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). Being self-employed, however, 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.
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 out there for self-employed people. This is because they are easy to establish and manage, and the rules are straightforward. These accounts are also good for those who are starting their retirement planning journey.
For example, if you recently started a business and wondering how you can save for retirement when self-employed, open an IRA. These accounts will allow you to stash away some money for retirement while looking for other plans.
There are two popular individual retirement plans you can choose from that 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 on a tax-free basis 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.
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 future 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 be earning less income during retirement, the combined distribution tax and other income taxes will be managed.
But, if you are currently 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 on your contributions. Since you are planning 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 that is designed for businesses with at most 100 employees. If you are a small business owner and 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.
- Your contributions to employee accounts will be deductible as a business expense. As an employer, you will 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 are required to 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 comes with higher contribution limits compared to the traditional IRA or Roth IRA. High contribution limits make 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. That is you can contribute up to $19,000 when you are 50 or older.
3. SOLO 401(k) plan
The SOLO 401(k) a.k.a Solo-k, Uni-k, or One Participant K is a great retirement to save for retirement when self-employed. This plan is designed for business owners with no other employees. In other words, this plan will cover the business owner and his/her spouse.
The SOLO 401(k) can be tricky to understand because you are the business and the employee at the same time. For normal 401(k) plans, you make contributions and your employer can match your contributions. This 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 normal 401(k) also apply to the SOLO 401(k) plan.
Total contribution limits to SOLO 401(k) in 2024
Just like your normal 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 normal tax-deferred contribution plus the 25% max contribution from your company. Keep in mind that the total contribution to the account should not go higher than the acceptable limits discussed above.
If your spouse also contributes to the plan, each one of you can contribute up to the limits allowed.
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 saving plan to save for retirement when self-employed. This plan is usually sponsored by an employer and contribution limits are mainly based on a few factors which include.
- Age
- Future returns on investments, and
- Retirement payouts
The defined benefit plan is good for a self-employed individual who earns a large income with no employees. If you are self-employed and have employees, you can define the plan and make contributions 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 costs more due to annual and higher administrative fees. If you have employees, you will also have to make contributions on their behalf which makes 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 good 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
As a self-employed person, the plan requires you to make equal contributions to all eligible employees. Whatever contributions you put to your accounts would 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 any qualified institutions such as banks, brokerage firms, insurance companies, etc. Just pick one institution, set up an appointment, and open the plan in person or online. Terms and requirements vary by institution.
Contribution limits to SEP IRA in 2024
The amount of money an employer can contribute to each eligible employee will be based on:
- 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 a great plan to save for retirement when self-employed as it comes with higher contribution limits compared to IRAs or SIMPLE 401(k) plans. For example, IRAs allow a $7,000 limit while the SEP IRA allows 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 on top of normal taxes on your withdrawals.
Other accounts you can use to save for retirement when self-employed
Besides the retirement accounts I mentioned above, there are other accounts you can use 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 you are enrolled in a high-deductible health plan(HDHP). The money must be used only for medical-related expenses. If you use the money 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 are withdrawing 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 the company pays you equally spaced payments in return for premiums you paid. Annuities are offered through insurance companies to protect you from outliving your retirement savings. If you want to save for retirement when self-employed, consider annuities as a way to diversify your retirement savings.
Buy long-term investments
One of the best ways to save for retirement when self-employed is to take advantage of the tax benefits of many financial products. A good way to build your retirement account is to buy long-term investments. Any return on investments (ROIs) you make on these investments will not be taxed until you sell except dividends. By reinvesting your earnings, you will still take advantage of compound interest regardless of whether you pay taxes or not.
The bottom line
There are a lot of ways to save for retirement when self-employed. The retirement plan you choose will depend on the size of your company and your retirement saving goals.
You should also diversify your retirement savings through different accounts to maximize your ROI but also protect your savings from high risk. 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
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