As independent workers who make a living through self-employment, it makes sense that we save for retirement on our own, too. Logical, sure -- but figuring out how to save for your own retirement can be a daunting endeavor. Fortunately, there are savings and investment plans specifically tailored for people who work for themselves.
If you’re already saving your hard-earned dollars for your golden years, we give you huge props. However, if you’re in the one-third of small business owners who don’t save for retirement, we have some solid options to help you start saving for tomorrow.
There are four main accounts that self-employed people can use to save for retirement: a Roth/Traditional IRA, a SEP IRA, a Solo 401k and a Personal Defined Benefit Plan (there are other types of accounts, of course, like the SIMPLE IRA for small businesses with up to 100 employees, but we’re focusing on these four today). Here’s what you need to know about each one.
Roth/Traditional IRA
What is it?
Any individual can open this type of retirement account -- which is why it’s called an Individual Retirement Arrangement. It’s basically an investment account managed by a brokerage or financial institution that you can’t access (without penalty) until you are 59 ½ years old.
There are two types of IRAs. The Traditional IRA is for pre-tax contributions you’ll be taxed on when you withdraw funds down the road (boo) but that generate extra money that grows with interest until that later date (yay). A Roth IRA is the opposite - you contribute post-tax dollars to the account now and, later, retrieve your dollars tax-free.
How much can I contribute?
You may contribute a maximum of $5,500/year. If you’re over 50, you may contribute an additional $1,000 for a total of $6,500/year.
How does the taxation on this work?
For a Traditional IRA, you are allowed to deduct the contributions on your annual income taxes depending on your Adjusted Gross Income. You cannot do this with a Roth because you are contributing taxed money, so you’ll see your benefit when you withdraw those funds tax-free later on.
When can I withdraw the money without penalty?
At 59 ½ years old. However, at 70 ½, required minimum distributions (RMD) for Traditional IRAs kick in. The RMD for each year is calculated by dividing the IRA account balance as of December 31 of the prior year by the applicable distribution period or life expectancy.
Make sure you withdraw at least the minimum amount. If you don’t, there is a 50 percent penalty on the amount that isn’t withdrawn. For example, you’ll face a $1,000 penalty if you were supposed to withdraw $2,000 but didn’t.
This rule does not apply to Roth IRAs. Roth IRAs do not require annual withdrawals at a specific age.
You can find out more details on how the required distribution amount is calculated at the IRS website.
What if I withdraw funds earlier than that?
You’ll be penalized for withdrawing early from both types of accounts. However, you can withdraw your contributions to the Roth at any time -- but not the earned interest on those contributions.
What’s the upside to a Traditional/Roth IRA?
Anyone can open an IRA, and they’re easy to open and maintain. There’s no special tax filings associated with this account. You can deduct your contributions to a Traditional IRA.
And the downside?
You are limited in the amount you may contribute per year.
Solo 401K
What is it?
Also known as an “Individual 401k,” a Solo 401k is a regular old 401k retirement account, but this type is just for owner-only companies who have no employees. It covers only you (or you and your spouse, if any). You can set up a solo 401k whether your business is incorporated or a sole proprietorship. You can contribute to it as both an employer and as an employee. These are different from Traditional or Roth IRAs because you can contribute a lot more per year.
How much can I contribute?
Think of yourself as two people here: employee and employer. As an employee of your own company, you can contribute up to $18,000/year. As the owner and sole employer, you can contribute 25% of your earnings up to $54,000 total/year (this total includes the $18K you contributed as an employee).
How’s the taxation on this work?
Like with IRAs, there are two types of Individual 401k accounts: Traditional and Roth. The former stashes away pre-tax money that is taxed upon distribution, while the latter holds on to your post-tax bucks to be distributed tax-free in retirement.
When can I withdraw the money without penalty?
At 59 ½ years old.
What if I withdraw funds earlier than that?
