferring a certain percentage of their income. Employers can choose to either match employee contributions or contribute to all eligible employees, regardless of participation. Employers who match contributions must generally match 100% of contributions up to 3% of employee compensation, with some exceptions. Alternatively, employers can contribute 2% of compensation to all eligible employees.
• Contribution limits: In 2009, the maximum SIMPLE IRA contribution per employee is $11,500, including the employer match. Employees who are 50 or older at the end of the year may make a “catch-up” contribution of an additional $2,500. The catch-up amount is reduced by catch-up contributions to a 401(k), SEP-IRA, or 403(b).
• Deadlines: Employers must establish SIMPLE IRA plans by October 1 of the calendar year that employees can first contribute. Employer contributions, however, can be delayed until the tax-filing deadline for that year, including extensions. Note that this only applies to the employer match portion. The employer must forward compensation deferred by employees no later than 30 days after the end of the month in which it was deferred (e.g., April 30 for March contributions).
• Taxation: Both employer and employee contributions to a SIMPLE IRA are deductible from the employer’s income, and are not included as employee income at the time of the contribution. Taxes on withdrawals are explained below.
• Vesting: There is no vesting period for SIMPLE IRA contributions. An employee has access to 100% of the contributions as soon as they are made.
• Withdrawals: SIMPLE IRA withdrawal rules are the same as those for traditional IRAs. Employees can withdraw at all times, including while they are employed. Withdrawals will be subject to ordinary income tax regardless of age or reason for withdrawal. In addition, SIMPLE IRA withdrawals will be subject to a 10% penalty if the account owner is younger than 59½. Some exceptions to the 10% penalty apply. If it is applicable, the 10% penalty increases to 25% if withdrawals are made within the first two years of participating in the SIMPLE IRA.

Special Characteristics

• Employers who maintain SIMPLE IRAs cannot maintain any other type of retirement/deferred compensation plan.
• SIMPLE IRAs can be rolled over to other SIMPLE IRA accounts for the first two years of plan participation without tax or penalty. After two years, you can do a tax- and penalty-free rollover into an IRA, qualified plan, 403(b), or 457.
• Airline pilots, nonresident aliens, and union employees who have separate retirement agreements can be excluded from the coverage requirements noted in the “Coverage” section above.

Establishing a SIMPLE IRA

To establish a SIMPLE IRA, an employer must only file a Form 5304 SIMPLE or a Form 5305 SIMPLE. The first is for employers who allow participants to select an institution to hold their SIMPLE IRAs, while the second allows the employer to select the institution for all employees. Any financial institution that offers traditional IRAs should be able to set up SIMPLE IRAs.

SIMPLE IRA Pros

The biggest advantage of a SIMPLE is that it allows both employers and employees to save in a manner similar to a qualified plan without extensive set-up or administrative fees.

SIMPLE IRA Cons

Because a SIMPLE IRA requires contributions to all employees, it is not a good plan for someone with employees who only wants to beef up his or her own retirement savings. The SIMPLE IRA has a lower contribution limit than any other retirement plan. If your small business is the sole source of your income and you make more than a few thousand dollars, a SIMPLE IRA will severely limit your ability for tax advantaged retirement savings.

Stay tuned for more in the series, including an explanation of Solo 401ks, and Madison’s analysis of which is best, in Solo 401k Versus SEP-IRA.

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SEP-IRA Overview

SEP stands for Simplified Employee Pension. A SEP uses an IRA to “hold” the contributions, is easy to establish, and is often more flexible than a qualified plan. It is ideal for sole proprietors and small businesses.

SEP-IRA Basics

• Coverage: If you are a business owner and contribute to an SEP-IRA plan in a given year, you must make contributions on behalf of all employees who are 21 or older, have worked for three years or more, and have earned more than $500 during the year.
• Contributors: A SEP-IRA is funded by employers only – employees cannot contribute.
• Contribution limits: In 2009, the maximum SEP-IRA contribution is the lesser of 25% of an employee’s compensation or $49,000. The maximum contribution is reduced by any employer contributions to a profit-sharing plan, and vice versa – together, employer contributions to a SEP-IRA and a profit-sharing plan are capped at the lesser of 25% of compensation or $49,000. For self-employed business owners, “compensation” refers to earned income, which excludes self-employment taxes and contributions to other employees.
• Deadlines: A SEP-IRA can be established and funded for a given calendar year up to the tax-filing deadline for that year, including extensions. For sole-proprietorships and partnerships, the final extension date is October 15 of the next calendar year, so you can establish and fund a SEP-IRA for 2008 as late as October 15, 2009.
• Taxation: Employer contributions to a SEP-IRA are deductible from the employer’s income, and are not included as employee income at the time of the contribution. Taxes on withdrawals are explained below.
• Vesting: There is no vesting period for SEP-IRA contributions. An employee has access to 100% of the contributions as soon as they are made.
• Withdrawals: Because SEP contributions are made to IRAs, the withdrawal rules are the same as those for traditional IRAs. Employees can withdraw at all times, including while they are employed. Withdrawals will be subject to ordinary income tax regardless of age or reason for withdrawal. In addition, SEP-IRA withdrawals will be subject to a 10% penalty if the account owner is younger than 59½. Some exceptions to the 10% penalty apply.

