Options for Retirement Plans
A guide for the self-employed and small businesses
Whether you have been self-employed forever, or have made a recent change, there is one important aspect to include in your business plan: saving for your retirement. In larger companies, employees may not give much thought to their participation in a company sponsored plan and making regular contributions pre-tax from their paycheck.
When you are on your own, you must set up this plan for yourself.
In addition, Minnesota is not the greatest state in the country regarding taxing retirement benefits. It is one of the few states that taxes Social Security income. It also taxes other forms of retirement income such as pensions and 401ks while providing no deduction or exemption for seniors. So again, planning early to ensure you have enough socked away for later is even more important in the Land of Lakes.
This would be a good time to mention that this article is for general information only. I am not a broker, adviser or brokerage service. I own a single entity, LLC, in other words, am a small business owner. In a flurry of adulting, my husband and I just went through a thorough evaluation of our finances and investments, hired a certified financial planner, changed our CPA and attorney. Now we are playing catch up on retirement savings so we don’t have to work until we are 80!
Here are a few things we learned along the way.
Before you meet with an adviser, take stock of your current situation and estimate how much money you will need to live on during retirement. Investopedia says most people should aim for an income of about 80% of what you will earn just before retirement. So, if you will earn about $5,000 per month at the end of your career, you would need $4,000 per month in income. There are variables to this, including your health and whether you own your home outright with no mortgage.
Also, think about what age you want to retire. Since my husband and I are different ages, but we want to retire together, the age of the older spouse (me) is our goal. Gather up and review all of your most recent investment account statements. These basic questions and tasks will help in figuring out how much you need to save for retirement.
NerdWallet has a fun retirement calculator you can try. The tool is kind of generic- if you have a partner, you need to add their income in too, adjust the amount you want to spend each month, and combine cash and retirement plan investments under savings. However, the calculator will give you a very rough idea.
Unless you are an investing genius (I am not) you should plan to talk to a financial adviser. There are a few different types to research, as the term “financial advisor” is not regulated. We narrowed down pretty quickly that we were looking for a certified financial planner who is a fiduciary—a person required to adhere to professional practices, called fiduciary principles, that make them worthy of clients’ trust. Fiduciaries have a legal responsibility to act in the best interest of their clients.
There is also a menu of options a financial professional can fulfill. We wanted:
- Investment advice. We were looking for a fee-based advisor, rather than the commission based advisor we had been using, which provided a very low level of service
- Input on tax planning
- Retirement planning
- Estate planning
- Advice on life insurance, disability and long-term care insurance
Some other typical services we did not need include:
- Debt management
- Budgeting help
- College planning (though this would have been helpful years ago)
Five types of retirement plans for self-employed and small businesses
I am a single-entity LLC with no employees, but some of these options are appropriate for small businesses with employees. NerdWallet provided the links and descriptions.
1. Traditional or Roth IRA
Best for: “Those just starting out. If you’re leaving a job to start a business, you can also roll your old 401(k) into an IRA.
IRA contribution limit: $6,000 in 2021 and 2022 ($7,000 if age 50 or older).
Tax advantage: Tax deduction on contributions to a traditional IRA; no immediate deduction for Roth IRA, but withdrawals in retirement are tax free.
Employee element: None. These are individual plans. If you have employees, they can set up and contribute to their own IRAs.
How to get started: You can open an IRA at an online brokerage in a few minutes, or with your own broker. An IRA is probably the easiest way for self-employed people to save for retirement. There are no special filing requirements, and you can use it whether or not you have employees.”
I would suggest you do some pre-reading on the differences between traditional and Roth IRAs, or speak with your CPA. The basic difference is whether you are taxed on the investment now or later. If your income is low right now as you start and grow a business, you may want to be taxed sooner, rather than later when your income might be higher.
2. Solo 401(k)
Best for: “A business owner or self-employed person with no employees (except a spouse, if applicable).
Contribution limit: For 2021, it’s $58,000, plus a $6,500 catch-up contribution or 100% of earned income, whichever is less. For 2022, it’s $61,000, plus a $6,500 catch-up contribution or 100% of earned income, whichever is less. To help understand the contribution limits here, it helps to pretend you’re two people: an employer (of yourself) and an employee (also of yourself).
- In your capacity as the employee, you can contribute as you would to a standard employer-offered 401(k), with salary deferrals of up to 100% of your compensation or $19,500 in 2021, $20,500 in 2022 (plus that $6,000 catch-up contribution, if eligible), whichever is less.
- In your capacity as the employer, you can make an additional contribution of up to 25% of compensation.
- There is a special rule for sole proprietors and single-member LLCs: You can contribute 25% of net self-employment income, which is your net profit less half your self-employment tax and the plan contributions you made for yourself.
- The limit on compensation that can be used to factor your contribution is $290,000 in 2021 and $305,000 in 2022.
