You won’t get the benefit of an employer-matching 401(k), not if self-employment is your full-time gig, but you do have access to a variety of tax-advantaged retirement accounts. And you may be able to sock away more into these accounts because of your self-employed status.
But, as with all things related to retirement savings, self-employed retirement options are complex and varied. So figuring out what options you can use and which is the best fit for you can be a bit confusing.
As a freelancer, retirement options are extremely important to me. So I put together this guide to cover everything you need to know about retirement savings options for the self-employed. You may still want to meet with a financial adviser to choose specific products for your needs, but at least you can go into that meeting with a good idea of what will work for you.
Keep in mind that I am not a retirement specialist or financial advisor. The information below is based on my own research as a freelancer. If you need advice specific to your circumstances, seek the help of a financial planner or other retirement expert.
An Overview of Retirement for the Self-Employed
Retirement Planning is Even More Important
One of the biggest advantages of being self-employed is that you can make your own choices. You decide when and where to work, and you also choose what type of retirement plan to use.
With this freedom, however, comes more responsibility for your retirement savings. Unlike employer plans, you are on your own when it comes to company matches, automated savings, and tax benefits. So for the self-employed, retirement planning is even more essential. It’s also more complicated.
This is why you need to carefully consider all the options available to you before deciding which retirement savings plan is best for your needs.
You Can Save More
One benefit of being self-employed is that sometimes you can contribute more to your retirement savings accounts. This is because with some accounts, such as the SEP-IRA, you can effectively create your own salary-matching incentive for retirement savings.
There’s only so much you can do as an employee to persuade your employer to increase a salary-matching incentive. As a self-employed individual, you’re in control of how much of your income you direct into your self-employed retirement accounts.
We’ll talk more in a bit about the limits for different types of accounts, but just know that as a business owner or self-employed individual, you may be able to save $52,000 a year in your tax-advantaged retirement accounts.
A Note on Compensation for Self-Employed Individuals
In this article, we’ll link to many official IRS publications on retirement accounts. These publications will talk about compensation and the total percentage of compensation that you can contribute to different types of retirement accounts.
It’s important to understand how the IRS calculates compensation for self-employed individuals. Surprise! It’s not as simple as it might seem.
To calculate your total compensation for retirement contribution purposes, you’ll need to start with your net profit — or your total revenue minus your total expenses. Then, you’ll need to subtract half of the self-employment tax you owe the government for that year, plus any plan contributions you make for yourself.
So any time we talk about compensation or income in the following sections, we’re referring to the IRS’ calculation of your income for retirement account purposes.
Now that we’ve got that cleared up, let’s talk about the types of retirement plans that are available to you as a self-employed individual:
An SEP (Simplified Employee Pension) IRA plan is available to employers and small-business owners/self-employed individuals alike. The SEP-IRA, like a traditional IRA, operates with pre-tax contributions.
This means that you don’t pay taxes on income that’s contributed to the account (up to certain annual limits), but you’ll pay taxes later when you make withdrawals. The main advantage to these plans is that they’re simple and streamlined, which usually translates into lower costs. This is true even if you add employees to the plan down the road.
A SEP-IRA is essentially a traditional IRA with a different name. You use form 5305-SEP to set up the plan for your business. You’ll fill out this form and open an SEP-IRA directly through a financial institution (here is a list of brokers where you can open an IRA).
You can set up an SEP-IRA at any point during the year, up to the due date (including extensions) of your income tax return for that year. So you can set up and contribute to an SEP-IRA for 2013 all the way up to your filing deadline for 2014.
If you add employees to the plan later, they would open a traditional IRA of their choice and then you would make SEP contributions to that account.
(Be aware that some financial institutions will require you and/or your employees to open an account labeled as an SEP-IRA to receive these contributions, according to Investopedia.)
One huge advantage of an SEP-IRA over a traditional IRA for the high-earning self-employed is its contribution limits. Right now, you can contribute up to $5,500 per year (plus a $1,000 50-and-older catch-up contribution) to a traditional IRA.
An SEP-IRA has much higher limits, shown below:
|Year||Maximum Total Contribution||Percentage of Income Limitation
|2013||$51,000||25% / 20%|
|2012||$50,000||25% / 20%|
|2011||$49,000||25% / 20%|
|2010||$49,000||25% / 20%|
|2009||$49,000||25% / 20%|
Since your SEP-IRA contributions are limited to 20-25 percent of your income, depending on what type of self-employed individual you are, these high contribution limits don’t matter if you’re not making much money at all.
