Being self-employed gives you a certain measure of freedom, but it doesn’t get you out of saving for retirement.
In fact, in many ways, it makes putting money away that much more crucial: Unlike an employee, who might have access to a 401(k) or — much more rarely — a pension, you’re on your own. But getting started is unlikely to be high on the priority list: 55% of self-employed Americans report being behind in retirement savings, according to a TD Ameritrade study. The online broker says that, in all, 5 million self-employed baby boomers are each short $355,000 from saving $1 million for retirement.
A million dollars is just a popular goal; whether that would suit your needs depends on when you plan to retire, how long you can expect to live and what sort of lifestyle you want to have in those later years. So that’s the first step: figuring out how much you need to save, which you can do with NerdWallet’s retirement calculator.
Once you have a number in mind, it’s time to decide where to put your savings contributions. There are five main retirement account options for the self-employed:
SIMPLE IRA
Defined benefit plan
1. Traditional or Roth IRA
Quick facts
Best for: Open to everyone with earned income, though Roth IRAs have income limits. An IRA can be used in combination with other plans, but the amount of traditional IRA contributions you can deduct from your income taxes might be reduced. If you’re leaving a job to start a business, you can roll your old 401(k) into an IRA.
Contribution limit: $5,500 in 2016 (plus $1,000 catch-up contribution for those 50 or older).
Tax advantage: Tax deduction on contributions to a traditional IRA; no immediate deduction for Roth IRA, but withdrawals in retirement are tax-free.
Employee element: None. These are individual plans. If you have employees, they can set up and contribute to their own IRAs.
The details
Maybe you like to keep things simple. Or maybe you’re just starting your career — 1 in 4 millennials is an entrepreneur, according to the Kauffman Foundation, a nonprofit that focuses on entrepreneurship — and you don’t have a great deal of money to put away. In that case, an IRA might be a good option.
It’s probably the easiest way for self-employed people to start saving for retirement: You simply open an IRA at an online brokerage and report contributions on your tax return each year. There are no special filing requirements, and you can use it whether or not you have employees.
We’ve given in-depth coverage to the differences between traditional and Roth IRAs, but here’s a quick rundown of the basics:
- A Roth IRA doesn’t reduce your taxes today, but after age 59½ you can pull out your money tax free.
- A traditional IRA nets you a tax deduction on contributions for the year you make them, but the money is taxed as income when you pull it out — again, after 59½.
- Both accounts are designed to remain untapped until retirement, and there are penalties, with few exceptions, for early withdrawals from an IRA. But a Roth IRA is more flexible — you can remove your contributions, but not your investment earnings, without penalty at any time.
The tax treatment of a Roth IRA might be ideal if it’s early days for your business — read: you’re not making much money — because your tax rate is likely to be higher in retirement, when you’ll be able to pull that money out tax free.
2. Solo 401(k)
quick facts
Best for: A business owner or self-employed person with no employees (except a spouse, if applicable).
Contribution limit: Up to $53,000 per year (plus $6,000 catch-up contribution for those 50 or older) or 100% of earned income, whichever is less. You can contribute as both an employee (of yourself) and as the employer, with salary deferrals of up to $18,000 in 2016 (plus that $6,000 catch-up contribution, if eligible). On top of that, you can add approximately 20% of net self-employment income, not exceeding the limit.
Tax advantage: This plan works just like a standard, employer-offered 401(k): You make contributions pre-tax, and distributions after age 59½ are taxed.
Employee element: You can’t contribute to a solo 401(k) if you have employees. But you can hire your spouse so he or she can contribute to the plan. Your spouse can contribute up to the standard employee 401(k) limit, plus you can add employer contributions, for a total of up to $53,000, plus catch-up contribution, if eligible. This effectively doubles what you can save.
the details
This plan, which the IRS calls a “one-participant 401(k),” is particularly attractive for those who can and want to save a great deal of money for retirement or those who want to save a lot in some years — say, when business is flush — and less in others. It’s easy to set up, although you’ll need to file paperwork with the IRS each year once you have more than $250,000 in your account.
You can make contributions in your capacity as both employer and as your own employee: As the employee, you can contribute up to $18,000 in 2016 (plus $6,000 catch-up contribution for those 50 or older). As the employer, you can also contribute up to 20% of your net income.
If you’d like, you can “hire” your spouse and have him or her contribute to the plan, up to the employee contribution limit, which you can then match as an employer would, for a total contribution of up to $53,000 (plus the $6,000 catch-up, if eligible).
Keep in mind that these limits apply per person, not per plan — so if you also have outside employment that offers a 401(k), or your spouse does, the contribution limits cover both plans.
One other thing to know: You can also choose a Roth solo 401(k), which mimics the tax treatment of a Roth IRA. Again, you might go with this option if your income and tax rate are lower now than they will be in retirement.
3. SEP IRA
quick facts
Best for: Self-employed people or small business owners with no or few employees.
