Being self-employed gives you the autonomy to choose when and how you work, but it doesn’t mean you can avoid saving for retirement. In fact, being self-employed makes putting money away that much more necessary. Entrepreneurs have several options to save for retirement, some which will qualify for tax benefits.
Consider these retirement plans if you are self-employed:
A solo 401(k) also called a single-participant 401(k) plan is appealing for those individuals who want to save a great deal of money in some years and less in other years. A solo Roth 401(k) is also available which copies the tax method of a ROTH IRA.
Best for: A business owner with no employees other than a spouse.
Contribution Limit: In 2020, Contributions up to $57,000 (+ $6,500 catch-up contribution or $63,500 if you are 50 years or older) or 100% of earned income (whichever is less). Contributions can be made as both an employer and a participant/employee.
- As the employee, you can contribute up to 100% of your compensation or $19,500 (+ the $6,500 catch-up contribution, if eligible), whichever is less.
- As the employer, you can contribute an additional contribution of up to 25% of your compensation or net self-employment income.
- Your spouse as an employee can also contribute up to 100% of their compensation or $19,500, plus the employer contributions, for up to an additional $57,000 total (+ catch-up contribution, if eligible). This can be attractive because it doubles what you can save as a couple.
- Contribution limits apply per person, not per plan. Therefore, if you or your spouse also have outside retirement accounts, the contribution limits cover both plans.
Tax Advantage: Contributions are made pre-tax and distributions after age 59 ½ are taxed as ordinary income. Distributions prior to 59 ½ may be subject to 10% penalty tax.
SEP IRA (Simplified Employee Pension)
The SEP IRA can be attractive because of the low administrative costs, limited required paperwork, and no annual reporting to the IRS.
Best for: Self-employed or small-business owners with no or few employees.
Contribution Limit: Up to $57,000 in 2020 or up to 25% of compensation or net self-employment income ($285,000 limit on compensation that is used to factor the contribution)
- Employers must contribute an equal percentage of salary for each eligible employee (The employer is counted as an employee). So, if you contribute 10% of your income to your SEP IRA, you must contribute 10% of salary for each employee
- No catch-up contributions for those 50 years or older
Tax advantage: Employers can deduct the lessor of the contributions or 25% of compensation (limited to the $285,00 cap per employee) on your business’ tax return. Distributions in retirement are taxed as income.
SIMPLE IRA (Savings Incentive Match Plan for Employees)
SIMPLE IRA plans may be a good option for small businesses with 100 or less employees. It is easy to set up, with no filing requirements, no start-up or operating costs, and accounts are owned by the employees.
Best for: Small-Midsize businesses with up to 100 employees
Contribution Limit: Up to $13,500 in 2020 (+ catch-up contribution of $3,000 if 50 or older). If the employee participates in another employer retirement plan, the total contributions are limited to $19,500 for all plans combined.
- Employers must either match each employee’s contribution up to 3% of the employee’s salary - or – make fixed contributions of 2% to every eligible employee up to the annual limit of $285,000 for 2020.
- Employers must contribute to their eligible employees’ SIMPLE IRA accounts; however, employees are not required to contribute to their accounts.
Tax advantage: Contributions are deductible, but distributions in retirement taxed as ordinary income. Employers may deduct their own salary reduction contributions and all contributions made to employees’ SIMPLE IRAS on their business’ tax return.
Defined Benefit Plan
A defined benefit plan or pension plan guarantees you a specific benefit or payout upon retirement based on a set formula. The formula is based on factors such as salary, age and length of service with the company. Benefit/payout is not dependent on asset returns.
Best for: A self-employed individual with no employees, high income and wants to save a lot for retirement on an ongoing basis.
Contribution Limit: Each year, pension actuaries determine the amount that needs to be contributed to the plan to fund the determined future benefits paid in retirement. The annual defined benefit cannot exceed the lesser of 100% of the employer’s average compensation for his or her highest consecutive calendar years, or $230,000 for 2020.
- If you have employees, you generally must offer the plan to them and make contributions on their behalf
Tax advantage: Contributions are tax deductible and the business owner is not taxed each year on investment gains. Upon retirement or termination of the plan, the employer may receive their defined benefit in a single sum distribution, which can be rolled into an IRA for continued tax-deferral. Distributions in retirement are taxed as income.
Traditional or Roth IRA
An IRA is usually the easiest way for self-employed individuals to save for retirement.
Best for: Those looking to save a modest amount or just starting out.
Contribution Limit: Up to $6,000 in 2020 or up to $7,000 if you are age 50 or older.
Tax advantage: Tax deduction on contributions to a traditional IRA, but distributions in retirement are taxed as ordinary income; no immediate tax deduction for a ROTH IRA, but qualified retirement withdrawals are tax-free.
Withdrawals from a traditional IRA prior to age 59 ½ may be subject to a 10% penalty tax. Withdrawals of Roth IRA earnings prior to age 59 ½ or prior to the account being opened for 5 years, whichever is later, may result in a 10% IRS penalty tax. Limitations and restrictions apply.
Each of these plans offers some unique benefits. The ideal retirement plan depends on how much you will be able to save, your age, tax benefits, whether you have employees, and ongoing administration. Self-employed or small business owners must choose the plan that suits their financial goals and investment objectives. A qualified Retirement Plan Advisor can help you decide and guide you through the process.
The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.
All investing involves risk including loss of principal. No strategy assures success or protects against loss.
This information is not intended to be a substitute for specific individualized tax or legal advice. We suggest that you discuss your specific situation with a qualified tax or legal advisor. general information, and should not be considered a solicitation for the purchase or sale of any security.
Joseph Cappuccino is a registered representative with, and securities and advisory services offered through LPL Financial, Member FINRA/SIPC #1-05021750