Most of the retirement account information we see in the media is geared toward W-2 employees, which makes sense, since they make up the vast majority of the workforce. However, if you are self-employed, you have unique retirement account options available to you that are often left out of discussions about personal finance and retirement planning. In this article we will go over the essential information about the different types of retirement accounts available to the self-employed individual, and for whom each type of account is most appropriate.
1) TRADITIONAL OR ROTH IRA
While these common retirement accounts are not specifically for self-employed individuals, they are available and can be used by the self-employed. As we will explore in this article, there are much better options out there for self employed individuals with significant income, but a traditional or Roth IRA can be good for someone who is just starting out in their business and has very little income to save in a retirement account.
- 2019 Contribution Limit: $6,000 (plus an additional $1,000 catch-up contribution for those 50 and older).
- Tax treatment: Contributions to a traditional IRA are tax-deductible and distributions in retirement are taxed as ordinary income. Contributions to a Roth IRA are not tax-deductible, but distributions taken in retirement are tax-free.
- Employee Treatment: If you have employees, your Traditional or Roth IRA accounts have no connection to your employees. If your employee wants to have a traditional or Roth IRA, they open it and fund it themselves.
- Who is it for? – Can be appropriate for self-employed individuals with low income, who don’t have the ability to save more than $6,000 in a retirement account. If your income is high enough to save more than $6,000, there are better options for you.
- Administrative requirements: No IRS reporting is required. Opening an IRA account is very simple. You can open one through many financial institutions such as a bank, brokerage company or mutual fund company.
2) SOLO 401(k)
The solo 401(k) is a great type of retirement account specifically for self-employed individuals; it gives you the opportunity to put away lots of tax advantaged retirement savings. For most self-employed people, a solo 401(k) usually gives the most “bang for your buck” in terms of how much you can contribute on a given income.
Solo 401(k) plans are also available as Roth 401(k) plans at some financial institutions.
- 2019 Contribution Limit: $56,000 (plus an additional $6,000 catch-up contribution for those 50 or older). Here’s how the solo 401(k) contributions work:
- As a self-employed individual, you can contribute $19,000 of your income as your employee contribution (plus the $6,000 catch-up contribution if you are 50 or older). This part of the solo 401(k) contribution is just like a regular employer sponsored 401(k).
- Here comes bonus #1: On top of your employee contribution, you can make an employer contribution of up to 25% of your self-employment income. The combined employer and employee contributions can’t exceed $56,000 ($62,000 for those 50 and older).
- And now bonus #2: You can hire your spouse, and they can make the same contributions as you, doubling your potential tax advantaged savings! If you have high self-employment income, this can really let you put a lot of tax deferred money away for retirement.
- Tax treatment: Contributions are tax-deductible regardless of your income. Distributions in retirement are taxed as ordinary income.
- Employee treatment: Solo 401(k) plans are for self-employed individuals with no employees. The exception to this is the ability to treat your spouse as an employee as described above.
- Who is it for? – A self-employed individual with no employees (with the exception of a spouse).
- Administrative requirements: Annual filing of IRS form 5500 may be required depending on the specifics of your plan and the amount you have invested. Opening a solo 401(k) plan is more involved than opening an IRA, but still certainly easy enough to do on your own and most financial institutions will guide you through the process.
3) SEP IRA
The SEP (Simplified Employee Pension) IRA is an IRA with a high contribution limit for self employed individuals and their employees, if any. The contribution limit is the same as for the solo 401(k), however a higher income is needed to meet the limit due to the contribution rules below.
- 2019 Contribution Limit: $56,000, no catch-up contribution is available for individuals 50 and older.
- 25% of self-employment income can be contributed, up to the maximum of $56,000. However, unlike the 401(k), you can’t make that big $19,000 employee contribution for yourself. This means that you have to be making more money to reach the maximum contribution limit with a SEP IRA, compared to the solo 401(k). In order to make your maximum SEP IRA contribution, your self-employment income has to he around $225,000, but to max out a solo 401(k) your income only needs to be around $150,000 (these are just approximate numbers…but you get the idea).
- Tax treatment: Contributions are tax-deductible regardless of your income. Distributions in retirement are taxed as ordinary income.
- Employee treatment: If your business has any employees, you must contribute the same percentage of their income to their account as you contribute to your own account. If you contribute 15% of your income to your account, you must also contribute 15% of your employee’s income to their account. This can get very expensive if you have numerous employees.
- Who is it for? – Self employed individuals with few or no employees.
- Administrative requirements: No IRS reporting is required. Opening a SEP IRA account is very simple.
4) SIMPLE IRA
The SIMPLE (Savings Incentive Match Plan for Employees) IRA is a retirement plan for self-employed individuals with fewer than 100 employees. It has a lower contribution limit than the SEP IRA and solo 401(k), but encourages contributions by employees
- 2019 Contribution Limit: $13,000 (plus an additional $3,000 catch-up contribution for individuals 50 and older). Note that the contribution limit is significantly lower than for the SEP IRA or solo 401(k).
- Tax treatment: Contributions are tax deductible. Distributions in retirement are taxed as ordinary income.
- Employee treatment: As an employer, you are required to make contributions to employee accounts in one of two ways. You must either contribute a dollar for dollar match of an employee’s contributions, up to 3% of employee compensation, or contribute a fixed contribution of 2% of employee compensation for each employee.
- Who is it for? – Self employed individuals with fewer than 100 employees who want to encourage contributions by employees.
Administrative requirements: No employer IRS reporting required. Opening an account is easy, but requires more paperwork than a standard IRA.
5) DEFINED BENEFIT PLANS
Defined benefit plans are essentially self-funded pensions for high-income self-employed individuals. These plans allow you to make very large tax deferred contributions to your retirement plan: we’re talking about the potential for six figure contributions with these plans.
Basically you decide how much you want as your defined benefit during retirement, and a minimum annual contribution is determined that you must contribute every year in order to meet that goal. But be careful, because the minimum contribution amount is set and must be met every year, even if your income decreases for a period of time. This makes defined benefit plans most attractive for self-employed individuals with very high and stable incomes.
Additionally, if you are making contributions to a defined benefit plan, you can still max out another standard tax-advantaged retirement account like a SEP IRA or a solo 401(k). So you can see how starting a defined benefit plan can be a great way for a high income individual to drastically ramp up tax-advantaged retirement savings.