Special Characteristics

• SEP contributions are made to traditional IRA accounts and cannot be made to Roth IRA accounts. Once contributions are made, the account can be rolled into a Roth IRA – the rolled over balance will be subject to income tax.
• Employer contributions to SEP-IRAs can be made at the employer’s discretion, meaning that an employer can establish the plan without being obligated to fund it each year.

Establishing a SEP-IRA

To establish a SEP-IRA, an employer must execute a formal, written agreement to provide benefits to all eligible employees, and inform employees of that agreement and the account establishment. An individual SEP-IRA must then be established for each eligible employee. Any financial institution that offers traditional IRAs should be able to set up SEP-IRAs.

SEP-IRA Pros

Sole proprietors or employers with just a few employees love SEP-IRAs because they are easy to establish and require little effort from year to year. The ability to choose whether or not to make contributions is also ideal for business owners with highly variable income from year to year. Finally, the late contribution deadline makes it easy to use a SEP-IRA to lower your tax bill after you calculate it.

SEP-IRA Cons

Because a SEP-IRA requires contributions to all employees, it is not a good plan for someone with employees who only wants to beef up his or her own retirement savings. It is also not good for businesses with employees that want to be able to contribute to their own accounts. Finally, the SEP-IRA may not maximize savings opportunities for business owners because of the way self-employment income is treated.

Stay tuned for more in the series, including an explanation of SIMPLE IRAs, Solo 401ks, and Madison’s analysis of which is best, in Solo 401k Versus SEP-IRA.

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It seems that keeping his house and saving a large amount for retirement are in direct conflict with each other. Marke would like some help trying to figure out what to do.

Background

• Age 59
• No retirement savings.
• Home has lost $250k in equity.
• Mortgage payment $1,700 per month.
• Owns a small vacation cabin with no mortgage.

Options

Marke is trying to decide which option will work best. Of course there are many more details than those provided here. However, many of those are emotional aspects, like quality of living, that only Marke will be able to answer himself.

1. Stay in Home

If Marke stays in his house, he’ll pay it off in 10 years. He’ll spend $204,000 in payments ($1700 x 120 months) over those next 10 years. He’ll have to work diligently to save for retirement in other areas of his budget, which may or may not have a big impact on the amount he’ll be able to save.

2. Sell Home and Save for Retirement

Since Marke has lost considerable equity in his home, if he sells it, he will break even after paying off the mortgage. However, if he sells the home, he’ll plan on saving the $204,000 that he would have spent on mortgage payments for the house and save it for retirement. I’m guessing he’ll live in the cabin if he chooses this route. Otherwise, he’ll have to subtract the cost to rent another place out of the money now earmarked for retirement.

3. Rent the House

The last option he is considering is to rent out the home with a negative cash flow, live in the cabin and hope to sell it someday. Unfortunately, this option probably won’t help him generate any additional funds for retirement, but it might allow him to live in the house after it’s paid off.

What Do You Suggest?

Let’s help Mark out! I’ll highlight your suggestions and add mine in a future article.

Should Marke keep his house? What’s more important saving for retirement or owning a house?

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My wife and I both opened a Roth IRA account with $4,000 each. Can we add more to our IRA before the end of the year? – Mac

The 2008 Roth IRA Limit is $5,000 (or $6,000 for age 50 and over). Assuming you meet the eligibility requirements, you can each put additional money in your IRAs for 2008. If you want to plan ahead for next year, the 2009 Roth IRA Limits and 2010 Roth IRA Limits remained the same.

Can I contribute to the maximum limit, for both the 401K and the IRA? Or are there some limits if you have each kind of account? – Rebecca

Yes, you can contribute to both a 401k and an IRA. The limits will be based on your income, but you can have both. I usually contribute to both each year.

