Today, most people cannot rely on Social Security alone to meet their retirement income needs. Many people have additional options for saving through their employers, primarily in the form of a 401(k). However, if you’re self-employed, you do not have the same instant access to retirement investment accounts and need to be more proactive with your savings. Many self-employed people do not plan adequately for their retirement, so it is critical to prioritize this goal, even when your finances are tight.
Luckily, there are several different options to help self-employed people save for retirement with tax-favorable accounts. Learning about the particular pros and cons of each can help you make the best decision for your situation. The most popular options include:
Solo 401(k)
Self-employed individuals can open a solo 401(k) and save up to $19,500 of personal money, as well as up to 25 percent of net earnings from employment, with a total limit of $57,000. These limits increase for people who are 50 and over through catch-up contributions. These generous contribution limits are the primary appeal of the solo 401(k), and these plans are the best option for people with the ability to invest a considerable amount of money toward retirement.
However, there are no contribution minimums—so you should not be afraid of the solo 401(k) if you have less to contribute. Another benefit is the fact that start-up and annual fees should be quite low, and some companies provide the plans at no charge. In addition, people with a 401(k) from a former employer can roll those savings into the solo 401(k). Roth options are also available.
The main downside of the solo 401(k) is that employees cannot participate, so self-employed people who hire employees in the future may need to rethink their savings plan. Importantly, the contribution limits count for all deposits into any 401(k), so people who have another job may already be close to the limits.
One additional thing to know about a solo 401(k) is the possibility of borrowing against the account up to half the balance, with a cap of $50,000. Generally, people get five years to repay the loan. While you should generally leave your savings alone, this rule can help if you need liquidity in an emergency.
SEP IRA
The simplified employee pension (SEP) individual retirement account (IRA) was designed to help self-employed people take advantage of pretax savings. With this account, you can contribute up to a quarter of your net income, with a maximum limit of $57,000. Unfortunately, the SEP IRA does not allow for catch-up contributions. However, this account is flexible. You do not need to fund the account until you file taxes, so you can increase your contributions to shrink your tax bill, or contribute less in a bad year. People who still have a 401(k) from an employer can contribute to that and a SEP IRA without any interference.
A SEP IRA allows self-employed people to contribute to the retirement of any employees they may hire, but this can become expensive. You’ll be required to put the same percentage of total income into the accounts of all covered workers. A covered worker is someone over the age of 20 who has worked for the employer for three of the past five years. However, spouses are exempt from this rule. In general, you can deduct the contributions you make to your SEP IRA and those of employees, so sometimes it makes sense from a tax standpoint to offer this option.
SIMPLE IRA
A savings incentive match plan for employees (SIMPLE) IRA is designed for both self-employed individuals and small businesses. Companies with fewer than 100 employees can offer SIMPLE IRAs, but it makes the most sense for people with less than 10 employees, all of whom make less than six figures. Contributions to the plan are tax-deductible and investments are allowed to grow without any taxes until retirement.
Self-employed people can contribute up to $13,500 per year into the account with an additional $3,000 available to individuals 50 and older. People with employees will generally need to contribute 2 percent of the employee’s annual pay or provide a match up to 3 percent. Employees can contribute more to the account on top of this if they wish. These requirements can make it difficult for business owners with employees, but the plan can also attract good workers.
The best part about the SIMPLE IRA is that the account is extremely easy to open, with very few forms to complete. An important drawback is that you cannot contribute to a SIMPLE IRA if you also have maxed out your annual contributions to a 401(k). You should also know that withdrawing money from a SIMPLE IRA within two years of setting it up incurs a 25 percent penalty, rather than the typical 10 percent fee for early withdrawals from a 401(k) or SEP IRA. Additionally, you must set up a SIMPLE IRA by the beginning of October to make contributions for that year, so some advanced planning is required.