How the self-employed or those lacking access to employer-sponsored plans can save for retirement.
First, establish how much you want to pay yourself. It could be 5%, 10%, 20% or more. Just find your number and stick with it. Unexpected expenses this month? Pay yourself first. This mindset is simple in theory, very difficult in execution. However, it’s critical to pay yourself first in order to save for retirement when self-employed.
Retirement Plans for Small Business Owners
Although the 401(k) is perhaps the best-known retirement savings plan, it isn’t close to universal—less than half of Americans had one in 2015. But fear not—there are plenty of options available for those who are self-employed, work somewhere that doesn’t offer a retirement plan, or (who knows?) have already contributed the full amount to their 401(k)s and have more funds to sock away. If any of those describe you, check out these options and investigate if they meet your needs.
Before we begin, an important consideration: The following are account types that, unless we state otherwise, can hold many different types of investments—stocks, bonds, mutual funds, exchange-traded funds and more. So finding which of these account types fits your circumstances shouldn’t have much to do with the investments you choose.
Traditional IRAs vs. Roth IRAs for Self Employed Individuals
This is just your good old-fashioned Individual Retirement Account. Many people use it as a retirement savings supplement even if they have a 401(k), and anyone can open one. There are two major types: traditional IRAs and Roth IRAs. In a traditional IRA, contributions may be tax-deductible and growth isn’t taxed until withdrawal (when it is taxed at ordinary income rates). Roth IRA contributions aren’t deductible, but growth isn’t subject to income tax. (Note that both traditional and Roth IRAs carry IRS penalties for withdrawals taken before age 59 ½.) The annual contribution limits are lower than for 401(k)s—$5,500 instead of $18,000. But those over age 50 are eligible for additional “catch-up” contributions of $1,000 per year.
Own or work for a small firm? Some smaller firms that don’t offer a 401(k) plan set up SIMPLE IRAs on behalf of their employees, who can’t do so independently. Owners may also participate. Companies must contribute either 2% of the enrollee’s salary regardless of employee contributions, or match the employee’s contributions fully up to 3% of salary.ii Contribution limits are $12,500 per year, plus another $3,000 in annual “catch-up” contributions for those over 50. They’re simpler to set up and run than 401(k)s, which is why they’re more popular for smaller businesses. But contributions are capped far below those of SEP IRAs. Speaking of which…
SEP stands for Simplified Employee Pension. Like a SIMPLE IRA, it is designed for small-business owners with one or more employees. Freelancers are also eligible. Though money accrues for employees, employees may not contribute themselves—only employers. As with a traditional IRA, the money isn’t taxed until withdrawal. SEP IRAs also have a much higher contribution limit than other IRAs—up to $54,000iii or 25% of compensation, whichever is lower. They are comparatively simple to set up, and allow employers to contribute widely varying amounts each year—a feature companies with fluctuating revenues often appreciate.
Self-Employed Profit-Sharing Plans
These plans share many similarities with SEP IRAs: Employers contribute on employees’ behalf, and companies choose how much they wish to contribute—if profits are suffering, “nothing at all” is an option. Earnings accrue tax-deferred, and employees are free to use other retirement savings accounts at the same time. There is one main difference: With SEP IRAs, the company can contribute up to 25% of a worker’s salary (as long as it’s $54,000 or less); under profit-sharing plans, the company can contribute up to 25% of its payroll costs to employees as a whole, which means individual workers could receive more than 25% of their salary in plan contributions.
Individual (or “Solo”) 401(k)s
These plans are limited to sole proprietorships (businesses with an owner but no employees), and come in both traditional and Roth versions. The contribution limits are much higher than with standard 401(k)s, because the contributor counts both as an employee ($18,000 cap) and an employer ($35,000 cap). If your spouse contributes too, the combined limit is $106,000, plus an additional catch-up allotment of $6,000 each once you hit 50. Big! Solo 401(k)s do carry more paperwork than SEP IRAs, though, and many custodians charge additional fees to set up and maintain them.
Keogh plans are another option for the self-employed. There are two kinds: defined-benefit and defined-contribution. The defined-benefit variety states the annual sum you’ll receive upon retirement, which is usually based on salary and tenure, and then you fund your own plan accordingly—hence its appeal for high earners. The defined-contribution version works like a SEP IRA, but with the added option of locking in a set percentage of your salary as a contribution. Now, there is a lot of paperwork and complexity here, so the aid of a tax adviser is indispensable.
In November 2015, the US Treasury unveiled “MyRA,” which stands for My Retirement Account.iv These are meant to be free, “safe” savings accounts anyone can access, even with an initial contribution of just $25. Contributions—which are capped at $5,500 a year—grow tax-free until the account value reaches $15,000, or the account is 30 years old, at which point it rolls over into an IRA. The only available MyRA investment option, however, is low-yielding government bonds, which may struggle even to outpace inflation. The same critique applies to the various state-sponsored retirement plans in place or in the works around the country. Participating in these plans is certainly better than not saving at all, but better options—perhaps some of those listed above—are available for the vast majority of workers. Consider getting together with your tax adviser to figure out what works best for you.
i“SIMPLE” isn’t capitalized because the plans are just that simple, but because it’s an acronym: Savings Incentive Match Plan for Employees. Because if there is one thing lawmakers enjoy, it’s stitching together a bunch of random words to make catchy titles for their legislation.
iiUnsurprisingly—we’re talking about taxes, after all—there is more to it than this. If you want to delve further into this or any of these other plans, the IRS website is a good resource.
iiiTechnically, this $54K limit applies to all defined contribution plans a person might have, which means you can’t put $54,000 into your SEP IRA while also contributing to (for example) a 401(k).
ivIt’s complicated when you include whole words in an acronym.