Retirement Savings Plans for the Self-Employed
- June 21, 2017
- by Emily
For self employed individuals contributing to a retirement plan is like giving yourself an instant raise without charging your clients more. The IRS allows you to contribute a percentage of your income into a retirement account and then deduct that contribution from your taxable income. There are several ways to go about it which we detail below.
Many conversations about retirement planning focus on the options available to employees. Before accepting a job, you’re encouraged to ask about 401(k) plans and to understand if the job offers a pension plan (like many union and government jobs do). Employer sponsored retirement benefits can amount to a substantial boost in net take home pay. These kind of perks available in a W-2 job can leave the self-employed feeling like the only retirement plan open to people like them is stashing money under the mattress. Nothing could be further from the truth.
Self Employed Retirement Plans are Awesome:
When you contribute to your own retirement plan, you pay yourself not the IRS. You get to keep more overall money. The net savings is up to 40%, but it varies by the vehicle you select, your income, how much you contribute, and your overall tax situation.
With your own retirement plan, you have total control over where and how to invest the money. It can be put into just about any type of asset - stocks, bonds, mutual funds, cash, ETFs, etc. The contributions grow tax free. Unfortunately it isn’t good for paying off debt, or going towards a down payment on a home. So you do lose some control over the money. However that is the same for a person in a W-2 job contributing to their employer sponsored retirement plan.
If you are your own employer, you have the responsibility (and the burden) of choosing how to save for retirement. But you actually have more choices than someone who punches the clock.
Here’s some guidance to help you choose the best strategy for retirement savings:
Traditional or Roth IRA
Traditional and Roth IRAs are open to everyone with an earned income. Whether you’re an employee or self-employed doesn’t matter. These types of IRAs are very simple, don’t require much paperwork to open or maintain and you can keep the same plan (and continue contributing to it) if you become an employee in the future.
The tax benefits are different depending on whether you opt for a traditional or a Roth IRA. Traditional IRA contributions are deducted from your taxes now, but withdrawals during retirement are taxed. Roth IRA contributions are not deducted from taxes, but the withdrawals in retirement are tax-free.
If you’re just starting a business or aren’t sure if you’ll be self-employed long-term, this might be the best retirement option. The biggest disadvantage is that the contribution limits are low: You can only contribute $5,500 per year ($6,500 per year if you are over 50).
Simplified Employee Pension (SEP IRA)
If you don’t want to deal with the paperwork involved with setting up a solo 401(k) but need to contribute more than a traditional IRA would allow, you might want to consider a SEP IRA. In 2017, you can contribute up to $54,000 or 25% of your net self-employment income, whichever is less.
SEP IRAs don’t require any annual reporting and are very easy to set up. Like a traditional IRA, the contributions are tax-deferred but disbursements are taxed. There is no Roth SEP, or option to have the disbursements be tax-free.
The biggest downside to SEP IRAs is that you are required to make identical contributions for all of your employees, as a percentage of income. This isn’t an issue if you have no employees, but can become very expensive if you do. The IRS has eligibility standards for employees, essentially they must have worked for you for 3 years of the last 5 years, be over 21 years of age, and have earned at least $600. For more information see the IRS publication: SEP Plan FAQs - Participation Requirements.
If you want the ability to contribute substantially more than an IRA would allow, a solo 401(k) might be the solution. These work very much like an employer-sponsored 401(k) plan, but you are both the employee and the employer. The contribution limit in 2017 is $54,000 or 100% of your earned income.
Solo 401(k)s function just like an employer-sponsored 401(k). Contributions are pre-tax, disbursements after age 59.5 are taxed.
Setting up a solo 401(k) plan requires a bit more paperwork, both up front and every time you file your taxes. In addition, once the account is worth more than $250,000 additional IRS filings are required. A Solo 401(k) plan is only open to soloprenuers: You can’t have any employees other than your spouse. However, you may also include your spouse in the plan, and contribute a combined $108k per year (or as much as $120k per year if you are both over 50)!
If you’re a freelancer who has the desire and the ability to stash away a significant amount of money for retirement every year, a solo 401(k) might be your best option.
Solo 401(k) plans also offer the option of taking out a short term loan against the balance. There are limits to the loan amount, and the duration of the loan should be 5 years or less, otherwise it may be treated as a withdrawal (and penalized). IRAs do not offer this kind of flexibility. For more information see bullet point #3 of the IRS publication Retirement Plans FAQs regarding Loans.
Note that there are also Roth 401(k) plans, which are similar to Roth IRAs in that contributions are taxed while disbursements are not.
Defined Benefit Plan
Who says pension plans are a thing of the past? Even freelancers can have them - that’s what a defined benefit plan is. You pay into a plan and are guaranteed a certain level of benefits when you retire.
If these were cheap and easy to set up, everyone would have them. These are best for self-employed people who have a high, stable income and no employees. The set-up fees are high and the annual fees are high. However, there are no limits to how much you can save, and the level of retirement security is unbeatable. If you are planning on putting more than $50,000 per year towards retirement and you have no employees, this might be the best option for you. For more see the IRS publication Choosing a Retirement Plan: Defined Benefit Plan.
The bottom line: There is no one best retirement plan for the self-employed. The best option for you will depend on your income level and stability, how much you’re planning to put away for retirement and whether or not you have employees. Talk to your CPA about it before doing anything. If you can automate the contributions that makes it even easier.
If you are saving for retirement or curious about how it works, you may be interested in our Nest Egg Savings & Investment Simulator. The simulator uses back testing to see how different savings profiles and asset allocations turned out over the years.