If your freelancing business is just a side job that you use exclusively to save for retirement, and neither you nor your spouse is eligible for a work-sponsored retirement plan, then you could contribute a portion of your self-employment income to a traditional IRA. With the SEP-IRA, you’ll be limited to 20-25 percent of your income, no matter what.
Still, a SEP-IRA may be an investment for the future if you expect your income to grow. It doesn’t take a staggering income to push 20-25 percent of your income over the traditional IRA’s $5,500 limit.
Pros and Cons
Low Administration Costs
According to the IRS, an SEP-IRA is one of the simplest ways to set up a retirement plan that will cover both you and future employees. With its low administrative costs, it’s a good option even if you don’t have employees.
High Contribution Limits
As we noted above, the SEP-IRA has higher contribution limits than a traditional IRA. So if you’d like to sock away a good portion of your self-employment income, this is an excellent way to do it.
Flexible Annual Contribution
One thing we haven’t talked about yet with the SEP-IRA is its annual contributions. With many types of retirement plans for employers, you have to contribute a certain amount or percentage, year in and year out, regardless of how much your business brought in that year.
With an SEP-IRA, you have the option of flexible contributions. If you don’t earn a lot in a year, you don’t have to contribute a lot. If you earn more, you can contribute more. You can make that decision on an annual basis based on your business performance for the year.
Necessary Employee Contributions
If you do establish an SEP-IRA plan for your business, you may be forced to add employees to that plan if you hire employees. According to the IRS, employees must be included in your SEP plan if they’re at least 21, have worked for you for any three of the past five years, and have received at least $550 in compensation from your business for the year.
You can make your eligibility requirements less strict if you want to, but you must include employees in the plan if they meet those three requirements. And if employees are included in your SEP-IRA plan, you must contribute to their accounts at the same rate you contribute to your account for any given year.
So if you have a bumper year and two employees, you won’t be able to contribute 25 percent to your SEP-IRA and only 10 percent to theirs. Everyone will get the 25 percent contribution, or whatever amount you set for that year.
Obviously, the monetary contribution for your employees may be smaller than yours, but you must contribute the same percentage for each person in your business, including yourself.
This makes the SEP-IRA a good option if you’ll never hire employees, or if you don’t mind giving employees considerable retirement contributions. But it’s essential to think about your business’s future before establishing an SEP-IRA plan.
A SIMPLE (Savings Incentive Match Plan) IRA is another type of IRA set up for small-business owners and the self-employed. You can open this account if you have between 0 and 99 employees making more than $5,000 each.
You can’t have another retirement plan for your business besides the SIMPLE IRA. So you can’t open it up alongside an SEP-IRA plan that would be effective for your employees, but you can contribute to both a SIMPLE IRA and a personal retirement account, like a Roth IRA.
(We’ll talk more about combining contributions to different types of accounts later.)
You can set up the SIMPLE IRA any time from Jan. 1 to Oct. 1. If you become self-employed after Oct. 1, you can set up a SIMPLE IRA for that year as soon as you can get to it.
Like the SEP-IRA, SIMPLE IRAs have much higher contribution limits than either traditional or Roth IRAs. Also like the SEP-IRA, they’re relatively simple (no pun intended) to set up and affordable to run.
Unlike the SEP-IRA, you can put 100 percent of your net earnings from self-employment into the account, up to the $12,000 limit (for 2014). Plus, you’ll add additional contributions of either a 2 percent of salary nonelective contribution or 3 percent matching contribution.
Like the SEP-IRA, the SIMPLE plan can grow with your business. You can start one now as a self-employed individual and continue to use the plan as you gain employees. Also like the SEP-IRA, as long as you stick with this plan, you’ll be required to offer certain incentives to your employees.
The chart below shows the salary reduction limits for the SIMPLE IRA. These limits are for employee contributions; and if you have employees, they can choose to have any of their income, up to the annual limit, withheld and added to the SIMPLE IRA.
|Year||Under Age 50||Age 50 or Older|
Remember, you’ll have to set up a SIMPLE IRA plan to offer either a 2 percent fixed contribution or a 3 percent matching contribution. So if, for instance, an employee makes $30,000 per year in salary and puts $10,000 of that into a SIMPLE IRA, you would make an employer contribution of either $600 (2 percent of salary) or $300 (3 percent of elected contributions).
Even if you have no employees, the SIMPLE IRA can be a good plan to check out. This is because you can contribute both the maximum employee contribution of $12,000 and the employer matching portion.
So if you made $50,000 in a year, you could contribute $13,000 ($12,000 + 2 percent of income) to your SIMPLE IRA plan. That’s $500 more than you could contribute with an SEP-IRA plan on those earnings.
