How should you save for retirement if you’re self-employed?
Previously, we discussed the retirement savings options for those who are employed but not covered by an employer retirement plan. They included a Traditional IRA, a Roth IRA, and a taxable brokerage account. But are those the only options available to self-employed individuals as well?
They are not. Those who have decided to be their own boss, also have additional options for their own retirement funding. While you could very well setup plans similar to larger companies, the expenses for doing so would not make much sense for a self-employed individual.Three of the better options are laid out below. Each of the accounts has nearly identical tax treatment. Contributions are not included in your income and they all grow tax-deferred, until the point when money is withdrawn as taxable income. More details on each account are below:
A solo 401(k) has the same rules and requirements as a normal 401(k). The main difference, as the name implies, is that it covers just a business owner with no employees, or that individual and their spouse. You can only open a solo 401(k) if you have no employees other than your spouse.
You each can defer up to $18,500 in 2018, plus an additional $6,000 if you’re 50 or older. As a quasi-employer match, you can also contribute an additional amount up to a certain percent of your net earnings from self-employment, depending on your business entity type. However, your deferral and additional contribution cannot exceed $55,000 in any given year.
Formally known as a Simplified Employee Pension Plan, the SEP IRA is essentially just a plan where only the employer contributes to IRAs set up for each employee. Unlike the solo 401(k), a SEP can be used for self-employed persons with multiple employees.
Contributions to each employee’s account is limited to the lessor of 25% of their compensation, or $55,000. The actual calculation to determine a self-employed individual’s compensation for this purpose can be a complex calculation, which you should have a tax professional assist you with. Essentially, it is your net earnings less one-half your self-employment tax.
There is an important point for consideration for those with multiple employees. The same percentage of compensation must be contributed for every employee. So if you decide to contribute the max 25% of salary for yourself, you must do so for everyone. This can make this option a poor choice for owners with many employees.
While the acronym stands for Savings Incentive Match Plan for Employees, the SIMPLE IRA is indeed simple. The process for setting this plan up is very similar to the SEP. Each employee has their own IRA. However, instead of just the employer making contributions, the employee can make salary deferrals. The employer has the option to either either match 100% of their deferral up to 3% of their income or make a guaranteed contribution of 2% of their income regardless of the deferral amount.
While it is the simplest option of the three, it also has the lowest contribution limits. In 2018, employee deferrals are limited to $12,500 ($15,500 if you are 50 or older). There is also an increased early withdrawal penalty (25%) if you withdraw from the account before age 59 ½ and within the first two years of participating in the plan.
Which One Should You Use?
As is often the case, the best plan option depends on your situation. What’s important is simply knowing that you have tremendous options available to you. There is no excuse to neglect your future retirement goals. You have decided to take your work into your own hands as a self-employed person. Do the same with your retirement savings!
There are numerous variables to take into consideration when picking the right plan for you. While I have tried to provide a quick overview, there are additional characteristics for each plan that should be taken into account. If you are ready, reach out and engage with me to start living your best life today!