Being self-employed offers the freedom to set your own path in the working world. Flexible hours, setting your pay rates and not having to answer to “the man” are some of the benefits.
Being your own boss also comes with a lot of responsibilities. Funding a retirement plan should be one of them.
Payroll deductions and 401(k) retirement plans set up by employers make it easy for workers at 9-to-5 jobs to contribute to retirement plans. But for the self-employed or those owning a small business with a few employees, it can be more of a challenge for the simple fact that they have to deal with it on their own and can’t leave it up to an employer to deal with.
The good news is that it’s not as complicated as you might think. There are plenty of options for putting your money away for retirement.
The first step is to figure out how much you need to save for retirement. Your financial adviser can help, as can an online retirement calculator, to determine how much you should save annually to meet your goal. That will help determine the best retirement account for you.
Here are the five main options for saving for retirement when you’re self-employed:
Traditional or Roth IRAs
If you’re just starting out or saving less than $55,000 a year, a traditional or Roth IRA is a good option. If you’re leaving a job to start a business, you can roll your old 401(k) into an IRA.
As of 2018 the IRA annual contribution limit is $5,500, plus $1,000 catch-up contribution if you’re 50 or older. The Roth IRA has income limits for eligibility, meaning that those who earn too much can’t contribute.
An IRA doesn’t have any special filing requirements and can be used if you have employees or don’t. The plans are individualized, meaning that if you have employees, they can set up and contribute to their own IRAs.
There are enough differences between traditional and Roth IRAs that you may want to talk to a tax or financial professional for advice.
A Roth IRA might be best if your business isn’t making much money because while there is no immediate tax deduction for a Roth IRA, withdrawals are tax-free in retirement, when your tax rate is likely to be higher. A Roth doesn’t require withdrawals at a specific retirement age.
A traditional IRA offers immediate tax deductions on contributions. Ordinary income taxes on withdrawals at retirement must be paid. You must start withdrawing from a traditional IRA when you retire or reach age 70-1/2, whichever comes later.
Solo 401(k)
For the self-employed or a business owner with no employees, except a spouse, a solo 401(k) plan is a good way to save a lot more money for retirement than through an IRA. It’s like the 401(k) retirement plan you may have had when you worked full-time for someone else, but is operated and used by a single person.
As of 2018 the contribution limit is up to $55,000 (plus $6,000 in catch-up contributions if you’re 50 or older), or 100 percent of earned income, whichever is less. Being self-employed basically allows you to contribute to the plan twice, or double the limits in a traditional 401(k) plan, as both an employee and employer.
As an employee to yourself, a solo 401(k) allows you to contribute up to all of your compensation or $18,500, whichever is less. As the employer who administers the plan, you can match contributions of up to 25 percent of compensation.
You can hire your spouse and they can contribute to the plan. A spouse can put in the standard employee 401(k) contribution limit, plus you can add in the employer contributions, for an additional $55,000 total, plus catch-up contribution if eligible.
The tax advantages are the same as a standard, employer-offered 401(k). Contributions are made pre-tax, and distributions after age 59-1/2 are taxed.
A Roth solo 401(k) is a related option. Like a Roth IRA, the solo plan doesn’t have an initial tax break but the distributions in retirement are tax-free. Generally, a Roth is a better option if you expect your income to be higher in retirement.
SEP IRA
A SEP IRA, or Simplified Employee Pension Individual Retirement Arrangement, is best if you have no or few employees.
The 2018 contribution limit is the lesser of two options: $55,000, or up to 25 percent of compensation or net self-employment earnings, with a $275,000 limit on compensation that can be used to factor the contribution. Net self-employment income is net profit less half your self-employment taxes paid and your SEP contribution. No catch-up contributions are allowed.
For tax purposes, either the contributions can be deducted from your taxes, or 25 percent of the net self-employment earnings or compensation can be deducted. Distributions in retirement are taxed as income.
If you have employees, you must contribute an equal percentage of salary for each eligible employee. You are also counted as an employee. So if you contribute 10 percent of compensation for yourself, you must contribute 10 percent of each eligible employee’s compensation. That can be an expensive downside to a SEP IRA.
SIMPLE IRA
For businesses with up to 100 employees, a SIMPLE IRA, or Savings Incentive Match Plan for Employees, is a simpler option than a traditional 401(k) if you intend to match your employees’ contributions.
The contribution limit is $12,500, plus $3,000 in catch-up contributions if 50 or older.
Contributions to a SIMPLE IRA for yourself are tax-deductible, but distributions in retirement are taxed. Contributions to employee accounts are deductible as a business expense.
Withdrawals from the plan before age 59-1/2 are taxed as income and subject to a 10 percent penalty. A withdrawal made within the first two years of participation in a SIMPLE IRA incurs a 25 percent penalty, which includes rolling over the plan to another retirement account within those two years.
While the SEP IRA puts the contribution burden solely on the employer, the SIMPLE IRA allows employees to contribute through salary deferral.
As an employer you’re generally required to either make matching contributions of up to 3 percent of employee compensation, or fixed contributions of 2 percent to every eligible employee. Giving fixed contributions as an employer doesn’t require the employee to contribute to earn your contribution. For 2018 the compensation limit for factoring contributions is $275,000.
Defined benefit plan
If you’re lucky and smart enough to be self-employed with no employees and a high income, and you want to save a lot of money for retirement on an ongoing basis, then a defined benefit plan is your best option.
A defined benefit plan allows you to contribute more than any of the other retirement plans listed above. It’s required to have a third-party administrator or actuary to determine the amount and timing of your contributions.
The plan administrator used a formula to set the maximum contribution amount, which will vary from person to person based on the plan’s terms. The calculation is based on the benefit you’ll receive at retirement, your age and expected investment returns.
Contributions are required each year and the amount is usually substantial. If you have steady profits and want to put away a large amount of money each year for tax deductions, this is one way to do it.
Contributions are generally tax deductible and distributions in retirement are taxed as income. An actuary will determine your deduction limit.
Employees can be brought on later and added to the plan, when you’ll be making contributions for them.
How to start
To open any of these plans — except for the defined benefit plan that can require finding a broker that offers them — you can usually start with an online broker. If you’re already working with a broker — either online or in person — check to see if they offer retirement plans for self-employed people.
Opening an online account should only take a few minutes. You may have to file some paperwork with the broker, and the IRS may want some paperwork too.
If you’re still unsure which retirement plan is right for your income and taxes as a solopreneur, check an IRS list of such plans or ask a tax or financial adviser who knows your situation.
You no longer have an employer to look after your retirement, so now is the time to look out for yourself. However you start, do it as a favor to put a path to retirement in front of your best employee — yourself.