One of the biggest drawbacks to being self-employed is the lack of employer paid or sponsored benefits. One of the biggest of these is a retirement plan. However, there are several self-employed retirement options available. You can choose the one that works best for you, but you can also start with one, and then switch to another plan as your business expands.
IRA ? Traditional and Roth ? a Good Starter Plan
The IRA has several advantages over other self-employed retirement options. They include:
- Simplicity
- Unlimited investment options
- They?re completely self-directed
- They offer low fees
- Contribution amounts may be greater than you think
Let?s focus on that last point for a bit. The IRS allows you to contribute up to $5,500 per year, or up to $6,500 per year if you are 50 or older. But there?s another IRA provision that people are generally unaware of. It?s the spousal IRA.
The spousal IRA allows you to make IRA contribution for your spouse even if he or she does not have an income. For example, let?s say that you earn $60,000 from your business. You can contribute $5,500 to your own IRA account, and then another $5,500 for your spouse. That gives you a total contribution of $11,000 per year.
IRAs come in two basic flavors, traditional and Roth. The traditional IRA allows you to deduct your contributions to the plan from your income. Investment earnings in the plan accumulate on a tax-deferred basis. IRA investment options are typically unlimited. The IRS has a few prohibited IRA investments, but they?re basically of an exotic nature.
You can begin taking withdrawals from the plan at age 59 ?, at which time you will owe ordinary income tax on the amount withdrawn. If you take withdrawals prior to turning 59 ?, you will be subject to a 10% early withdrawal penalty, in addition to ordinary income tax.
The Roth IRA works in much the same way, but for two major exceptions:
- The contributions that you make to a Roth IRA are not tax-deductible, and
- Withdrawals from a Roth IRA or tax-free, as long as you are at least 59 ? at the time distributions begin, and you have the plan for at least five years.
With a Roth IRA, you are making a trade-off. You are forgoing tax deductibility of your contributions now, in exchange for tax-free income in retirement.
An IRA, whether traditional or Roth, is usually the best of the self-employed retirement options for a new business.
SIMPLE IRA
You can contribute 100% of your income, up to a maximum of $12,500 per year. If you are 50 or older, the contribution amount rises to $15,500. However, in order to qualify, you must earn a minimum of $5,000 in either of the past two years.
From an administrative standpoint, the major advantage of the SIMPLE IRA is that there is no requirement for you to file a specific tax return with the IRS for the plan itself.
However, the SIMPLE IRA does have one complication – you will have to make an employer contribution to the plan as well. IRS regulations for the SIMPLE IRA require you to make contributions based on one of two formulas:
- A 3% matching contribution, or
- A 2% non-elective contribution of up to $5,000.
Of course, either formula is only an issue if you have employees. If you don?t, it just means that you contribute more to the plan for yourself. For example, if you earn $60,000 in net profit from your business, and you choose a 3% employer matching contribution, you can contribute an additional $1,800 to the plan. If you make an employee contribution of $12,500, that means that your total contribution will be $14,300.
A SIMPLE IRA is a good choice for a business that has grown, but business income is still modest. It offers higher contributions than regular IRAs, and 100% of income up to the contribution limit. It?s also good if you want to begin hiring employees and want to offer a retirement plan.
SEP IRA
The Simplified Employee Pension Plan Individual Retirement Account, or SEP IRA, is also an IRA account, and one specifically tailored to the self-employed. For that reason, the SEP functions much like an IRA, except that it has much more generous contribution limits. Contributions are tax-deductible, investment earnings are tax-deferred, and you can begin taking withdrawals at 59 ?, subject to ordinary income tax.
The maximum contribution to a SEP IRA is $54,000, or $60,000 if you?re 50 or older. But another departure from an ordinary IRA is that your contribution is based on a percentage of your income.
In theory, you can contribute up to 25% of your net income to the plan, however the IRS formula actually limits your contribution to 20% of your income. In order to determine the 25%, you must first deduct the amount of the contribution from your income. That means that your 25% contribution will be reduced by 20%, making it effectively 20%. Yes, it?s convoluted, but that?s the IRS.
There?s another benefit to having a SEP IRA. You can set it up as a sole practitioner, but if you hire employees, you can offer to include them in the plan. They will have to set up an individual account within the plan, and make similar contributions based on their own income.
The SEP IRA is a good plan for a well-established business with generous profits, and where there is a need for a large tax deduction.
Solo 401(k)
Now we?re leaving the realm of IRA plans. The solo 401(k) plan is basically a 401(k) plan for a one person business. That means that you will have all the advantages of an employer-sponsored retirement plan for your own small business. A solo 401(k) plan cannot have any employees, other than you and your spouse.