I am a current college student and I want to open up a Roth IRA, but don’t think I will have Adjusted Gross Income of more than $2500 for 2008. What happens if I fund it to the ‘maximum’ amount of $5000 with money I have just sitting (and not growing) in my checking account. – Scott

Unfortunately, you can only contribute as much to a Roth IRA as your earned income (or a spouse who has earned income). Here is a helpful list to determine what Qualifies as Income for IRA Contributions. Money sitting in a checking account will not count.

Can you withdraw from your Roth IRA before age 59 1/2 without a 10% penalty? -Mo

You can. I covered some of the ways to do so in How to Make Early Roth IRA Withdrawals. Although please note the disclaimer that the withdrawal methods are only explained as part of a plan to access funds for early retirement. I don’t recommend tapping your retirement funds for other purposes!

What if I earn too much to contribute to a Roth? – Mike

You can contribute to a nondeductible IRA and convert it to a Roth IRA in 2010 when the conversion limits disappear. Although the conversion will be taxable, since you must convert a pro-rata amount of your traditional and nondeductible IRA. (For those who want to convert just their traditional IRA to avoid the tax, there is a Roth IRA Conversion Strategy to Avoid Taxes.)

My daughter is 14 now. If I open a Roth IRA account for her in her name now, how will it affect her when she is going to apply for college financial aid or scholarships? – David

As long as she has earned income, there is no age restriction for a Roth IRA. In fact, I plan to do the same once my children are earning some income. For more information see Roth IRAs for Minors.

As far as financial aid, if she doesn’t make any withdrawals during her college years, it shouldn’t affect her financial aid. The money in a Roth IRA is not counted as an asset, although any withdrawals during the year would be. Although, from what I’ve read it looks like this is the federal financial aid standard. If she were to apply to a private school, they may have their own formula for determining aid which may or may not include retirement accounts.

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It all started when I got an email from David at My Two Dollars who was looking to compare self employed tax deferral options for his own business. As I was pointing out some pros and cons, I realized that I could use one of these myself!

Even though I’m beginning to withdraw retirement contributions, instead of contribute them, I remembered that it would allow me an easy way to facilitate my unconventional Roth IRA strategy to lower our tax bill.

Contribution Deadlines

One of the big advantages over a traditional 401k, is that you don’t need to contribute until your tax filing deadline (plus extensions). It will open up an option to shelter additional money, if needed, after you file your taxes.

The deadline to set up a new plan is December 31, however, you don’t need to make any contributions when you set it up. I don’t plan to make a contribution until we know exactly how much we will need to defer at tax time.

Calculating Contributions

The contribution limits for 2008 are:

• $15,500 deferral of your pre-tax income (less any contributions made to a 401k at your regular job).
• Profit sharing contribution up to 25% of your pay, with a maximum of $46,000.
• Total contribution is the sum of the deferral and profit sharing, limited to 100% of your pay.

Because of the two different types of contributions, it can get a little tricky to figure out, because you must account for self employment tax in the calculation. Here is a helpful calculator to determine your maximum contribution.

Selection of Administrator

I chose the self-employed 401k at Fidelity, mainly because Vanguard didn’t offer one when I set it up a few months ago. (Now they offer one.)

Fidelity has great fund choices for low cost index funds, and no plan fees. My Money Blog also completed a review that confirmed my research. They also offer a Fidelity cash back credit card.

The only downside is that to access the index funds with .10% expense ratio, you need a minimum of $10,000 in each fund.

The process to set up the plan was easy. I couldn’t do it online, but I filled out the forms and sent them in. My new accounts were established within a week. It was painless.

Solo 401k Tidbits

Reporting. Once the plan reaches $250,000 in assets, you must complete a Form 5500. I used to complete these for clients back when I worked in Employee Benefits, so that shouldn’t be a problem.

Employees. The solo 401k is for you and your spouse only. Part-time employees who work less than 1000 hours per year can be excluded.

Pros and Cons. Checkout a complete rundown on the pros and cons of a solo 401k at Chance Favors.

Other Self Employed Tax Deferral Options

I selected the solo 401k, mainly because it usually gives the option to shelter as much income as possible, allowing more room to execute various tax strategies.

If you have a small business, there are other options you can consider including a SEP IRA and Simple IRA. Here is a great comparison of all three.

Thanks to Patrick at Cash Money Life for reminding me that I needed to write about my solo 401k!

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