Self-employment gives people a lot of freedom and flexibility but it can make saving for retirement quite difficult. People who work for themselves have to be diligent enough to save on their own since there isn’t an employer-sponsored plan that allows for automatic contributions.
Once you have some idea of how much you want to save, it’s time to decide what kind of account is best for you and your business. There are plenty of options to choose from.
1. Solo 401(k)
This is a good choice for a sole proprietor that doesn’t have any employees. As of 2019, the yearly contribution limit is the lesser of $56,000 or 100% of earned income. There’s also an additional $6,000 catch-up contribution allowed for people over age 50.
If this sounds confusing, think about it like this. When you own your own business, you’re both a business owner and an employee. A solo 401(k) allows you to contribute $19,000 a year as an employee or up to 100% of your compensation, whichever is less.
As the owner, you’re allowed to make additional contributions. For LLCs or sole proprietors, you can contribute 25% of your net income, or your business’ profit minus half of the self-employment tax you pay and the contributions you make for yourself as an employee.
This type of 401(k) is taxed just as any employer-sponsored plan is. All contributions are before tax and distributions taken after age 59 ½ are subject to income tax.
If you have employees, you are prohibited from contributing to a solo 401(k). This does not include your spouse, however, so he or she can also contribute to the plan using standard contribution limits, currently $56,000 a year, essentially doubling your savings.
2. Traditional or Roth IRA
Traditional or Roth IRAs are a good choice for people who are just starting to save or plan to put away less than $6,000 a year. You can also roll an existing 401(k) into an IRA if you left a previous employer to start your own business. IRAs don’t have any special requirements and are arguably the easiest way to get started saving.
The yearly contribution limit for an IRA is currently $6,000. Anyone 50 or older can contribute up to $7,000 a year, which includes a $1,000 catch-up contribution. You get a tax deduction for any contributions to a traditional IRA. Plus, withdrawals made after retirement age are not taxed.
When choosing between a traditional or Roth IRA, consider this. The way a Roth IRA is taxed might be better if you’re just getting started and money is a little tight. Why? Because the tax implications aren’t as big as they may be in the future. But, keep in mind that the Roth IRA has income limits. If you make too much, you’re better off with a traditional IRA.
3. SEP IRA
For small business owners with or without employees, a SEP IRA is another option. The annual contribution limit is $56,000 or up to 25% of net earnings. There’s also a $280,000 limit on what compensation can be used to figure out the limit. Also, this plan does not have a catch-up contribution.
As far as taxes go, you are allowed to deduct either your contributions or 25% of your net earnings respective to the $280,000 limit, whichever is lower. In retirement, all disbursements are subject to income tax.
Since you are the employer, you’re required to contribute the same amount to the plans of all your employees as you do for yourself as the owner. If you save 12 percent for yourself, you have to contribute 12 percent to each employee’s income to their plan.
A SEP IRA is pretty simple. There’s limited paperwork and you don’t have to make annual reports to the IRS. You also have the flexibility to contribute when you can since there’s no requirement to make a contribution every year.
An obvious downside is that you have to make contributions for your employees but remember that this is a percentage, not a dollar amount. Still, this can cost you a lot if you have multiple people on staff or if you’re planning to save a lot for your own retirement. You cannot use this plan to save only for yourself. You have to consider your employees as well.
4. Simple IRA
If you have a larger business with up to 100 employees, consider a simple IRA. You can contribute up to $13,000 a year with a $3,000 catch-up contribution after age 50. If you contribute to another plan, remember that the total of everything cannot exceed $19,000 a year.
All contributions are tax-deductible and any contributions you make on behalf of your employees can be written off as a business expense.
Disbursements made in retirement are taxable. Early withdrawals are subject to income tax as well as a 10% penalty. Withdrawals made in the first two years of setting up the account face a 25% penalty, including rollovers.
The difference between this and a SEP IRA is that a simple IRA does not place the financial burden of employee contributions solely on you, the employer. Employees can contribute to their own plans but you are required to match up to 3% of employee contributions or make a fixed 2% contribution for every employee who’s eligible, including those who are not saving for themselves.
This option is relatively easy to set up and isn’t overly complicated since employees own their own plans. However, it can get expensive making mandatory contributions to employee accounts.
5. Defined Benefit Plan
If you make a lot of money and don’t have any employees, a defined benefit plan allows you to save a lot for your retirement while making on-going contributions. If you have employees, you can also offer this plan to them but you will have to make contributions on their behalf.
Limits are calculated based on the amount you’ll receive when you retire factoring in your age and the expected returns from your investments. To do this, an actuary must figure out your limit which adds additional costs to set up the account. Most contributions are tax deductible and will be taxed as income when funds are distributed in retirement.
If this sounds complicated, here’s a better way to look at it. You’re basically setting up your own pension plan by figuring out how much you’ll need every month when you retire and then working backward to figure out how to fund it, guaranteeing the income.
This sounds great but these plans can be expensive and include a lot of fees. If you offer this plan to employees, it will cost even more plus you’ll be required to make contributions on their behalf. The commitment to fund the plan can be financially burdensome and any changes that you have to make will amount to additional fees.
The big perk to these accounts is you can save a lot of money. If you’re close to retirement age, you can really put a lot away in a very short time.
How to Open an Account
Once you have an idea of the kind of account you want to open, you have to figure out where to do it. A CERTIFIED FINANCIAL PLANNER ® can help you through the whole process by explaining any paperwork and helping you understand what you need to report to the IRS. Working with an accountant at tax time is a safe bet, too, just to make sure you don’t miss anything.
Any opinions are those of Thomas B. Fleishel and not necessarily those of RJFS or Raymond James. The information contained in this report does not purport to be a complete description of the securities, markets, or developments referred to in this material. There is no assurance any of the trends mentioned will continue or forecasts will occur. The information has been obtained from sources considered to be reliable, but Raymond James does not guarantee that the foregoing material is accurate or complete. Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. Investing involves risk and you may incur a profit or loss regardless of strategy selected. Please note, changes in tax laws may occur at any time and could have a substantial impact upon each person's situation. While we are familiar with the tax provisions of the issues presented herein, as Financial Advisors of RJFS, we are not qualified to render advice on tax or legal matters. You should discuss tax or legal matters with the appropriate professional. 401(k) plans are long-term retirement savings vehicles. Withdrawal of pre-tax contributions and/or earnings will be subject to ordinary income tax and, if taken prior to age 59 1/2, may be subject to a 10% federal tax penalty. Roth 401(k) plans are long-term retirement savings vehicles. Contributions to a Roth 401(k) are never tax deductible, but if certain conditions are met, distributions will be completely income tax free. Unlike Roth IRAs, Roth 401(k) participants are subject to required minimum distributions at age 70.5. Matching contributions from your employer may be subject to a vesting schedule. Please consult with your financial advisor for more information.