Pros and Cons
The SIMPLE IRA is simple to set up and operate. Because of this, it’s also relatively inexpensive as far as administration costs.
Good Contribution Limits for Some
The SIMPLE IRA has lower contribution limits than the SEP-IRA, but its limits may be easier for some self-employed individuals to reach. If you’re earning $50,000 a year or less, you’ll probably be able to save more in a SIMPLE IRA than you would in an SEP-IRA plan. That’s because the SIMPLE IRA doesn’t have a percentage-of-income contribution limit.
So if you want to save more than $5,500 in a traditional IRA but probably won’t qualify to save more than $13,000 in an SEP-IRA, then a SIMPLE IRA can maximize your savings. However, if your income grows, you won’t be able to save as much in a SIMPLE plan as the SEP-IRA.
Better Tax Benefits for the Self-Employed
Employee contributions to a SIMPLE IRA plan aren’t tax-deductible, but employer contributions are tax-deductible for the employer. So if you’re a sole proprietor or partner, you can deduct your salary reduction contributions and matching or nonelective contributions on Form 1040.
Employees Must be Added
If you think you’ll have employees some day, you’d have to add them to your SIMPLE IRA plan. If an employee made at least $5,000 in compensation from your business during any two preceding calendar years (consecutive or not) and are reasonably expected to earn at least $5,000 from you during this calendar year, they’re eligible to participate in the year’s SIMPLE IRA plan.
Employees can’t opt out of this plan as they can with the SEP-IRA, but they don’t have to contribute in a year.
Employer Contributions May be Simpler
Unlike with the SEP-IRA, SIMPLE IRA contributions are inflexible. You have to choose either the 2 percent option or the 3 percent option, and you must stick with it for that year.
In years that you really need to reduce business expenditures, you can choose to reduce employer contributions on a 3 percent matching contribution plan. However, you can’t reduce employer contributions below 1 percent, and you can’t impose the new limit for more than two out of five years. (The five-year count begins in the year in which you first reduce the amount.)
To change between the nonelective and matching contributions, or to lower a matching contribution for that year, you have to notify your employees well before the annual 60-day election period, during which employees decide how much they’ll contribute to their own SIMPLE accounts that year.
Even though employer contributions are money out of your business’s pocket, they can be a good incentive for attracting and keeping excellent employees. Plus, the SIMPLE IRA employer contributions for your business could be much lower than similar SEP-IRA contributions, as long as you elect the lowest-cost option for your business.
Solo 401(k)s are also called one-participant 401(k) plans, the IRS terminology for these plans. Basically, a Solo 401(k) covers a business owner with no employees. While it can cover a spouse, it cannot cover employees.
The Solo 401(k) is a relatively new option. Before 2002, self-employed individuals could open a 401(k), but the paperwork and costs associated with it put it out of reach for many sole proprietors. Now Solo 401(k)s are much more streamlined and affordable.
The overall annual limit for a Solo 401(k) is the same as the annual limit for an SEP-IRA, $52,000 for 2014. However, with the Solo 401(k), you can get to the limit more easily by making both employee elective deferrals and employer nonelective contributions.
With a Solo 401(k), you can contribute up to the annual limit of $17,500 ($23,000 for those 50 and older) as an employee and add an employer nonelective contribution of up to 25 percent of your total self-employment income.
(Remember, this figure – your total self-employment income – will exclude the money you contribute to your Solo 401(k) as an employee.)
Since you can first max out your employee contribution of $17,500 and then add 25 percent of your remaining compensation, you could potentially save more money with the Solo 401(k) than with the SEP-IRA. (Even though the SEP-IRA is a little simpler to figure.)
As noted above, annual elective deferral limits for Solo 401(k) plans are the same as annual contribution limits for regular 401(k) plans. In 2014, you can contribute up to $17,500, or up to $23,000 if you’re older than 50. You can contribute 100 percent of your compensation, if you want. That’s the limit for your employee elective deferral.
However, you can also contribute up to 25 percent of your compensation as an employer nonelective contribution. You’ll have to set this up when you create your plan.
Total contributions to your account can’t exceed $52,000 for 2014. This doesn’t include catch-up contributions, so you may be able to contribute more than $52,000 limit if you’re older than 50.
Pros and Cons
High Contribution Limits
One of the best features of the Solo 401(k) is its high contribution limits. High earners older than 50 could save $54,500 per year. It’s also easy to add your spouse to this plan, if you work your sole proprietorship together. In this case, you could save even more for retirement between the two of you.
You may be able to get these same high savings levels with an SEP-IRA, but it depends on how much you’re earning annually. If you aren’t earning enough to max out an SEP-IRA with 20-25 percent of your income, but you can set aside a large portion of your self-employment earnings for retirement, a Solo 401(k) may be your best savings bet.
