facebook twitter instagram linkedin google youtube vimeo tumblr yelp rss email podcast phone blog search brokercheck brokercheck Play Pause
How to Save for Retirement When You're Self-Employed Thumbnail

How to Save for Retirement When You're Self-Employed

I am writing this blog post on a Saturday night. Welcome to entrepreneurship! Having fun yet? 

When you are master and commander of your own business, incessant emails and calls and Slack channels and double-bookings bubble up to block your way despite your best efforts to focus on your highest value-add work. 

Fitting in strategic planning for next year’s business goals, or even pondering your end game, feels like a pipe dream.

Running your own business is an exquisitely rewarding and rapaciously demanding experience, pulling all of your attention to the here and now. But don’t slide saving for your retirement down your to-do list.

Try implementing one of these six retirement accounts and start socking away for that day in the future when you’re free from contracts, bookkeeping, and deadlines.

Traditional IRA 

A traditional IRA offers valuable optionality as you start your retirement savings journey, though they do have some meaningful limitations… not to mention complications when you get to the withdrawal stage. 

Best For?

Traditional IRAs are best suited for beginning savers, or those who can only save $6,000 (for 2020) or less a year. 

Where the optionality comes in is around 401(k) rollovers. Let’s say you left a cushy job to build your brand-new business (congrats!). You hopefully had some retirement savings in your company 401(k). You can roll over those funds from your old 401(k) to a traditional IRA. 

Why do this? You likely will have better, and lower-cost, investment options available to you via the traditional IRA. Note, though, that creditor protections differ between 401(k)s and IRAs, so if you are entering a high-risk business, you may want to speak to a legal or financial advisor before initiating a rollover.

Contribution Limits?

The price you pay for IRA optionality is the contribution limits ­— frankly, they aren’t great. You can contribute up to $6,000 (for 2020), plus a $1,000 catch-up contribution for those 50 or older.

There are no technical limits on rollovers from 401(k)s) to traditional IRAs, though again creditor protection limits and rules differ state to state. 

Tax Advantages?

You can defer paying income tax on up to $6,000 (plus $1,000 for those aged 50 and up) that you contribute to a traditional IRA in 2020.

What Else?

While making a traditional IRA contribution can lower your income tax bill this year, your ability to make that deduction depends on your income level.

The rules can get a bit complicated (are you or your spouse covered by a plan at work? What is your filing status?). You can review the exact limits and stipulations on the IRS website here.

How Do I Get Started?

It’s very easy! Just go to your custodian of choice (we use Fidelity with our clients but there are many reputable options), click the open account button, fill out some personal information, and voilà!

You will want to review your income levels before contributing to understand whether or not that contribution will be deductible on your tax return.

Roth IRA

The promised land for financial planners. Roth IRAs — everyone likes ‘em, from the government to the retiree. But why are they so valuable and versatile?

Roth IRAs allow you to make after-tax contributions (or conversions) and grow the funds tax deferred. Qualified withdrawals are tax-free, assuming that the admittedly byzantine withdrawal requirements are met.

And, you aren’t required to start emptying the account in retirement, like traditional IRAs! 

Best For?

Similar to traditional IRAs, contributions to Roth IRAs are best suited for beginner and modest savers.

However, and this is a biggie, they are incredibly powerful when considering techniques like Roth conversions. This is a topic for another blog post, but Roth IRAs are the Swiss Army knife of financial planning tools.

Contribution Limits?

The same as traditional IRAs: $6,000 in 2020, plus $1,000 catch-up for those 50 and up. 

Tax Advantages?

Roth IRAs don’t offer an immediate tax deduction today — you fund them with after-tax dollars. However, all growth is tax-deferred and qualified withdrawals are tax-free.

The calculation as to whether contribute that $6,000 to a traditional IRA or a Roth IRA is based on your current income levels, expected future income levels, and current versus future tax brackets.

If you think you will make more money in the future and tax rates will be higher, contributing to a Roth IRA today makes sense. If you are in peak earning years and are taxed a high marginal rate already, perhaps making a traditional IRA contribution is a better choice (assuming you are not above the income limitations for deductibility). 

What Else?

If you make too much income, you can still make a contribution to a traditional IRA; the contribution just won’t be deductible.

Roth IRAs are a bit different. If you are above the Roth IRA income limits, you cannot make a contribution.

You still might be able to do a conversion, however.

Further, the withdrawal rules for Roth IRAs differ considerably from traditional IRAs.

How Do I Get Started?

Same process as the traditional IRA. Easy peasy.

I’ll reiterate, though, that you should thoroughly review your income levels before making a contribution. 

If you accidentally made a contribution and it’s ineligible, the process to withdraw those funds is cumbersome. Plus, the contribution may be subject to IRS penalties if you don’t take it out in time.

SIMPLE IRA

The Savings Incentive Match Plan for Employees (or, more simply, the SIMPLE) IRA allows employees and employers to contribute to traditional IRAs set up on the employee’s behalf. 

