Not having access to a retirement plan can be detrimental to your future, it's important to know your alternatives to an employer 401k when you're self-employed.
Being self-employed certainly has it’s perks, but making the trade-off of working for an employer versus working for yourself comes with quite the learning curve, especially when it comes to retirement savings.
The most common method of saving for retirement for Americans is through an employer defined contribution plan, like a 401k or 403b. These accounts are great, because not only do they come with a heap of tax benefits, your employer is the one setting it up for you, and often they are matching up to a certain percentage of your contributions. Who doesn’t like free money?!
When you are self-employed, it’s a whole different story, because the only one responsible for your retirement savings, is you. Luckily, you have several options out there. Read on to find out what accounts you can take advantage of, or check out this free online course that will walk you through all of your options, and tell you how to get started.
Traditional IRA and Roth IRA
Both the Traditional and Roth IRA are easy to open on your own, and anyone with earned income can contribute to them. The contribution limit for 2019 is $6,000 or $7,000 if over age 50, but when it comes to tax-benefits, these accounts are quite different.
Similar to a 401k or 403b, in a Traditional IRA, you can deduct your contributions from that years taxable income. This is a nice tool for lowering your tax burden for the current year, especially if you find yourself in a high tax bracket. Once in the account, your money will grow tax-deferred, but you will be taxed when you take the money out in retirement.
On the other hand, with the Roth IRA, contributions are considered after-tax. This means you do not deduct them from your taxable income, as you would for other IRA contributions, and in exchange you can make withdrawals in retirement tax-free. Currently, our tax brackets are historically low, so many people are taking advantage of that by making contributions to Roth’s now and paying tax at today’s known rate, in anticipation of taxes being higher in the future.
When considering a Roth IRA, there is an additional rule in regards to income threshold. If you file taxes as a single person and your modified adjusted gross income (MAGI) is over $137k (or 203k if married filing joint) in 2019, you are not eligible to contribute to a Roth directly. If your MAGI is under $122k as a single filer (or under 193k if married filing joint) you are eligible for the full contribution. If your income is somewhere in-between, you will be in the “phase-out” period, where the contribution amount is reduced.
Keep in mind, you can contribute a total of $6,000 annually, but not to each account. You are able to contribute to both in a given year, as long as your combined annual contribution of the two does not exceed the $6,000 (or $7,000 if over age 50) limit. For example, you could put $3,000 in a Roth and $3,000 in a Traditional for 2019.
If you are just getting started in your career, and maxing out one of these accounts at $6,000 a year seems like a stretch, start here, and start with what you can. While maxing out your IRA is a great goal to set, starting with even just $50 a month will put you in the right direction for retirement, especially if you have a few decades ahead of you.
There are different rules when it comes to different IRA accounts, but the most important ones are when it comes to taking withdrawals. Any withdrawals before age 59 ½ could incur an additional 10% penalty, so it’s important to remember that this money is for retirement, not for emergencies. Make sure to read up on the rules before thinking about any premature withdrawals.
The SEP IRA stands for Simplified Employee Pension Individual Retirement Account, and this is an account that can be opened by self-employed individuals. Like the traditional, SEP contributions are tax deductible for the year they are made, and taxes are paid when withdrawals are taken in retirement.
A SEP is different from a traditional or a Roth, because when you are contributing into your SEP, you are doing so as an employer, rather than just an individual. Because of this, there is a much higher contribution limit, which is great for people who are trying to put away more than $6,000 annually.
The SEP contribution limit for 2019 is the lesser of $56,000 (plus $6,000 if over 50) or 25% of your net income. This means you aren’t going to be hitting that maximum unless your income is in the $200k range, so be sure you aren’t contributing more than 25% of your net income. You can contribute to a SEP in addition to a Traditional or Roth, so you could potentially be investing 25% of your income + $6,000 in a Roth or Traditional.
Having a SEP IRA requires an additional piece of paperwork, Form 5305-SEP. Currently, you are not required to file this form with the IRS, but you are required to maintain it on file.
The SEP is most beneficial to those who have no or few employees, because if you are contributing for yourself, you must also establish SEP’s and contribute for all eligible employees. As an employer, you are required to match the contributions across all accounts, if you are contributing 25% of your income into yours, you are required to contribute 25% of each of your employees income onto theirs. If you have many employees, this can get expensive quickly, and you might be better off considering the SIMPLE IRA.
This account is designed for small businesses with less than 100 employees, and unlike the SEP, it allows both employees and employers to contribute. However, the contribution limit is a bit lower; employee contribution limits for 2019 are $13,000 or $16,000 if age 50 or older.
When it comes to the employer side, there are two options for contributing to employees accounts. The employer can either choose to match 3% of employee contributions annually, or set a fixed annual contribution of 2% to all eligible employees- regardless if they are contributing. Employer contributions are tax-deductible for your business, and employee contributions are tax-deductible for that year to the employee.
The SIMPLE carries a lot of the same rules as other IRA’s, with a pretty hefty additional one. Any early withdrawals (before age 59 ½) made in the first two years of the account being opened will see a 25% penalty, rather than just a 10% penalty.
Individual or Solo 401k
Unlike the SEP and SIMPLE, you cannot contribute to a Solo 401k if you have employees, with the exception of your spouse. The contribution limit for 2019 is also $56,000 (plus $6,000 if over age 50) like the SEP, but how the limit is applied works slightly different.
When you are funding a Solo 401k, you are funding it as both an employer and an employee. On the employee side, you can contribute up to $19,000 for 2019 (with an additional $6,000 for those over age 50) and on the employer side, you can contribute up to 25% of your net compensation, as long as you don’t go over the total annual maximum of $56,000 (or $62,000 for those over age 50).
If you are comparing the Solo 401k with the SEP, it is worth to run the two scenarios to see which is more worthwhile for your business. If your net income is in the $100k-$200k range, you might see that you are able to contribute more to a Solo 401k because of how the contributions are set up.
Opening a Solo 401k is a little more time consuming than the other accounts discussed. Once you establish where you want to open your plan, there will be a significant amount of paperwork to get everything up and running, including employee disclosures of your plan (even though you’re the only employee). Once the account is over $250,000 you will also have to report it annually to the IRS.
A huge perk of the Solo 401k, besides having one of the largest contribution limits, is it’s also available as a Roth. Unlike a Roth IRA, the Roth Solo 401k does not have income thresholds, so Roth contributions can be made regardless of income. For people willing to pay taxes now on their contributions, in exchange for tax-free withdrawals later in retirement, a Roth 401k is just the vehicle to make that happen.
It’s important to remember that these accounts are not a one-size-fits-all.
Your needs as a self-employed individual will vary from others, and might change significantly as your business grows and evolves. Keep in mind you are not stuck to one option, you might start with one account and a few years later find it is more worthwhile to open a different account type.
To learn more about how to open, fund, and invest in these accounts, I encourage you to get in touch, or check out this free online course. One of the biggest mistakes made by entrepreneurs is ignoring or delaying their retirement savings, a mistake that will hurt your future self for years to come.
If you are overwhelmed at the idea of establishing these accounts and investing on your own, you might consider working with a financial advisor, someone who will open the accounts and manage the investments inside on your behalf. If you would like to learn more about a fiduciary advisory relationship, click here.
If you have any questions, please feel free to reach out to me at firstname.lastname@example.org.
To learn more about saving for retirement and open your own account, enroll in my FREE online course: Crash Course in Retirement for Entrepreneurs!
Hi, I'm Alicia, welcome to Friend of Finance! This site is a way for me to share helpful things I've learned from working in the financial industry, important money things that I probably wouldn't have learned otherwise, and things everyone should know about.