Retirement plans for the self-employed

Saving for retirement and building wealth for the future is important for everybody, but it can be difficult for the self-employed, particularly when they are just starting out in a new business endeavor. Unlike a standard benefit package one might get as a regular W-2 employee (401k, health insurance, disability etc.), people who are self-employed need to purchase their own benefits and run their own plans. Saving for retirement is potentially even more important for small business owners or contractors because there is substantial risk and uncertainty when venturing out and building your own source of income.

The benefits of using a retirement plan when self-employed are the same as any “regular” employer sponsored plan. That is, your contributions don’t count as taxable income within the defined limits of each plan type. This can be a major tax break for people that are self-employed and paying estimated quarterly taxes throughout the year.

There are four primary choices for the types of retirement plans a self-employed person might choose, but there is a host of considerations to find the right choice. First, how much can you save each year? Secondly, do you have any employees or are you a sole proprietor? Third, do you plan on contributing towards the retirement of your employees? Finally, what kind of tax benefits are best for your situation?

Traditional or Roth IRA

Individual Retirement Accounts (IRA’s) are not employer plans, but anyone with earned income can contribute up to $6,000 per year (or $7,000 if over 50). These plans have no special filing requirements and are easy to set-up. This should always be the starting point for a self-employed or small business owner just starting out. Once you can max your IRA contributions, then you will want to move onto one of the other 3 plans. Regular IRA’s can be used in combination with the other self-employed plans listed below (SEP, SIMPLE, individual 401(k)).

Employee situation: N/A. These are individual plans open to anybody with earned income.

Tax benefit: Traditional contributions are tax deductible below specific income thresholds, Roth IRA contributions are not deductible, but are not taxed on withdrawal.

Choose this if: If you’re just starting a business and you’re unable to contribute more than $6,000 per year to a retirement plan.

SEP IRA

SEP IRA’s (Simplified Employee Pension) are extremely easy to set-up and maintain. They function just like a traditional IRA, with no annual IRS reporting requirements like a 401(k) plan would. They also have high contribution limits (up to 25% of net income/earnings, max $305,000 in 2022). Calculation of your self-employment income is net profit minus half of your self-employment taxes paid and your SEP contribution.

Employee situation: SEP IRAs are best for sole proprietors that want to contribute a large amount but have a small number (or no) employees. This is because a SEP requires the owner to contribute the same percentage of salary to their employees as they contribute themselves. If the owner contributes 12% of their net income, then they also need to contribute 12% for each of their employees.

Tax benefit: Contributions are deductible up to 25% of net self-employment earnings or compensation (limit $305,000 cap per employee in 2022). Roth options are not available for SEP IRA’s.

Choose this if: You’re able to max your regular IRA, don’t have any additional employees and want to save extensively for retirement.

SIMPLE IRA

SIMPLE IRA’s (Savings Incentive Match Plan for Employees) are basically simplified 401(k)’s for companies with less than 100 employees. They have a rigid basic structure, but have considerably less cost, reporting requirements, and administrative costs compared to a regular 401(k). There is still some annual reporting forms and documents, so they do require more oversight than a regular IRA. Contributions to SIMPLE IRA’s are available up to $14,000 in 2022, plus a catch-up contribution of an extra $3,000 if over 50.

Employee situation: SIMPLE IRA’s need to be offered to all employees that have at least $5,000 in compensation in either of previous two years, though this requirement can be waived to provide full eligibility to your entire staff. Employee contributions are salary deferrals, and the employer can either match up to 3% of those contributions (most common) or elect a flat 2% non-elective contribution. The non-elective option means everybody gets employer contributions, regardless of if they deferred any salary.

Tax benefit: Contributions are deductible for the employee, and the employer can also deduct their contributions as a business expense.

Choose this if: If you have a substantial number of employees (but under 100) and want to contribute for both yourself and your employees without the expense of a full 401(k) plan.

Individual 401(k)

Individual (or “solo”) 401(k)’s are plans that are available only to self-employed people that have no employees (except a spouse). They have higher contribution limits than SEP or SIMPLE IRA’s, so they are best for high income sole proprietors. Because these plans function like a regular 401(k), there is both limitations on the employee and on the employer, but in this case, they are both the same person (you). In other words, you will need to track your contributions in your capacity as “employee” (limited to $20,500 in 2022), and your contributions as “employer” (up to 25% of compensation/net earned income), with a total limit of $61,000 for 2022.

Employee situation: You can’t contribute to an individual 401(k) if you have any employees other than your spouse. Your spouse can contribute to the plan in the same capacity as the owner, potentially allowing for double the saving amount.

Tax benefit: This plan works like a regular 401(k). Contributions are pre-tax unless you choose a Roth option, and you will have to file IRS paperwork each year once the account has more than $250,000 accumulated.

Choose this if: You are self-employed high earner, have no employees, are already maxing your IRA’s, and don’t mind a little extra paperwork and work tracking contributions. This is also a good choice if you would like a Roth option, since some brokers offer Roth Individual 401(k)’s.