Contribution limit: Up to 25% of compensation or $53,000 per employee, whichever is less, or 20% of net self-employment income for yourself (again, up to that $53,000 limit). Contributions must be an equal percentage of salary for each eligible employee, and you are counted as your own employee. No catch-up contribution.
Tax advantage: For contributions to employees’ SEP IRAs, you can deduct the lesser of your contributions or 25% of employees’ compensation on your tax return. The IRS has a special worksheet for figuring out what portion of your contributions are deductible if you are self-employed and contributing for yourself. These function like traditional IRAs and 401(k)s in that distributions in retirement are taxed as income. There is no Roth version of a SEP IRA.
Employee element: Employers must contribute for employees; employees cannot make contributions to their own account.
the details
The SEP IRA rules make them popular with small businesses that have a few employees because they’re easier than a solo 401(k) to maintain — there’s a low administrative burden with limited paperwork and no annual reporting to the IRS — and they have similarly high contribution limits. Like the solo 401(k), SEP IRAs are flexible in that you do not have to contribute every year.
The downside for you, as the business owner, is that you have to make contributions for employees, and they must be equal — not in dollar amount, but as a percentage of pay — to the ones you make for yourself. That can be costly if you have more than a few employees or if you’d like to put away a great deal for your own retirement. You cannot simply use a SEP to save for yourself; if you contribute for the year, you have to make contributions for all eligible employees.
4. SIMPLE IRA
quick facts
Best for: Larger businesses, with up to 100 employees. Unlike the SEP IRA, the contribution burden isn’t solely on you: Employees can contribute through salary deferral.
Contribution limit: Up to $12,500 in 2016 (plus catch-up contribution of $3,000 if 50 or older).
Tax advantage: Contributions are deductible, but distributions in retirement are taxed. Matching contributions to employee accounts are deductible as a business expense.
Employee element: Employers are required to make either matching contributions to employee accounts of up to 3% of employee compensation, or fixed contributions of 2% to every eligible employee, meaning the employee does not have to contribute to earn your contribution.
the details
If you’re the owner of a mid-size company with fewer than 100 employees, the SIMPLE is a fairly good option, as it’s easy to set up and the accounts are owned by the employees.
SIMPLE IRA contribution limits are significantly lower than a SEP IRA or solo 401(k), however, which will limit how much you can save for retirement, and you may end up having to make mandatory matching contributions to employee accounts, which can be expensive if you have a large number of employees.
The SIMPLE IRA is also inflexible, particularly early on: Early withdrawals, before age 59½, are treated the same as early 401(k) or IRA distributions, in that they are taxed as income and subject to 10% penalty. But if you make a withdrawal within the first two years of participation in a SIMPLE IRA, the 10% penalty is increased to 25%. That means you also can’t roll over a SIMPLE to another retirement account within that two-year period. Zing.
One other thing to know: There is a 401(k) version of a SIMPLE, which works in much the same way but allows participants to take loans from their accounts. This version requires more administrative oversight and can be more expensive to set up.
5. Defined benefit plan
quick facts
Best for: A self-employed person with no employees who has a high income and wants to save a lot for retirement on an ongoing basis.
Contribution limit: Calculated based on the benefit you’d like to receive at retirement, your age and expected investment returns.
Tax advantage: Contributions are generally tax deductible, and distributions in retirement are taxed as income.
Employee benefit: If you have employees, you must offer this plan to them and make contributions on their behalf.
the details
We often lament the decline of pension plans, and this is exactly that: If you’re self-employed, you can set up your own pension — a guaranteed stream of income — in retirement by using a defined benefit plan.
So why wouldn’t everyone do it? They’re expensive, with a set-up fee that often tops $1,000 and annual fees that hover in that same range. If you have employees, that fee will likely go up, and you’ll need to contribute on their behalf. They carry a heavy administrative burden each year, and they require a commitment to fund the plan with a certain amount per year. If you need to change that amount, you’ll pay additional fees.
The upside is that you can stash a lot of cash in these, so if you’re fairly close to retirement, earning a high income that you know you’ll maintain and that allows you to save a significant amount per year — we’re talking $50,000 to $80,000 or more — you might consider using this plan to supercharge your savings efforts.
Where to open a retirement plan if you’re self-employed
Once you’ve decided to open one of these accounts, you’ll have to decide where to do it.
Most online brokers will allow you to open the four most common account types: IRA, solo 401(k), SEP IRA and SIMPLE IRA. The account providers on our list of best IRA providers are all good choices. If you’re interested in a defined benefit plan, your options are more limited, but Charles Schwab offers these plans.
Each broker will walk you through the process of opening one of these accounts and explain any the paperwork you may need to file with the IRS. But to be on the safe side, you may also want to work with an accountant.
Arielle O’Shea is a staff writer at NerdWallet, a personal finance website. Email: aoshea@nerdwallet.com. Twitter: @arioshea.
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