Quite a number of people dream of becoming self-employed, and quite a number have gone ahead to achieve that dream. But being self-employed comes with its own drawbacks and one of them is that you do not get the 401k retirement savings plan that was instituted for employees to enable them save for retirement.
As a self-employed person, it would be really terrible if retirement creeps up on you and you did not put anything aside to take care of yourself during this period. According to a 2017 survey by online business community Manta, roughly a third of small-business owners don’t have a self-employed retirement plan; and of those, only 21% tapped into retirement funds to help their businesses.
This is why it is recommended that all self-employed persons explore other options that can help them save for their retirement years since they have nobody to do that for them. Opening a retirement savings plan when you are self-employed is the right way to go. These plans would provide you tax benefits, in addition to providing financial security after you retire.
The IRS offers several retirement plans that business owners and the self-employed can take advantage of. The key is to choose the right plan for your business model from the start so you do not have to go through the tedious process of changing it much later. Here they are, and you are free to choose more than one.
7 Smart Tips on How to Save for Retirement When Self Employed
- The Traditional IRA
The traditional IRA is similar in nature to the 401(k) that you would get through an employer, except that you have to open the account yourself, as an individual. This account holds cash and investments that you purchase with your own contributions, and you contributions are generally tax deductible.
Once you open your account, you start making deposits and your investments will grow tax free. You will, however, pay ordinary income taxes on the money that you withdraw (known as a distribution) from the account during retirement.
The combined amount you can contribute to your traditional IRA is capped in 2018 at $5,500 annually for anyone under 50, and $6,500 annually for older IRA owners. If your earned income for the year is less than that amount, you can contribute only up to the total amount you’ve earned.
Know that you can only withdraw from this account when you retire or reach 70½ years of age, whichever comes first.
2. ROTH IRA
A Roth IRA is a retirement account that holds cash and investments, just like its traditional IRA counterpart. But, while a traditional IRA defers taxes until withdrawal, a Roth requires you to pay taxes upfront before you make the contribution.
The upside of this approach is that at retirement age, you will not have to pay taxes on any of your withdrawals. Plus, unlike a traditional IRA, a Roth IRA comes with no requirement to withdraw money you put into it on a specified timetable.
As of now, you can contribute $5,500 per annum to your Roth IRA—or $6,500 if you’re 50 or above that age. There are tons of mutual funds that you can choose from to diversify your investment evenly between these four categories: growth, growth and income, aggressive growth and international.
In order to be eligible to fully contribute to a Roth IRA, you must:
- Have an earned income
- Have a modified adjusted gross income—total adjusted gross income (which is the total gross income minus deductions) plus any tax-exempt interest income—that’s less than $189,000 for married couples filing jointly or $120,000 for single people.
Spouses can have two Roth IRAs even if one spouse does not work. You can contribute the maximum to both accounts, a total of $11,000 a year. For a vast majority of people, fully funding two Roth IRAs will be enough to reach the goal of investing 15% of their income for retirement.
3. SIMPLE IRA
A Savings Incentive Match Plan for Employees, or SIMPLE IRA, is an option for sole proprietors and small businesses. You can create a SIMPLE IRA if you have a small business (typically 100 or fewer employees) and you don’t offer any other retirement plan.
A SIMPLE IRA, permits you to make both an employee contribution of up to $12,500 (or $15,500 if you’re 50+) and an employer contribution whose size is a percent of your business profit.
When you create a SIMPLE IRA, all eligible employees — including you — open an IRA account. Employees can choose to make contributions to the account from their salaries, up to a maximum of $12,500 in 2018. Employees 50 or older can make catch-up contributions up to $3,000.
If you’re self-employed, you’ll make these contributions for yourself from your net earnings, and the same dollar limits will apply — $12,500, plus $3,000 catch-up contribution if you’re 50 or older. Because of this, the SIMPLE IRA is perhaps more suited for the business owner that has employees and wants to reward their staff for their work.