While contribution limits aren’t as great as 401(k)s, setting them up is pretty… simple.

Best For?

SIMPLE IRAs are best for midsize businesses, or those with up to 100 employees.

Contribution Limits?

Each eligible employee may make a salary reduction contribution and the employer must make either a matching contribution or nonelective contribution.

An employee may defer up to $13,500 in 2020, with a $3,000 catch-up for those 50 and up.

It’s important to note that the salary reduction contributions under a SIMPLE IRA plan are “elective deferrals” that count toward the overall annual limit on elective deferrals an employee may make to this and other plans permitting elective deferrals.

Employers must make some form of a contribution to an employee’s SIMPLE IRA. An employer can choose to either make a dollar-for-dollar match of up to 3 percent of a worker’s pay or contribute a flat 2 percent of compensation, whether the employee contributes or not. 

Tax Advantages?

Employee contributions are deductible. The contributions made by employers are deductible as a business expense.

What Else?

SIMPLE IRAs have somewhat punitive withdrawal caveats. Early withdrawals (aka, those before 59 ½) are treated the same as early traditional IRA or 401(k) distributions. This means that early withdrawals will be taxed as ordinary income and also subject to a 10 percent penalty.

However, if you make a withdrawal from a SIMPLE IRA within the first two years or participating in a SIMPLE IRA, the penalty percentage ramps up to 25 percent. This even applies for rollovers to other retirement accounts. Ouch.

How Do I Get Started?

First, you will need to choose a financial institution to serve as trustee of the accounts. You can also let your employees choose their own financial institution to receive their contributions.

The IRS requires three steps to set up a SIMPLE IRA plan:

  1. Execute a written agreement to provide benefits to all eligible employees.
  2. Give employees certain information about the agreement.
  3. Set up an IRA account for each employee. 

SEP IRA

A simplified employee pension (SEP) IRA is a retirement savings plan established by employers, which can include self-employed individuals. A SEP does not have the start-up and operating costs of a conventional retirement plan, like a 401(k).

Further, there are no filing requirements for the employer. 

Best For?

The SEP IRA is best for self-employed people or small-business owners with no or few employees.

Contribution Limits?

Business owners can contribute the lesser of $57,000 in 2020 or up to 25 percent of compensation or net self-employment earnings, with a $285,000 limit on compensation for calculation purposes. Note, net self-employment income is net profit less half of your self-employment taxes paid and your SEP contribution.

Unfortunately, SEP IRAs do not have a catch-up provision. 

Tax Advantages?

Contributions based on the formula mentioned above are deductible on your tax return. Similar to a traditional IRA or 401(k), distributions in retirement are taxed as ordinary income.

Note, as well, there is no Roth version of a SEP IRA.

What Else?

SEP IRA plans are often favored by small businesses because of eligibility requirements for contributors, including a minimum age of 21, at least three years of employment, and a $600 compensation minimum. SEP IRAs also allow employers to skip contributions during years when revenues take a hit. 

Further, most SEP IRA plans require you to make allocations proportional to your employees’ salary/wages. This means that everyone’s contribution is the same percentage of salary. So, if you want to defer 25 percent of your salary, you will have to use the same percentage for all eligible employees.

Finally, SEPs are funded by employer contributions only. Employees cannot make a contribution.

Another unique feature of SEP IRAs is that you can set up a SEP plan for a tax year as late as the tax filing due date (including extensions). Most other retirement plans can only be set up through calendar year-end.

How Do I Get Started?

Similar to a SIMPLE IRA, the IRS requires three basic steps in setting up a SEP IRA:

  1. Adopt a formal written agreement by signing one of these documents:
    • IRS model SEP using Form 5305-SEP PDF, Simplified Employee Pension - Individual Retirement Accounts Contribution Agreement;
    • IRS-approved prototype SEP, offered by banks, insurance companies, and other qualified financial institutions; or
    • individually designed SEP plan document.
  2. Provide each eligible employee with information about the SEP. If you established the SEP using the Form 5305-SEP, the information must include a copy of the Form 5305-SEP, its instructions and the other information listed in the Form 5305-SEP instructions. If you used a prototype SEP or individually designed SEP, you must provide similar information.

  3. Set up a SEP-IRA for each eligible employee with a bank, insurance company, or other qualified financial institution. The employee owns and controls the SEP-IRA.

Solo 401(k)

This is one of our favorite tools for a solo business owner or married couple working together.

The solo 401(k), colloquially known as a solo-k, offers all of the benefits of a large 401(k) plan at typically a fraction of the cost. 

Best For?

These types of plans are best suited for an established business owner or self-employed person with no employees. Outside of your spouse, of course.

Contribution Limits?

