Retirement Savings Options for the Self-Employed
Being self-employed or owning a small business gives you a certain measure of freedom in your career. According to the U.S. Bureau of Labor Statistics, 15 million people were self-employed in 2015 or about 10% of the country’s workers. But this also means that saving for retirement for those 15 million Americans might not be as simple as it could be if they worked for a company that sponsored a retirement plan such as a 401(k) or pension. That doesn’t mean that self-employed individuals need to fret about their financial situation in retirement. There are a variety of retirement plan choices for business owners or freelancers including a traditional or Roth IRA, a solo 401(k), a SEP IRA, or a SIMPLE IRA. To choose the option that is right for you, consider sitting down with a wealth manager to discuss your financial goals in retirement and what you want to provide to your own employees if you have any. Here are some of the options you may want to consider.
Traditional or Roth IRA
A traditional or Roth Individual Retirement Account (IRA) is best for individuals (business owners or otherwise) that are saving less than $6,000 (with a $1,000 catch-up for those 50 years old and over). This is probably the easiest way to save on your own as there are no special requirements for the account such as employee contributions. But, keep in mind that if you are married and your spouse participates in an employer-sponsored retirement plan, it may affect your ability to contribute to these types of plans.
The toughest part is deciding whether to invest within a traditional or Roth IRA. The biggest differences between the two are how and when you get a tax break, income restrictions and age limits. You may only contribute to a traditional IRA if you are younger than 70½, and your entire contribution may be tax deductible, but only if you and your spouse do not have retirement plans through other jobs. There are also phase out limits which are based on marital status and income. Plus, you are required to start taking your required minimum distributions (RMDs) by April 1st, the year after you turn age 70 ½. On the other hand, Roth IRAs have no age restriction but there are income restrictions, meaning you can continue to let this account grow and you are not required to take any withdrawals. If you’re not hitting the income restrictions, a Roth IRA might be a better choice since withdrawals in retirement are tax-free. With a traditional IRA, you are deferring taxes upon depositing the money into your account, but you are taxed at ordinary income tax rates when funds are withdrawn.
Solo 401(k)s are beneficial for business owners that have no employees and are particularly attractive for those who can and want to save a large amount of money for retirement. As opposed to an IRA, the contribution limit for a solo 401(k) is higher, at $56,000 plus a $6,000 catch up for those 50 years old and over, or 100% of earned income, whichever is less. The solo 401(k) works just like a standard, employer-sponsored 401(k), meaning you make contributions pre-tax and distributions can be taken after age 59 ½ and are taxed at ordinary income rates.
This option appeals to those who are in the position to save a great deal of money for the future or those who are interested in saving more in years when business is flourishing. The downside to solo 401(k)s is that you MAY NOT contribute to one if you have employees. Additionally, there is an annual reporting requirement imposed by the IRS if your account value exceeds $250,000. Contribution limits also apply yearly per person, not per plan, so those investing in retirement funds through outside employment must be vigilant since the contribution limit applies to both (or all) plans combined. You may also choose to invest in a Roth 401(k) which mimics the tax treatment of a Roth IRA and is a good choice if you expect your income and tax rate to be lower now than in retirement. However, unlike the Roth IRA, RMD rules do apply to a Roth 401(k).
A SEP (simplified employee pension) IRA is best for self-employed or small business owners with few to no employees, and it benefits both employers and employees. Employers make contributions on behalf of eligible employees. Additionally, SEP IRAs have higher contribution limits than standard IRAs. However, they are treated like traditional IRAs for tax purposes and provide the same investment options, and employers receive a tax deduction for contributions to a SEP IRA.
A SEP IRA is easier to maintain than a solo 401(k) with low administrative burdens and no annual reporting, and employers have flexibility since contributions can change and are not required each year. It also has less costly start-up and operating costs than most employer-sponsored plans. The downside to a SEP IRA is that you must make equal contributions (by percentage) to ALL eligible employees as you make to your own retirement fund, which can become costly depending on the number of employees you have.
It is important to note that money given to employees through a SEP IRA is vested immediately, meaning that 100% of the money belongs to the employee as soon as it is deposited. This contrasts typical 401(k) plans, where the employer has the option to implement a vesting schedule and is important as it may have an impact on employee retention.
A SIMPLE (savings incentive match for employees) IRA is common for business with up to 100 employees. This retirement plan has a $13,000 contribution limit and allows for a $3,000 catch up for those age 50 and over. If you also contribute to an employer plan, the total of all contributions may not exceed $19,000. While contributions are deductible, distributions in retirement are taxed. Employer contributions made to employee accounts in this type of plan are deductible as business expenses.
The benefit of a SIMPLE IRA is that the contribution burden does not lie solely on the employer, unlike with a SEP IRA. Employees can make contributions to their funds, and generally, employers chose to either match employee contributions of up to 3% or a fixed 2% to every eligible employee. However, the fixed option means that you must contribute 2% to every employee, regardless of whether they are contributing or not.
A SIMPLE IRA is easy to set up and accounts are owned by each employee. Contributions limits are significantly less than a solo 401(k) or SEP IRA, but there is potential for mandatory contributions, which can become expensive. Additionally, the same vesting rules that apply to the SEP IRA are also applicable for a SIMPLE IRA.
Finally, there are benefits to creating an employer-sponsored retirement plan for your small business, no matter which option you choose. Not only do you receive tax benefits, but you also have retirement benefits that will help to attract, retain and reward your employees.
If you need help deciding which of these plans is the best for you or your business or need help getting started with a retirement plan, contact me at [email protected].