When you are self-employed, you don’t have access to standard retirement savings plans such as pre-tax 401(k), Roth 401(k), or 403(b). However, being self-employed or a small business owner does not mean you cannot save for retirement. There are retirement savings plans for self-employed people you can use to build your nest egg.
This article will discuss retirement strategies for small business owners and self-employed individuals. I will also cover the requirements for each account, including contribution limits and tax benefits.
Without further ado, here are alternative ways to save for retirement when self-employed.
1. Individual retirement accounts(IRAs)
Individual retirement accounts, or IRAs, are some of the best retirement plans for self-employed people and small business owners. IRAs are easy to establish and manage, and the rules are straightforward. These accounts are also good for you when you are new to retirement planning.
For example, if you recently started a business and are wondering how you can save for retirement when you are self-employed, open an IRA. These accounts will allow you to stash away some money for retirement while you look for other plans.
There are two types of IRA to choose from, which include the Roth IRA and Traditional IRA.
Roth IRA
The Roth IRA allows you to make contributions with after-tax money. Although you will not get upfront tax benefits, the Roth IRA will help you grow your retirement account tax-free and pay no tax on qualified distributions.
- Benefits of Roth IRA:
- Tax-free growth
- Tax-free on qualified distributions
- No required minimum distributions(RMDs)
- You will transfer your money to beneficiaries tax-free
- A lot of investment flexibility
- How to open a Roth IRA? You can easily open a Roth IRA from any online brokerage company such as Charles Schwab, Fidelity, or a bank. The process is simple and manageable. With this account, you will have a wide range of investment options such as mutual funds, ETFs, Index Funds, etc.
Traditional IRA
The Traditional IRA is similar to the Roth IRA in some ways. The main difference between these two retirement accounts is when you pay taxes. For the Roth, you make contributions with after-tax money. That is, there are no upfront tax benefits associated with a Traditional IRA.
On the other hand, contributions to a Traditional IRA can be tax-deductible. Your deduction eligibility will depend on your filing status and income limits. With a Traditional IRA, you will grow your account on a tax-deferred basis and pay income tax on deductible contributions and associated earnings to the account.
- Benefits of Traditional IRA:
- Tax-deferred growth through compounding interest
- Upfront tax benefits (eligibility based on income limits and filing status)
- Great investment options in stocks, bonds, ETFs, Mutual funds, etc.
- How to open a Traditional IRA? Just like a Roth IRA, it is easy to open a traditional IRA. Most brokerage companies and banks offer these accounts. You can complete the whole application process online.
Contribution limits to an IRA in 2024
The contribution limits for both IRAs in 2024 are $7,000 or $8,000 if you are 50 or older. For 2023, IRA contribution limits are $6,500 or $7,500 if you are 50 or older.
Should you choose a Roth IRA or a traditional IRA?
Which retirement account is good for you when self-employed? Should you choose the Roth IRA or the Traditional IRA? The answer to this question depends on your current financial situation and retirement saving goals.
If you can afford to pay tax now and expect a higher retirement income, open a Roth IRA. A Roth IRA will help you minimize your retirement tax liabilities since withdrawals will be tax-free. On the other hand, if you are making a higher income and expect a lower retirement income, choose a traditional IRA. The Traditional IRA lowers your current tax liabilities, especially if you are a higher-income earner.
For example, if you are in a higher tax bracket now and think you will earn less income during retirement, you can use the traditional IRA to help you lower your current taxable income. Since you will earn less income during retirement, the combined distribution tax and other income taxes will be managed.
But, if you are making less income and think you will be earning more during retirement, use the Roth IRA. Paying taxes on your contributions will allow you to pay no tax. Since you plan to have a higher income during retirement, you might end up in a slightly lower tax bracket since distributions from your Roth account will not be taxed.
2. SIMPLE IRA
SIMPLE IRA is a retirement plan for businesses with no more than 100 employees. If you are a small business owner planning to stay small for a while, this could be a great way to save for retirement when self-employed. You can easily open a SIMPLE IRA plan with most brokerage firms.
What makes the SIMPLE IRA one of the best retirement plans for self-employed individuals is its tax benefits. Here is how a SIMPLE IRA can help you save for retirement while giving you exceptional tax incentives.
- Contributions to employee accounts are deductible as business expenses. You must choose one of the two mandatory contribution options.
- A nonelective contribution of 2% to every eligible employee, or
- A Matching contribution of up to 3% of each employee’s compensation
- Contributions to your plan will also be tax-deductible. This plan allows you to grow your retirement savings on a tax-deferred basis. However, you will pay income tax on distributions from your account during retirement.
NOTE: Since you must contribute to your employees’ accounts, the SIMPLE IRA becomes expensive as the number of employees increases.
Read more: What is a SIMPLE IRA plan, and how does it work?
What are the contribution limits for SIMPLE IRA in 2024?
The SIMPLE IRA has higher contribution limits than the traditional IRA or Roth IRA. These high contribution limits make the SIMPLE IRA a good retirement plan for self-employed individuals and small business owners.
For 2024, you can contribute up to $16,000 to your SIMPLE. If you are 50 or older, you get an extra catch-up contribution of $3,000. You can contribute up to $19,000 when you are 50 or older.
3. SOLO 401(k) plan
The SOLO 401(k), also known as Solo-k, Uni-k, or One Participant K, is a great way to save for retirement when self-employed. This plan is designed for business owners with no other employees. In other words, the SOLO 401(k) plan only covers the business owner and his/her spouse.
The SOLO 401(k) can be tricky to understand because you are simultaneously the business and the employee. When you have a standard 401(k) plan, you make contributions which are then matched by your employer up to a certain percentage. This option applies to the SOLO 401(k) plan as well. The only difference is that you are the employer and employee simultaneously.
