Self Employed? You Can Still Build Your Own Retirement Plan
A look at four plans ideal for the self-employed
Being self-employed gives you the freedom and flexibility to be your own boss. You also have to take care of a lot of administrative details that an employer normally would have taken care of. One is setting up a retirement plan. If you want to retire someday, and have a satisfying post-working lifestyle, the earlier you start planning, the better.
The good news is, setting up a retirement plan is fairly easy, and something you can do yourself.
There are four types of plans tailored for the self-employed: a one-participant 401(k), SEP IRA, SIMPLE IRA, and Keogh plan. A traditional or Roth IRA are supplemental options with some different tax advantages.
We will explore all of these.
Why Save?
Entrepreneurialism is a driving American force. More than 44 million Americans are self-employed or working for self-employed people, according to PEW Research. This group of people is often crazy busy, and are not taking the time to invest in themselves. FreshBooks, a provider of accounting software for freelancers, estimates that only about 40% of self-employed people save for retirement, and then only sporadically.
There are many good reasons to turn this around and start saving—no matter what your age. First, you don’t want to count on Social Security. You may have heard on the news that Social Security is due to exhaust reserve funds sometime this year. Unless Congress makes changes to the benefit formulas, raises the payroll tax, or makes other changes such as raising the cap on taxable wage income, future retirees may only get a portion of what they expected to receive from Social Security. Even if benefits remain at current levels, the amount is often not enough to live on—at least not comfortably.
The money you contribute to a retirement account can defer a significant amount of income taxes you pay now. The account you contribute to should provide investment returns over time, helping you retire more comfortably.
As a business owner, many plans allow you to contribute more than you could to a traditional IRA.
Barriers to Saving Toward Retirement- and How to Overcome Them
Some of the most common reasons the self-employed give for not saving toward retirement include: A lack of steady income, having to pay health care expenses, paying off student loans or other education expenses, paying off major debts and the everyday costs of running a business.
Often, a self-employed person won’t know until the end of the year how much they are able to contribute. But there is a solution.
Create a budget and determine how much you can comfortably afford to contribute to your retirement plan each month. Set up a separate interest savings account and make an automated monthly contribution. If you have a good month, make an extra contribution. At the end of the year, see if you have additional funds you could add to your account before transferring to your retirement plan. Think of it as your own end of the year company match. Even if you make the minimum contribution you budgeted for, saving a little bit every month is a relatively painless way to save for your retirement.
Putting funds in a savings account, then investing at the end of the year takes discipline—you need to leave the money alone for its intended purpose. Of course, you could contribute monthly directly to your retirement plan. Just keep in mind this is more limiting.
Withdrawing funds early from a retirement plan—before age 59½—will mean a 10% penalty tax that will dig away at your savings. There are a few exemptions that you can read about on the IRS website.
Only you can determine your level of discipline and commitment, and weigh the risk of tying up funds should you have a business or personal emergency during the year.
Self-Employed Retirement Saving Plans
Let’s look at five retirement plan options where you can make contributions that are tax deductible until you cash out at retirement. Note that plan details do vary based on the size of your business. You can read more details on IRS Publication 560.
One-Participant 401(k)
A one-participant 401(k), as the IRS calls it, also is referred to as a solo 401(k), solo-k, uni-k or individual 401(k). It is only for sole proprietors with no employees, other than a spouse working for the business.
With a one-participant IRA, you can contribute both as an employer and an employee.
Plans are similar to 401(k)s offered by large companies, including amounts you can contribute each year. But since you get to contribute as the employee and the employer, you have a much higher contribution limit than many other tax-advantaged plans.
Solo contributions can be up to $57,000 in 2020 (it was $56,000 in 2019), with an additional $6,500 catch-up contribution if 50 or older. If your spouse is working for you, he or she can also make contributions up to the same amount, and then you can match those. That ends up being quite a potential nest egg.
Set Up. A financial institution will set up your 401(k). Some may attach fees or limit you to certain types of investments. Often an institution might have their own plans which could limit you to funds sponsored that institution. Do a little shopping around to find a low-cost plan with the most flexibility.