But, since a solo 401(k) plan is a 401(k), you can add employees to the plan as you hire them. Once you hire your first employee, the solo 401(k) becomes a regular employer 401(k) plan. That makes it the perfect self-employed retirement option. The plan can easily grow as your business grows.
As is the case with both the SEP and SIMPLE IRAs, as the business owner, you function as both employee and employer. But that combination is more pronounced with a solo 401(k).
As is the case with an employer-sponsored 401(k) plan, you can contribute up to $18,000 per year, or $24,000 per year if you are 50 or older, as an employee. But since you?re also the employer, you can also make an employer contribution.
The employer matching contribution is a little bit complicated, and it largely depends on the type of business formation it is ? S corporation, partnership or sole proprietorship.
In the case of a sole proprietorship, you can make a contribution that is equal to 25% of your net business income. However, that income must first be reduced by the amount of your employee contribution, and then by 50% of the amount of self-employment tax that you pay on your business income.
For example, let?s say that your net business income is $100,000. You made an employee contribution to your solo 401(k) plan of $18,000. You also paid roughly $14,000 in self-employment tax (FICA for the self-employed). That means that you must deduct $18,000, and half of the self-employment tax ($7,000) from your net income – $25,000 total. That drops your effective net income to $75,000.
You can make an employer matching contribution of 25% of that $75,000 adjusted net income. That comes to $18,750.
But despite the complication in calculating the employer matching contribution, your total contribution on a solo 401(k) plan is higher than what it will be for virtually any other plan. Using this example, you will be able to contribute a total of $36,750 to the plan, based on a net business income of $100,000. That?s your $18,000 employee contribution, plus the $18,750 employer contribution.
That means that you are making a contribution that is equal to 36.75% of your income, which is higher in both percentage and dollar amount than you can make with any of the other self-employed retirement options at the same income level.
S-Corporation limitation. The business net income calculation is limited for a solo 401(k) for an S-Corporation. You cannot include an S-Corp income distribution as part of your net business income. That?s because the distribution is considered a profit distribution, similar to a dividend, and therefore not earned income. Your employer contribution will be based primarily on your W2 wages from the business, and not your total profit.
The solo 401(k) will work for a business of any size, due to its flexibility. You can start it as a sole practitioner, and then convert it to a regular 401(k) if you want to hire employees.
Now let?s do some thinking outside the box?
Creative Self-Employed Retirement Options: Non-retirement Savings
Most people don?t think in terms of non-tax-sheltered retirement savings in connection with retirement. They should. Regular taxable investments have a definite place among the self-employed retirement options. While you should still have a basic core, using an actual retirement plan, taxable investments create even more options ? particularly for a business owner.
For one, there are no dollar limits on what you can save in a taxable account. This can be especially important if you are close to retirement age, and don?t have adequate savings to retire on. Saving in taxable investment accounts can enable you to fast-forward your savings.
Here?s another big advantage: due to the fact that taxable accounts don?t provide either a tax deduction for your contributions, nor tax deferral of investment income, you can withdraw the money from the accounts free from tax consequences.
As a self-employed person, it?s easy to see the benefits that this will provide:
- Having a tax-free income source will minimize your taxes in retirement, particularly if you don?t have a Roth IRA account.
- Withdrawals from taxable accounts can provide you with a tax-free/penalty-free income source for early retirement.
- Taxable investments can provide you with an income source in early retirement, so that you don?t draw down your retirement plans before you reach retirement age.
- As a self-employed person, it?s always to your advantage to have a large reserve of liquid assets available ? the kind where you don?t have to pay taxes or penalties on the withdrawals.
- Taxable investment accounts could represent a large emergency fund in retirement ? you can access the funds, without incurring a tax liability or drawing down on your regular retirement savings.
Don?t be afraid to include regular taxable investment accounts among your self-employed retirement options. It?s always best to diversify your investment holdings, and when you include taxable investments, you?re actually giving yourself valuable tax diversification when retirement comes around.
Create Passive Income Sources
As a self-employed person, you have the advantage of having an entrepreneurial mindset. That can enable you to develop income sources in unexpected ways. Passive income sources are an excellent way to either supplement your retirement income, or even provide a revenue stream for early retirement.
Here are three examples:
- The sale of your business ? if you set the sale up on an installment basis, it can provide you with income for anywhere from 5 to 10 years.
- Investing in real estate ? if you invest early, and pay off the mortgage by retirement, the rental income can provide a large cash flow.
- Becoming a silent partner ? you could do this either in a similar business to your own, or even one that?s completely different. You can invest capital in a business that is actively managed by another person, in exchange for a share of the profits.