Tax advantage: This plan works just like a standard, employer-offered 401(k): You make contributions pretax, and distributions after age 59½ are taxed
Employee element: You can’t contribute to a solo 401(k) if you have employees. But you can hire your spouse so they can also contribute to the plan. Your spouse can contribute up to the standard employee 401(k) contribution limit, plus you can add in the employer contributions, for up to an additional $58,000 total in 2021 or $61,000 total in 2022, plus catch-up contribution, if eligible. This potentially doubles what you can save as a couple. You’ll need to file paperwork with the IRS each year once you have more than $250,000 in your account.”
The IRS calls these solo 401(k) plans a “one-participant 401(k).” It is particularly good for those who are able to save a great deal of money for retirement or those, like us, are trying to catch up on our retirement in years when business is good. There is also a Roth 401(k), good for those who expect their income and tax rate to be lower now than around retirement time.
3. SEP IRA
Best for: “Self-employed people or small-business owners with no or few employees.
Contribution limit: The lesser of $61,000 in 2022 ($58,000 in 2021) or up to 25% of compensation or net self-employment earnings, with a $305,000 ($290,000 in 2021) limit on compensation that can be used to factor the contribution. Again, net self-employment income is net profit less half of your self-employment taxes paid and your SEP contribution. No catch-up contribution.
Tax advantage: You can deduct the lesser of your contributions or 25% of net self-employment earnings or compensation — limited to that $305,000 cap per employee in 2022 — on your tax return. Distributions in retirement are taxed as income. There is no Roth version of a SEP IRA.
Employee element: Employers must contribute an equal percentage of salary for each eligible employee, and you are counted as an employee. That means if you contribute 10% of your compensation for yourself, you must contribute 10% of each eligible employee’s compensation.”
A SEP IRA is easier to manage, with limited paperwork and no annual IRS reporting. However, if you choose this option, you will have to make contributions for employees, at a percentage equal to what you make for yourself.
4. SIMPLE IRA
Best for: “Larger businesses, with up to 100 employees.
Contribution limit: Up to $14,000 in 2022 ($13,500 in 2021), plus catch-up contribution of $3,000 if 50 or older). If you also contribute to an employer plan, the total of all contributions can’t exceed $20,500 in 2022 ($19,500 in 2021).
Tax advantage: Contributions are deductible, but distributions in retirement are taxed. Contributions made to employee accounts are deductible as a business expense.
Employee element: Unlike the SEP IRA, the contribution burden isn’t solely on you: Employees can contribute through salary deferral. But employers are generally required to make either matching contributions to employee accounts of up to 3% of employee compensation, or fixed contributions of 2% to every eligible employee. Choosing the latter means the employee does not have to contribute to earn your contribution. The compensation limit for factoring contributions is $305,000 in 2022 ($290,000 in 2021).”
The SIMPLE is fairly easy to set up if you have fewer than 100 employees, and easier to manage since employees own their own accounts. Early withdrawals are penalized, but there is also a 401K version of a SIMPLE IRA which allows participants to take loans from their accounts.
As an Amazon Associate, Arvig earns from qualifying purchases.
5. Defined benefit plan
Best for: “A self-employed person with no employees who has a high income and wants to save a lot for retirement on an ongoing basis.
Contribution limit: Calculated based on the benefit you’ll receive at retirement, your age and expected investment returns.
Tax advantage: Contributions are generally tax deductible, and distributions in retirement are taxed as income. An actuary must figure your deduction limit, which adds an administrative layer.
Employee benefit: If you have employees, you generally offer this plan to them and make contributions on their behalf.”
Note: These plans can be expensive to set up and manage, and few brokerages offer them.
Where and how to open a retirement plan
You likely will want to select a financial advisor before deciding which type of retirement plan to choose. I tried to manage things on my own for years, and lost valuable investment time. Finally, we asked people we trusted, and that appeared to be doing better than us, “who manages your portfolio?” In addition to this research, we also spoke with an accountant friend that is a very savvy investor as well as our CPA.
We ultimately interviewed three certified financial planners. One we liked but eliminated because he was located too far away, and the time difference to communicate with him was not practical. One we eliminated because they had logistical problems in receiving our documents prior to a meeting (we had to reschedule) and were not well prepared for the second meeting. She also disclosed that some investments she would recommend were commission based (plus a separate fee). The third, which we chose, offered the highest level of service and professionalism. Their fee was the highest. However, since we were close to the next higher tier of investing, we were able to negotiate a slightly lower fee. They have a well-performing socially responsible fund, which was also on our list.
The only thing I would have done differently in setting up a comprehensive self employed/small business retirement plan, is start much, much sooner.
If you are ready, go with a real fiduciary and check their credentials and reviews. Understand how they get paid. See how well the adviser you meet answers your questions. This person will have a good level of involvement to keep you on track with your goals.