If you’re likely to benefit more from tax-free withdrawals down the road than from tax savings now, you might consider a Roth Solo 401(k). Not all financial institutions offer them, but many do.
Relatively Low Fees
According to Forbes, most of these accounts can be set up for a fee of $100 or less. And then you may pay an annual set fee of anywhere from $10 to $250. Of course, you’ll want to price out different options before choosing the plan for your needs.
According to an IRS paper, many self-employed individuals don’t have to decide how much to electively defer to a one-participant 401(k) plan until just before the last day of the year.
Here’s how it works: With a regular 401(k) plan through an employer, employees are generally required to opt in for a certain level of 401(k) savings near the beginning of the year. This is because regularly employed individuals usually have an idea of how much they’ll earn throughout the year.
Self-employed individuals don’t have that luxury. The IRS considers that variable-income self-employed people (this doesn’t include those operating partnerships that promise a certain amount of income each year) don’t know what they’re compensation will be until the end of the year. So as long as you decide how much to contribute to your individual 401(k) before the last day of the year, you’re good to go.
This basically means that with this account, you don’t lock yourself into any certain level of savings, and you can base your savings amount on your earnings for the year. If you make a lot, you can save a lot. If you make a little, you can save a little.
With this account, you have until your tax filing date, including extensions, to contribute to your account. As long as you open an account by the end of the fiscal year, usually Dec. 31, you can add money to it by your tax deadline, using that contribution to lower last year’s tax liability.
Potential for Loans
Although it’s usually not a good idea to take a personal loan from your retirement account, with a Solo 401(k), you have that option. The loan program works similarly to how it would if your 401(k) was with an employer.
If you’re leaving an employer with a 401(k) plan to become self-employed, it’s pretty simple to roll your old 401(k) over to your Solo 401(k). You can also roll over a traditional IRA plan into your new 401(k).
If you’re still working a day job, a Solo 401(k) can make your life more complicated. You’ll have to stick with the employee contribution limit of $17,500 (or $23,000 if you’re older than 50) per year for the combination of your self-employed and employee retirement accounts.
No Employees Can be Added
The Solo 401(k) plan can be used only by yourself and your spouse. You cannot add employees to this plan. If you decide to hire employees later on, you’ll have to expand to a regular 401(k) or switch to a different retirement plan.
Keogh Plans are also known as HR 10 plans or Qualified Plans in the IRS literature. According to CNN Money, 2001 tax law changes made these complex plans fall out of favor compared with other plans. It’s still a good idea to know that this option is available, especially if you’re an exceptionally high-earning self-employed person.
Keogh Plans come in two different flavors, if you will: defined contribution and defined benefit.
Defined contribution plans work much like SEP-IRAs, with a similar maximum contribution and a percentage-of-income contribution limit. With some of these plans, you can flex your contribution amount each year. With others, such as money purchase plans, you’ll contribute the same percentage of your income year after year.
Defined benefit plans work like traditional pensions. You choose how much you’ll get out of your plan per month, and then you contribute as much as you need to in order to reach your goal. Very high income individuals may still find that a self-employed pension plan allows them to save more money than other options.
As with other plans, the Keogh options are set up for both sole proprietors and small-business owners. If you hire employees, those who are eligible must be added to your plan, which can cost your business a hefty amount of money.
Generally, Keogh plans are much more complicated and paperwork-heavy than more streamlined IRA or 401(k) options, which is why they’ve fallen out of favor. But if you’re a high earner, these plans are worth talking over with your financial adviser.
If You’re Still Employed, Too
If you still have a day job, your retirement planning can get a bit more complicated. For the most part, limits on IRAs, 401(k)s and other tax-advantaged retirement accounts are across the board. Maximum contribution amounts apply to all of your retirement accounts combined, not to each account individually.
In other words, if you have an employer-sponsored 401(k) and a Solo 401(k), you can’t exceed the annual limit ($17,500/$23,000) between your accounts. So your employee contributions must add up to $17,500/$23,000 total.
However, you can take employer matches from your employer-sponsored 401(k), and you can still make employer contributions to your Solo 401(k).
See how things get complicated?
It’s impossible for us to say without knowing your specific situation just how you should combine and contribute to various retirement plans if you have both employer-sponsored and self-employed options.
In general, it’s best not to turn down free money when you can get it. So if your employer offers a contribution match, consider maxing that out. Beyond that, you should talk with a financial adviser to figure out how to maximize your savings across your various retirement accounts.