SEP IRA
A simplified employee pension, or SEP IRA, is a variation on a traditional IRA. It’s easy to set up and operate, with a generous annual contribution limit of $58,000. The simplicity is a good option for many sole proprietors, and can continue on if you add employees.
However, SEP IRA contributions are calculated on 25% of your net earnings, meaning your annual net profit less than half of your self-employment taxes. For those with a small net income (and hey, who doesn’t like to take every deduction possible?), the actual contribution would be small.
If you have a larger net income and are able to make the full contribution, it is a worthy plan to consider. All contributions would be made by you as the employer. You can make planned contributions, a lump sum at the end of the year, or skip a contribution.
A word of caution—if your business grows and you need to put on employees, they must be included in the SEP plan. Any year you contribute to a SEP plan as an employer, you will also need to do so for all of your eligible employees—up to 25% of their compensation, limited to $290,000 annually.
Set Up. The account is simpler to set up than a solo 401(k). You can easily open a SEP IRA with an online brokerage.
SIMPLE IRA
A SIMPLE IRA, which stands for Savings Incentive Match Plan for Employees, is kind of a hybrid between an IRA and a 401(k) plan. Small businesses with 100 or fewer employees are attracted to the plan because it is easy and affordable to set up and manage.
A SIMPLE IRA provides a vehicle to do a company sponsored match for employee contributions. The match can be taken as business deduction on taxes.
While likely not the best choice for the self-employed sole proprietor, if you have a business that is scaling up, it is good to have on your radar.
Set up. According to the IRS, there are three steps to setting up an SIMPLE IRA: Execute a written agreement to provide benefits to all eligible employees; Give employees certain information about the agreement; Set up an IRA account for each employee. An online brokerage can be used to set up IRA accounts.
Keogh Plan
The Keogh plan, or often referred to as a qualified or profit-sharing plan, is a complex plan. However, it is very attractive for high earning sole proprietors and small businesses with one or two high earners and a small number of lower wage earners, like a legal or medical practice. Keogh’s offer the most potential retirement savings.
A Keogh plan is typically set up one of two ways. In a defined contribution plan, a fixed sum or percentage is contributed every pay period pre-tax. The contribution cap is $58,000. Another option is as a defined benefit plan. For 2021, the allowed contribution is $230,000 or 100% of the employee’s compensation, whichever is lower.
A business must be unincorporated and set up as a sole proprietorship, limited liability company (LLC), or partnership to use a Keogh. Although all contributions are made on a pretax basis, there can be a vesting requirement.
As you might imagine, these plans are mainly beneficial to high earners, especially the defined-benefit version, which allows greater contributions than any other plan. A Keogh is best suited for firms with a single high-earning boss or two and several lower-earning employees—as in the case of a medical or legal practice.
Set Up. A company must be unincorporated sole proprietorship or LLC. Since Keogh plans are complex, including federal filing requirements, plans are usually set up by an accountant or financial adviser.
Traditional or Roth IRA
Anyone with employment income can start a traditional or Roth IRA, including the self-employed. The biggest difference between a Roth and a traditional IRA is how and when you get taxed. Contributions to a traditional IRA are tax-deductible in the year they are made. With a Roth IRA, withdrawals in retirement are not taxed.
Another advantage to a Roth IRA is you can withdraw deposits (but not interest) with no tax penalty. Many self-employed people have both a Roth and a 401K for this reason. The Roth helps protect you against unexpected emergencies.
If you had a previous employer sponsored plan, you can roll over those savings into a traditional or Roth IRA.
Contributions are limited to $6,000, or $7,000 if you are age 50 or older.
Set Up. You can set up a traditional or Roth IRA via an online brokerage. It is helpful to decide what kind of investor you want to be ahead of time- hands on, or have someone help you decide.
The Takeaway
If you are self-employed, pay yourself first by setting aside money each month, and contributing the maximum amount you can afford to a retirement plan. It is an investment that will earn you dividends in the long run, and help you plan for a comfortable retirement.
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