The magic of a 401(k) is in the contribution limit. Relative to the other plans we have discussed thus far, solo 401(k)s have the highest contribution limit: up to $57,000 in 2020 (plus a $6,000 catch-up contribution for those 50 or older) or 100 percent of earned income, whichever is less. 

The mechanics of those contributions get slightly complicated, though. 

In your capacity as an employee, you can contribute as you would to a standard 401(k). This means that you can defer 100 percent of your compensation, up to $19,500 in 2020 (plus an additional $6,000 catch-up contribution for age 50-plus), whichever is less. 

If your capacity as the employer, you can make additional contributions of up to 25 percent of compensation.

Note, though, there are special rules for sole proprietors and single-member LLCs: you can contribute 25 percent of net self-employment income, which is your net profit less half your self-employment tax and the plan contributions you made for yourself.

Finally, the limit on compensation that can be used to factor your contribution is $285,000 in 2020.

Tax Advantages?

Similar to what we’ve discussed for tax-deferred plans, solo 401(k) plan contributions can be done pre-tax, and distributions after age 59½ are taxed.

However, there is additional flexibility within the 401(k) relative to the other vehicles we have discussed. Depending on how you set up your plan, you may be able to make Roth 401(k) contributions (which are contributions made after-tax).

Further, you can also make non-Roth, after-tax contributions. Why would you choose to do this when you can just make the Roth 401(k) contribution and be done with it? This strategy can amplify your ability to convert funds into a Roth IRA.

What Else?

While you can’t have a solo 401(k) if you have employees, your spouse (if an employee) can also contribute to the plan. The same contribution limits and contribution waterfall applies. 

How Do I Get Started?

You can open a solo 401(k) at nearly all major financial institutions.

This point often goes unnoticed, but you will need to file paperwork with the IRS each year once you have more than $250,000 in your plan. 

Defined Benefit Plan

Defined benefit plans for the self-employed. The big kahuna. The biggest of them all, spared no expense

There are several different types of defined benefit plans, from a pure pension plan to a cash balance plan. For the purposes of this blog post, we will focus on cash balance plans. 

Best For?

Defined benefit (DB) plans are best for self-employed individuals with no employees who have high incomes and want to accelerate their retirement savings.

A cash balance plan has features similar to a traditional pension plan, but with a twist. Like a traditional pension, a cash balance plan provides workers with the option of a lifetime annuity. 

However, unlike pensions, cash balance plans create an individual account for each covered employee. An employee (or self-employed owner) can choose to take a lump sum distribution and invest on their own.

Contribution Limits?

DB plans like a cash balance plan allow for contribution limits that are significantly higher than other retirement options.

Contributions are made according to a formula:

Wage x Pay Credit Rate,

Where the pay credit rate is the percentage of the employee’s, or owner’s, wage that the employer provides in contributions. Pay credit rates typically range between 5 and 8 percent.

DB plans like cash balance plans allow business owners to adjust contribution amounts each year depending on their situation.

Tax Advantages? 

Like the other tax-advantaged plans we discussed above, DB plans like cash balance plans allow for significant deductible contributions as well as tax-deferred growth.

What Else?

Did you know you can layer on other retirement plans with a defined benefit plan to turbocharge your retirement savings?

This is a favorite strategy of ours with established small business clients.

For instance, you can pair a defined benefit plan with a solo 401(k) plan to further increase your deductible contributions. 

The cost of all of the prime tax-deferral features of a DB plan are, well, the cost. These plans are a good bit more expensive than your lower cost options, like traditional or SIMPLE IRAs.

An actuary must certify each year that the plan is properly funded. Typical costs include $2,000 to $5,000 in setup fees, and $2,000 to $10,000 in annual administration fees and investment expense ratios.

Additionally, DB plan participant benefits are guaranteed by the employer, who solely bears the investment risk. Participant benefits grow in two ways: a contribution credit and an interest crediting rate. 

The contribution credit is the amount that the employer contributes annually on behalf of the owners and the participants. The contribution credit can either be a flat dollar value or a percentage of income. 

The interest crediting rate (ICR) is the rate at which the plan guarantees interest on accumulated contributions. This rate is typically tied to an index, such as the thirty-year treasury yield.

How Do I Get Started?

Defined benefit plans, like cash balance plans, require a more involved setup and maintenance process. We highly recommend partnering with a financial advisor or CPA to determine how to craft the plan so it fits your business.

Choosing a high-quality third-party administrator (TPA) is critical, too. TPAs handle much of the hefty administrative work so you can concentrate on the remaining investment work.

Retirement Planning with Harbor Crest Wealth Advisors

There are many levers to pull to manage your income, expenses, and even your retirement savings within your business. While we did a deep dive into all of the retirement plan options available to you, don’t let the sheer amount of information out there stop you from taking that first step. We are happy to help you dream up and implement a retirement plan that works best for your personal and business goals.

If you would like to learn more tips on how to optimize your taxes and lower your lifetime tax bill, sign up for our newsletter.