Self-Employed Retirement Plans: Getting Ahead
No matter how you define “self-employed”—freelancer, sole proprietor, entrepreneur, company owner—one of the coolest parts of being self-employed is that you’re your own boss! You get to call the shots on everything.
The not so cool part of being self-employed is that you’re your own boss. You have to call the shots on everything. That means deciding which clients to take and not to take, what direction you’re going to take your company, and even how to administer benefits.
Being self-employed does mean that you’re the benefits department. While you’ve probably considered health insurance and taxes, have you thought about retirement? Neglecting your retirement as a self-employed worker could be very dangerous for your financial future. So, let’s review the details of self-employed retirement plans.
Who Is Self-Employed
Before we talk about how the self-employed need to fund their retirement, let’s talk about who the self-employed are. Anyone that’s an independent contractor, a freelancer, or runs their own company (online or in a brick-and-mortar setting) is self-employed.
Put another way, the IRS says that you are self-employed if:
- You are a sole proprietor or independent contractor.
- You are part of a partnership (like a partner in a doctor’s practice, for example).
- You are in business for yourself—even if that’s only part-time.
To clear up any confusion, you are not self-employed if you work for an employer and receive wages or salary. And, you’re not self-employed if you’re a corporate shareholder (meaning you invest in the company and only get dividends from the investment).
The Self-Employed Need Retirement Plans
When you’re self-employed, you have to fund your retirement plan. While part of that funding means figuring out how much money to funnel to that account, it also means choosing the right plan for you. Which, in turn, means doing a lot of research and potentially filling out a lot of paperwork.
It’s easy to get overwhelmed by the choices and the nuances of retirement planning even when you’re not self-employed. But, always putting retirement planning off until you’ve “got the time” may mean that you may find yourself in your golden years without any savings to rely on.
A 2019 report from the Federal Reserve found that while 36% of all adults believe their retirement savings are on track, nearly 25% of adults have no retirement savings at all. And, according to the Bureau of Labor Statistics, the average retiree spends about $46,000 a year during their retirement. Given that the average length of retirement is 20 years, to maintain that spending level, you need approximately $1.15 million in savings by the time you retire.
As for the self-employed, a Pew Trust study found that of all self-employed workers, approximately 13% of them, participate in some kind of retirement plan. This is in stark contrast to the nearly 75% of employees who participate in an employer-sponsored plan.
And, the self-employed that do participate in retirement plans have smaller balances. The study also found that, on average, the self-employed have an average savings of $61,735 versus the employees’ average balance of $122,800.
Retirement Plan Options for the Self-Employed
Of course, the sooner you start saving for retirement, the better, no matter what your employment status is. And being self-employed doesn’t mean your only retirement savings vehicle is a loose change jar on the counter. There are plenty of retirement savings plans for the self-employed.
The best self-employed retirement plans will depend on your income and a few other business facts. Therefore, you will have to do your due diligence and compare plans, contribution limits, tax impacts, and other details. While we’ve got an overview to help get you started, always consult a qualified tax professional for advice and guidance before you open an account.
Individual Retirement Accounts (IRAs)
One of the most popular ways for anyone with an income to save for retirement is with an Individual Retirement Account (IRA). That’s because as long as you’re earning money, you can contribute to an IRA. However, when it comes to the self-employed, there are several IRA options open to you.
Traditional and Roth IRA
A traditional or Roth IRA is a retirement account that any individual can open. As long as you earn income in a tax year, you can contribute to that fund. For the 2019 tax year, an individual can contribute up to $6,000.
The advantage to a traditional or Roth IRA is that they’re easy to open. There are no special documents to file, and it doesn’t matter whether or not you have employees. Find an account you want to invest in, open the account, and get started.
The disadvantage of these IRAs is that there are different tax burdens. For a traditional IRA, the contributions you make are tax-deductible. However, your withdrawals will be taxed at whatever your tax rate is at that time. With a Roth, the reverse is true. You pay taxes on your contributions at your tax rate, but your withdrawals are tax-free.
And, of course, the contribution limit is low compared to other plans. However, if you want to start saving today, opening an IRA is the way to go.