Unlike IRAs, you can borrow against your Individual 401k (up to 50% of your balance with a maximum loan of $50K) at prime rate plus 1% (today that would be 5.5%). If it’s not repaid in five years’ time, the unpaid balance will be considered a withdrawal, you’ll pay income tax on this amount and you’ll most likely pay an early distribution penalty, as well.
What’s the upside to an Individual 401k?
You can save larger amounts for retirement, and you can also hire your spouse and make contributions for them, too, effectively doubling your saving rate.
And the downside?
If you end up hiring a full-time employee, you will not be eligible to continue contributing to this type of account. There is usually a set-up fee and an annual fee to maintain the account. And you’ll have to file special tax paperwork once your balance is $250,000 or more. Yearly contributions are mandatory.
SEP IRA
What is it?
SEP stands for “Simplified Employee Pension” and IRA, as you know already, stands for “Individual Retirement Arrangement”.
Similar to a Roth or a Traditional IRA in some ways, SEP IRAs differ in that they must originate from your job (as opposed to setting up a Roth or Traditional as an individual person, independently from your job). The employer (you) sets up the account for the employee (yourself or someone who works for you) and then contributes to that employee’s account.
How much can I contribute?
Whichever is less: up to $54,000 a year or 25% of compensation or net self-employment earnings, up to a maximum of $270,000 in compensation.
How’s the taxation on this work?
The funds contributed are pre-tax, which means you have more money to grow until the day you withdraw. When you do withdraw, the money is taxed at your current income tax rate. On the employer side, you get a tax deduction for your contributions.
When can I withdraw the money without penalty?
When you reach the magic age of 59 ½.
What if I withdraw funds earlier than that?
The distribution will be taxed at your regular income tax rate, and you may also have to pay a 10% penalty.
What’s the upside to a SEP IRA?
You can contribute significantly more to a SEP than you could to a Roth or Traditional IRA. And, unlike an Individual 401k, yearly contributions are not mandatory - you contribute when you can.
And the downside?
If you have employees, you must contribute the same percentage of salary to each and every one of their accounts. So, if you give yourself 8% of your pay, guess what? Everyone else also gets 8% of their pay, which can really start to add up for you, the employer. You may be restricted on contributions to other types of IRAs.
Personal Defined Benefit Plan
What is it?
This is similar to your grandad’s pension in that it pays out an expected, set amount each year in retirement. It’s for self-employed, high-income individuals who can contribute a significant amount each year. Charles Schwab recommends this account for those who earn $250,000 or more per year.
How much can I contribute?
The contribution amount is based on your age, the amount of money you’ll receive at retirement and what you expect your investment returns to be.
How’s the taxation on this work?
Pre-retirement contributions are usually deductible, while post-retirement distributions are taxed as income. The IRS requires minimum yearly contributions that, if not met, will result in penalties.
When can I withdraw the money without penalty?
At the age you pre-determine when you set up the plan.
What if I withdraw funds earlier than that?
You’ll be subject to penalties and fines.
What’s the upside to a Personal Defined Benefit Plan?
You can stash away a lot of money for retirement in a fairly short amount of time. You’ll know exactly how much you’ll be receiving at retirement.
And the downside?
An accountant must figure out your annual deduction amount for your tax filing. The accounts are expensive to set up and maintain, and they require an annual minimum contribution that, if changed, will mean you pay a fee. If you have employees who work more than 1,000 hours a year, you must also maintain an account for them.
As you can see, whether you work entirely for yourself or have an employee or two on your team, there are options for saving for your retirement. Speak with your investment and tax professional to find out which plan is right for you -- and then enjoy the warm, fuzzy feeling you get when you start planning for the future. Good luck!
Additional Resources:
Retirement Calculator via NerdWallet
Retirement Plans for Self-Employed People via the IRS
Small Business Retirement Plans Explained via Charles Schwab
5 Ways to Better Prepare for Your Retirement via QB Resource Center
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