Choosing the Right Plan for Your Needs
Again, it’s difficult to say exactly what you ought to do when it comes to your self-employed retirement options. We don’t know your exact situation, and we aren’t financial advisers. However, here are some general notes about how to choose the right self-employed retirement plan for your needs:
Find Your Maximum Contribution
Even if you can’t max out your retirement savings plan right now, it’s a good idea to choose the plan that would give you the greatest contribution options. You never know when you’ll have an excellent year and extra money to save.
Remember that the SEP-IRA and the Solo 401(k) offer a total contribution limit of $52,000 for 2014. However, the SEP-IRA has the added restriction of 20/25 percent of your self-employment income. So typically, if you’re a middle-of-the-road earner, you’ll probably be able to sock away more in the Solo 401(k).
On the other hand, high earners can more easily max out contributions to an SEP-IRA. Just toss in 20/25 percent of your self-employment income, and you’re good to go. Figuring up how to max out contributions between employee and employer contributions for a 401(k) is probably not worth your time if you can easily max out an SEP-IRA.
If you’re not earning a lot of money right now, then the SIMPLE IRA is probably the best way for you to max out your retirement savings. Its limits are much lower than the limits for the other accounts, but because there’s no percentage-of-income restrictions for either employee or employer contributions, it’s fairly easy to max out this retirement savings option.
Dealing with Employees
If you’re certain that your business will never hire employees who qualify for a retirement plan (or if you have a high employee turnover that disqualifies most employees from your plan), then this is less of a consideration for you. However, you may want to figure out whether and how you can leverage your plan to increase your spouse’s retirement savings.
If, on the other hand, you are planning to hire employees, or you already have them, be sure that you understand how each retirement plan option will affect your business’s bottom line.
While it’s great to offer employees excellent retirement plan options, especially if you want to attract the best of the best, you also need to be sure that your retirement plan’s regulations won’t sink your business in expenses that you can’t afford.
Ease of Use
As with any other financial product, be absolutely sure you understand the details of what you’re getting when it comes to retirement plans. Yes, these are complex plans. Yes, you might need some help sorting out the details. Become educated on your plan and how it works.
And while you’re in the process of learning about the plan of your choice, be sure you understand the paperwork that goes with it. Even if you have an accountant to deal with many of the details you, as the business owner, should understand what goes into maintaining your business’s retirement plan.
If you’re like most self-employed individuals, your income varies from year to year. For most of us, the variance can be pretty dramatic and often unpredictable.
So unless your business has a good track record of bringing in a certain level of money for several years, you’ll likely need to choose a plan that gives you the ability to increase or reduce your employee plan contributions on an annual, or even a monthly, basis.
Working with an Adviser
As a self-employed individual, choosing a retirement plan is more complex than opening an IRA to supplement an employer-sponsored savings plan. So you’ll probably want to work with a financial adviser, probably one who specializes in retirement plans and gives you plenty of options to consider.
Before you choose an adviser, take this advice:
- Check certification. As you’re looking for an adviser, be sure to check for certification. A Certified Financial Planner (CFP) with an up-to-date certification is licensed and regulated and is required to take continuing education courses.
- Ask about pay structure. It may feel awkward, but it’s acceptable – and even expected – to ask about a financial adviser’s pay structure. Some are paid on a commission basis and others have a flat rate, usually charged hourly. There’s nothing wrong with a commission-based adviser, but know that these individuals will be pressured to direct you toward certain products.
- Ask for the adviser’s code of ethics. Be sure the financial adviser’s code of ethics ensures that this person will look out for your best financial interests, rather than his or her own.
- Look at specialties. While some financial advisers, usually known as financial planners, have a more overarching approach to giving financial advice, many specialize in a particular area. If you’re looking for someone to advise you specifically on your self-employed retirement plan, find someone who specializes in that area.
- Find someone who will teach you. When you’re choosing a retirement plan as a self-employed individual, as we explained above, it’s essential to understand what you’re getting. You’ll want to choose a financial adviser with whom you feel comfortable, and who will teach you about your options, not just push you to buy certain products.
We’ve thoroughly covered self-employed retirement options here, but if you need more information, or want to check out our sources, here are some helpful resources to consider:
- Choosing a Retirement Solution for Your Small Business – This article from the Department of Labor features a detailed chart that breaks down various small business/self-employed retirement options.
- Retirement Plans for Self-Employed People – This IRS article outlines the major options among self-employed retirement plans.
- SIMPLE IRA – From the IRS.
- SEP-IRA – From the IRS.
- One-Participant 401(k) – From the IRS.
- Profit-Sharing Plan – From the IRS.
- Money Purchase Plan – From the IRS.