The next type of IRA is a SIMPLE IRA. These are usually used by business owners with less than 100 employees to help the owner fund not only their own retirement, but the retirement funds of their employees.
Much like a standard IRA, the contributions you make are tax-deductible, and the distributions are taxed. However, if you have employees and make contributions to their accounts, those contributions are a tax-deductible business expense.
Employees can contribute to their own accounts. However, employers must make matching contributions to the account. Those contributions are either 3% of the employees’ compensation or a 2% fixed contribution.
As a self-employed worker, you can contribute up to $13,000 to your account for 2019. However, while the contribution limit is higher than IRAs, the limit is still lower than other retirement plans. And, SIMPLE IRAs come with a hefty penalty if you try to withdraw the money early.
During the first two years of participation, you cannot withdraw money from the account for any reason. Not only will the withdrawal be taxed, you will also have to pay a 25% penalty (unlike the 10% penalty for other IRAs). This also means that you cannot roll the money over to another account for the first two years.
A SEP IRA is another popular self-employed retirement plan. This has higher contribution limits, but determining that upper amount takes some work to calculate. For 2019, you can contribute one of the following:
- Up to 25% of net self-employment earnings up to $280,00
However, you must choose the smaller amount when you contribute. And the contributions are tax-deductible while the distributions are taxed.
As an employer, the rulers are trickier. If you contribute to a SEP for yourself, you must contribute equally to your employees. For example, if you contribute a total of 15% of your net earnings to yourself, you must contribute 15% of each employees’ compensation to their accounts.
While SEP’s are easy to open, if you have employees—especially highly paid ones—you may find that the required contributions outweigh any benefits a SEP might have.
A solo 401(k) works the same as an employer 401(k). For 2019, you can contribute the lesser of up to $56,000 or 100% of your earned income, which is more than an employer 401(k). And, just like an employer plan, your contributions are not taxed, but the distributions are.
The disadvantage to a solo 401(k) is that you cannot use it if you have employees. You can, however, hire your spouse so they can contribute to your plan to possibly double what you can save as a couple.
Solo 401(k)s are easy to open. But, you will have to file extra paperwork with the IRS once you have more than $250,000 in savings.
Pronounced Kee-yo, these plans have been around since 1962. In 2001, Keogh plans were changed by the Economic Growth and Tax Relief Reconciliation Act. In fact, they are so different now that they’re more commonly called HR10s or qualified plans. And, they’re not nearly as popular as they once were mainly because of the other options available.
However, Keogh plans may still be the right choice for some highly-paid self-employed individuals. That said, depending on your circumstances, a Keogh plan may work as a retirement savings vehicle for you.
You can invest the money in a Keogh however you want. However, unlike other plans, you have to file a lot of annual paperwork with the IRS. And, given the complexity of the rules, maintaining a Keogh plan is likely not something you can do yourself.
Defined Contribution Plan
In a defined contribution plan, you define the contribution amount up to the contribution limit, and you define how you want to make those contributions.
If you use profit sharing to contribute, you can contribute up to $56,000 a year and deduct up to 25% of your income. You can also change the contribution amount every year.
If you choose the money-purchase plan for contributions, you’ll choose the percentage of money you contribute every year. But, you cannot change the contribution amount without IRS penalties.
Defined Benefit Plan
A defined benefit plan is a lot like a traditional pension plan. You decide the pension amount you want for retirement, then contribute money until you reach that goal. Like other plans, there is a maximum amount you can contribute each year. For 2019, the maximum contribution amount is the lesser of $255,000 or 100% of your salary per year.
Plan for All Futures
Many people love their jobs and want to do them forever. And that’s great! But, the reality is that you may not be able to work forever. So, it’s important to plan now for a future that may or may not include work for whatever the reason.
Funding future goals and utilizing self-employed retirement plans can’t be overlooked. There’s no annual reminder that you need to enroll. And, with each year you don’t fund your retirement, you’re losing out on returns that you’ll probably need down the road.
Don’t worry about how much you can or can’t put in. Just start investing. And, in the meantime, check out our selection of freelance and contract work for the self-employed to help land more work that will help you invest in your future self.
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