The joys of self-employment are many, but so are the stressors. High among those is the need to plan for retirement entirely on your own. You are in charge of creating a satisfying quality of life post-retirement. When it comes to building that life, the earlier you start, the better. Luckily, there are several retirement plans for those who are self-employed.
- For self-employed workers, setting up a retirement plan is a do-it-yourself job.
- There are four available plans tailored for the self-employed: one-participant 401(k), SEP IRA, SIMPLE IRA, and Keogh plan.
- Health savings plans (HSAs) and traditional and Roth IRAs are two more supplemental options.
A 2019 study conducted by the Freelancers Union and Upwork estimates that there are 57 million freelancers in the U.S., representing more than 35% of the entire workforce, up from 53 million in 2014.
While the spirit of entrepreneurialism is to be applauded, less laudable is the fact that 30% of the self-employed save for retirement sporadically and 15% aren’t saving at all, according to a 2019 report published by Transamerica Center for Retirement Studies. That’s a problem. If you are self-employed, you are busy—crazy busy, probably—but retirement savings must be a priority.
The reasons for not saving toward retirement won’t be a surprise to any self-employed person. The most common include:
- Lack of steady income
- Paying off major debts
- Healthcare expenses
- Education expenses
- Costs of running the business
In addition, setting up a retirement plan—like just about everything an entrepreneur undertakes—is a do-it-yourself job. No handy human resources staffer is walking you through a 401(k) plan application, or whatever the company-sponsored retirement program is. No matching contributions, no shares of company stock, and no automatic paycheck deductions.
You’ll have to be highly disciplined in contributing to the plan and, because the amount you can put in your retirement accounts depends on how much you earn, you won’t really know until the end of the year how much you can contribute.
Still, if freelancers have unique challenges when it comes to saving for retirement, they have unique opportunities, too. Funding your retirement account can be considered part of your business expenses, as is any time or money you spend on establishing and administering the plan. Even more important, a retirement account allows you to contribute pretax dollars, which lowers your taxable income.
Many retirement plans for the self-employed allow you, as a business owner, to contribute more money annually than you could to an individual IRA.
There are four retirement savings options favored by the self-employed. Some are basically single-player 401(k) plans, while others are based on IRAs. They are:
With all four of these options, your contributions are tax-deductible, and you won’t pay taxes as they grow over the years (until you cash out at retirement). Their complexity and suitability varies, depending on the size of your business, both in terms of personnel and earnings. Let’s look at each in more depth.
To avoid penalties with any of these plans, you’ll need to leave your savings in the account until you are 59½—early withdrawals carry penalties—although there are certain hardship exemptions.
A one-participant 401(k), as it’s officially dubbed by the IRS, also goes by the names solo 401(k), solo-k, uni-k, or individual 401(k). It is reserved for sole proprietors with no employees, other than a spouse working for the business.
The one-participant plan closely mirrors the 401(k)s offered by many larger companies, down to the amounts you can contribute each year. The big difference is that you get to contribute as the employee and the employer, giving you a higher limit than many other tax-advantaged plans.
To elaborate, if you participate in a standard corporate 401(k), you would make investments as a pretax payroll deduction from your paycheck, and your employer would have the option of matching those contributions up to certain amounts. You get a tax break for your contribution, and the employer gets a tax break for its match. With a one-participant 401(k) plan, as you’re both the boss and the worker, you can contribute in each capacity, as an employee (called an elective deferral) and as a business owner (an employee non-elective contribution).
Elective deferrals for 2021 can be up to $19,500, or $26,000 if age 50 or older. Total contributions to the plan cannot exceed $58,000, or $64,000 for people age 50 or older as of 2021. If your spouse is working for you, they can also make contributions up to the same amount, and then you can match those. So you see why the solo 401(k) offers the most generous contribution limits of the plans.
“Generally, 401(k)s are complex plans, with significant accounting, administration, and filing requirements,” says James B. Twining, CFP®, founder and wealth manager of Financial Plan, Inc., in Bellingham, Wash. “However, a solo 401(k) is quite simple. Until the assets exceed $250,000, there is no filing required at all. Yet a solo 401(k) has all the major tax advantages of a multiple-participant 401(k) plan: The before-tax contribution limits and tax treatment are identical.”
Some paperwork is required, but it’s not too onerous. To establish an individual 401(k), a business owner has to work with a financial institution, and that institution may impose fees and certain limits as to what investments are available in the plan. Some plans, for instance, may limit you to a fixed list of mutual funds (typically sponsored by that institution), but a little bit of shopping will turn up many reputable and well-known firms that offer low-cost plans with a great deal of flexibility.
Officially known as a simplified employee pension, a SEP IRA—as the name implies—is a variation on a traditional IRA. As the easiest plan to establish and operate, it’s an excellent option for sole proprietors, though it allows for one or more employees too.
In a SEP IRA, the employer alone contributes to the fund, not the employees. So, unlike the solo 401(k), you’d only contribute wearing your employer hat. You can contribute up to 25% of your net earnings (defined as your annual profit less half of your self-employment taxes), up to a maximum of $58,000 in 2021.
The plan also offers flexibility to vary contributions, make them in a lump sum at the end of the year, or skip them altogether. There is no annual funding requirement.
Its simplicity and flexibility make the plan most desirable for one-person businesses, but there’s a catch if you have people working for you. Although you do not have to contribute to the plan each year, when you do contribute, you will need to do so for all of your eligible employees—up to 25% of their compensation, limited to $290,000 annually.
While SEP IRAs are simple, they are not necessarily the most effective means of saving for retirement. “You can contribute more to a SEP IRA than a solo 401(k), excluding the profit-sharing, but you must make enough money since it’s based on the percentage of profits,” says Joseph Anderson, CFP®, president of Pure Financial Advisors, Inc., based in San Diego, Calif.
The account is simpler to set up than a solo 401(k). You can easily open a SEP IRA online,…