These are just three examples of what can be done, but the possibilities are really limited only by your own creativity.
I hope you can see from all of these examples, that there really are plenty of self-employed retirement options. There?s no reason for you to go without some form of retirement provision just because you don?t have an employer sponsoring a plan for you.
The Self-Employed Don’t Ever Need to Retire
In a real way, talking about self-employed retirement options almost seems like a contradiction. In my experience, most self-employed people have no desire to retire, at least not in the same way that W-2 employees do. Employees tend to see retirement as a blessed exit strategy. But for the self-employed, retiring is akin to quitting on yourself.
Speaking for myself, that?s pretty much my position. I really enjoy my life as a blogger/freelance blog writer, and have no plans to retire. In fact, if I could do this business until the day I die (OK, maybe the day before) that I?ll die a happy man.
But whether you plan to retire or not, it?s always best to have self employed retirement options up and running. It?s not always that you want to leave your business, but more that you might want to just slow down and spend more time on the non-business side of your life. Well-funded retirement plans ? as well as some of the other income sources we?ve discussed ? can help you create that perfectly blended lifestyle of doing work that you enjoy, while also enjoying your life. These options should help you to do just that.
Remember also that you can set up any of these self-employed retirement options even with a part-time business, though naturally the retirement contributions you?ll make will be smaller in each case.
Run your business, enjoy your work, but make a provision for your retirement. That will give you the best mix of options when the retirement years come around. It?s all about creating options.
Hi Kevin. Another great article about options for the self-employed. Great summary work, and thank you for that. We are self-employed, as you know, and we have a SEP account, which works for us. I just read your link about the self-employed perhaps not wanting to retire, which I hadn’t read before. More good insight. My husband and I differ here…I want the option of being able to retire, if/when we ever choose or need to. He, maybe because he’s a man (no offense) believes he can work forever because he loves his work and he likes to be busy. There’s a difference. So, while I continue to save for the inevitable, we most likely will continue to work as long as we can just because we enjoy it and it would be a good income stream later in life. The beauty is that we can work as little or as much as we want, depending upon our needs, which is not usually available when you work for someone else. But we continue to live and work in a high cost-of-living area, which we do like, but it gets expensive. I often think of heading south, just because I believe it is lower cost there, but I may be wrong about that. Since you are someone who moved north after living in the south, I’d be interested in your take on working/living in different areas. I also think I suffer from that old-fashioned belief that people retire and move south. I think that’s just out-of-date thinking, however. What do you think?
Hi Bev – No, it’s not an out-of-date concept, people are still moving to the South for retirement. The two main reasons are warmer weather and lower cost of living. For obvious reasons, I don’t believe we’ll move back to the South for retirement. But there are a couple of things to be aware of. One is that “warm” really means hot, especially if you’re more than a few miles from the beach. You get a similar cabin fever in the South in the summer as you do in the North in the winter. 90-something degrees with high humidity every day for months gets old really fast.
Cost of living is a mixed bag. Don’t assume it’s cheaper. Always compare income and sales taxes. Florida and Tennessee have no income tax, but other Southern states have rates comparable to most Northern states. Also, housing in some cities is as high or higher than much of the North. The rural areas and smaller cities continue to be cheaper.
But perhaps the biggest caution I’d advise is that you’ll be moving to a place that’s very different. While much of the North has attractive historic districts and deeply established local culture and social structure, much of the South is recent development. It tends to have a monotonous sameness to it – hundreds of similar shopping centers, apartment complexes, condominiums and subdivisions. Much of it looks obviously faux and uninteresting. Largely because of the newness, they also lack social cohesion, or it’s cohesion on a more superficial level. It’s hard to describe, but if you’ve lived in both the North and the South you’d be able to identify it.
Of course it’s different strokes for different folks. I’ve lived in both the North and the South and personally prefer the cultural and geographic diversity of the North, as well as the bluntness of Northerners. But thousands of Northerners move to the South every year to retire. But while living in the South I also became aware of the reverse migration factor. Some of the people who move to the South end up going back up North after a few years. Not everyone can adjust to the different lifestyle and the absence of familiarity. For others the change is exhilarating and opens up a new chapter in life.
I’m guessing that my comments will only confuse you…
Not at all confusing, and thank you for that. I also agree that it’s different strokes for different folks, and thank goodness we’re not all looking for the same things. So, I respect anyone’s opinion on where they live and why they prefer it..it’s all up to the individual. I was just wanting your particular opinion since you did the reverse migration. And back to your point about retirement and different plans, your post was very informative and hopefully helpful to anyone who may be anticipating self-employment. As you say, there are many options. Thanks again.