The rules that apply to a standard 401(k) plan also apply to the SOLO 401(k) plan.
Total contribution limits to SOLO 401(k) in 2024
Like your standard 401(k) plan, the contribution limits to a SOLO 401(K) for 2024 are $23,000. If you are 50 or older, you get an extra $7,500 for a total contribution limit of $30,500. The total contribution to the account for both employer and employees is $69,000. If you are 50 or older, you get an extra $7,500 catch-up contribution, which brings the total contributions to $76,500.
Since you will be self-employed, you will have a regular tax-deferred contribution plus your company’s 25% max contribution. Remember that the total contribution to the account should not exceed the acceptable limits discussed above.
If your spouse also contributes to the plan, you can each contribute up to the allowed limits.
To qualify for SOLO 401(k) when self-employed, you must be the only employee in the company except for your spouse. If you have other employees, you will not be eligible to open a SOLO 401(k) plan.
SOLO 401(k) tax benefits
Contributions to SOLO 401(k) are pre-tax. This allows you to grow your retirement savings plan on a tax-deferred basis and pay tax when you withdraw the money during retirement.
4. Defined plan/pension plan
The defined plan, also known as a pension plan, is a retirement savings plan for self-employed people. An employer usually sponsors this plan, and contribution limits are mainly based on a few factors, including.
- Age
- Future returns on investments and
- Retirement payouts
The defined benefit plan is suitable for self-employed individuals who earn significant income without employees. If you are self-employed and have employees, you can open the plan and contribute on their behalf.
Pros and cons of defined benefit plan
- Higher contributions options
- Benefits are easily calculated and can be predictable
- In general, the employer contributes more money to the plan
- The plan costs more than other plans
- The plan requires the annual filing of Form 5500
Those who are self-employed can establish their pension plan. The downside of the pension plan is that it costs more due to annual and higher administrative fees. If you have employees, you will also have to make contributions on their behalf, making the plan more expensive. In addition, you might be required to commit to a particular contribution amount every year that can be changed when you pay a fee.
5. SEP IRA
The SEP IRA is a retirement plan that allows self-employed business owners and their employees to save for retirement. The SEP stands for Simplified Employee Pension.
Benefits and cons of SEP IRA
- Any business can use it, but it is suitable for small businesses and self-employed individuals
- No filing requirements for employer
- 100% vesting
- Comes with low administrative costs
- The plan is easy to set up and manage
- Mandatory contributions to all eligible employees
- Taxable distributions
Contribution options to SEP IRA
The plan requires you to make equal contributions to all eligible employees. Whatever contributions you make to your accounts will be the same percentage that goes to employees’ accounts.
For example, if you contributed 12% of your compensation to your account, you must contribute the same percentage to each eligible employee’s compensation.
- How to set up a SEP IRA? You can set up a SEP IRA with qualified institutions such as banks, brokerage firms, insurance companies, etc. Pick one institution, schedule an appointment, and open the plan in person or online to get started. Terms and requirements vary by institution.
Contribution limits to SEP IRA in 2024
Like other retirement savings plans we have discussed, the SEP IRA has early contribution limits. The following are the conditions and contribution limits for 2024.
- The employer must contribute the same percentage of compensation for every eligible employee.
- The annual total contribution limits must be the lesser of $69,000 or 25% of compensation in 2024 or $66,000 in 2023.
The SEP IRA is an excellent plan for saving for retirement when self-employed. It comes with higher contribution limits than IRAs or SIMPLE 401(k) plans. For example, IRAs allow a $7,000 limit, while the SEP IRA allows contributions of up to $69,000 in 2024.
Withdrawal rules for SEP IRA
The SEP IRA follows the general withdrawal rules of traditional IRAs. To take advantage of the full benefits of the SEP IRA, you must keep the money in the account until you have turned 59½ years old.
If you withdraw the money before you reach 59½, you may pay a 10% tax penalty in addition to normal taxes on your withdrawals.
Other accounts you can use to save for retirement when self-employed
Besides the retirement accounts I mentioned above, other accounts allow you to save for retirement when self-employed. The following are retirement savings accounts to reach your retirement goals faster.
Health Savings Account(HSA)
A health savings account(HSA) is a tax-advantaged savings account to save for medical-related expenses if enrolled in a high-deductible health plan(HDHP). The money must be used only for medical-related costs. If you use your savings on non-health expenses, you will pay tax and a penalty.
However, your HSA can be used as a retirement savings account, especially if you are self-employed. Your account will allow you to invest some of the funds and pay tax only when you withdraw the money. To avoid a penalty, you must be at least 65 years old. After reaching 65, you will withdraw the money and use it however you want.
Tax-deferred annuities
An annuity is a contract between you and a life insurance company where you pay premiums in exchange for equally spaced payments during retirement. Insurance companies offer annuities to protect you from outliving your retirement savings. If you want to save for retirement when self-employed, consider annuities to diversify your retirement savings.
Buy long-term investments
One of the best ways to save for retirement when self-employed or a small business owner is to take advantage of the tax benefits of many financial products. An excellent way to build your retirement account is to buy long-term investments. What makes long-term investment suitable for retirement savings is that your return on investment from your assets is not taxed until you sell, except for dividends and interest payments. You will still take advantage of compound interest by reinvesting your earnings regardless of whether you pay taxes.
The bottom line
There are a lot of ways to save for retirement when self-employed. The retirement plan you choose will depend on your company’s size and retirement saving goals.
To maximize your ROI and minimize risk, diversify your retirement savings through different accounts. This is because each retirement savings plan comes with its pros and cons. Through diversification, you can create a balance between account growth, risk, and cash flow benefits.
More retirement tips
How can you transfer a traditional IRA to a Fidelity IRA?
What happens when you default on a 401(k) loan?