4. Simplified employee pension IRA (SEP-IRA)
This account functions like a traditional IRA, in that you make pre-tax contributions or get a tax deduction for your after-tax contributions. In 2018, a SEP IRA allows you to contribute $55,000 or up to roughly 20 percent of your business profits.
This type of plan is simple to administer, and you can decide throughout the year or at the end of the year how much to contribute. However, if you add employees to the SEP-IRA, you have to contribute the same percentage to their accounts that you put into yours.
Employees are eligible for the plan if they are 21 years and above, have worked for your company in at least three of the previous five years, and have received at least $600 in compensation during the tax year.
Contributing to a SEP IRA will not only decrease your tax burden, it will also allow your deposits to be tax-deferred until you retire. With lots of flexibility with your investment options, a SEP IRA is a good choice. You can open one at most banks, mutual fund companies or brokerage firms.
5. Solo 401(k)
A Solo 401(k) — sometimes called a Solo(k), Uni-k, or one-participant k — is simply a 401(k) plan that’s operated and used by a single person. A solo 401(k) is set up for sole proprietors or businesses run by a married couple. As a business owner, you can open your own 401(k) in which you’re both the employer and the employee. When you create a solo 401(k) and you’re self-employed, you can make contributions as both the employee and employer.
You can make elective deferrals (the kind an employee would make) of up to 100% of your compensation (your earned income as a self-employed person) but not more than the annual contribution limit, which is $18,500 in 2018. The limit bumps up to $24,500 if you’re 50 or older, because you are allowed $6,000 extra as a “catch-up” contribution.
You can also make non-elective contributions (the kind an employer could make for you if you worked for someone) of up to 25% of your compensation. As a self-employed person, your compensation is your earned income (net earnings minus half your self-employment tax and the contributions you made for yourself as elective deferrals).
One of the merits of Solo 401(k) plans is that they allow you to save more than other alternatives, since as a self-employed individual, you can contribute as both an employer and an employee. But one downside it has is that a Solo 401(k) plan can require more administration than an IRA, especially if the plan allows for loans.
If you are a high earner, a Solo 401(k) might be a good option for you, but the downside is that if you have employees other than your spouse, you can’t use this plan.
6. Tax-Deferred Annuities
Annuities are yet another avenue by which someone can save for retirement due to the tax deferral and varied investment opportunities it provides. Annuities are offered to individuals or couples through insurance companies. They are made available with a fixed interest rate, an indexed interest rate (based on the performance of a specific index) or a variable rate (tied to market performance).
The funds that have been deposited into the annuity can then grow tax-deferred, however, they still remain taxable once funds are distributed during retirement years. In addition to tax deferral, annuities can provide a guaranteed income stream to the account holder for a certain number of years or for a lifetime.
With tax-deferred annuities you can delay your taxes on compound interest. Tax-deferred annuities are a good supplemental option to consider if you have other retirement savings accounts and have maxed out your annual contributions. You can contribute additional funds to the plan for tax-deferred growth.
In truth, annuities may not be suitable for all investors, and in addition, annuities are only backed by the claims-paying ability of the issuing insurance company. Investment performance within this type of vehicle is not guaranteed.
In addition, finding an annuity that’s tax-deferred and has low fees will take some effort. Again, your contributions aren’t tax-deductible so you can’t use them to decrease your tax burden. You are also unable to touch this money for emergencies and you can’t leave it to your heirs.
Saving for retirement when you are self-employed can be tough, but you should make sure that you choose a plan that grows with how you want your business to grow. You don’t want to have to go through the time-consuming task of switching plans as you grow your business.
Depending on your circumstances, you have to choose a plan that will allow you to save the most of your self-employment income. The solo 401(k) and SEP-IRA options have higher overall contribution limits. But if you’re earning relatively little income from self-employment, a SIMPLE IRA that allows you to save 100 percent of that income, rather than capping you at 25 percent, might be a better fit.
If you’re concerned about your ability to build an adequate savings fund before retirement, you may have to consult a credit counselor so that he or she can help you find the best savings plan for you. Counseling is free and can help you understand the steps you need to take to reach your goal, which is a comfortable, debt-free retirement.