Retirement options for the self-employed

Sarah Swan, Vice President, Portfolio Manager

Today’s StreetSmarts is geared towards those of you not earning a traditional paycheck from an employer in which a portion is automatically contributed to a 401k. You are your own boss! So the onus is really on you to get some sort of retirement plan rolling, and the landscape looks a bit different for all of you self-employed individuals. You have a few plan options to choose from, which is great, but that also tends to mean there are lots of nuances to understand, and what feels like guesswork can be too much for people to want to deal with. But lucky for you, that’s our job! What I will say, before we dive in, is that these options are all retirement plans, and they should really be thought of as such. I say that for two reasons: #1, your goal with one of these plans should be to put away money so that it grows between now and when you’re in retirement, and #2, which is a bit more punitive—is that you would have to pay penalties if you wanted to withdraw the funds in these plans before age 59.5. But the great flip side is that because there are rules and parameters like that, the IRS allows serious tax benefits, whether in the form of deductions or tax-deferred growth.

So! Let’s get after it. The first option is a really good one: it’s the #1: Solo or Individual 401k.

This is basically just what it sounds like—a standard 401k where you make contributions from your earnings, pre-tax—but it is specifically only an option for small-business owners who don’t have any employees. Your spouse doesn’t count as an employee, though, if your spouse happens to work for you. Now this is the incredible part: as the owner of a solo 401k, you’re actually allowed to contribute as BOTH parties: the employer, and the employee, which means that the contribution limit is among the highest of all retirement plan options. It’s essentially as much as $58,000 in 2021! That’s $19,500 in your capacity as the employee, plus up to 25% of compensation in your capacity as the employer. Also, depending on the structure of your business, solo 401k contributions that you make should be either deductible from your personal income or eligible to be counted as a business expense. Win, Win.

Now like I said early on, if you have employees other than yourself and your spouse, this disqualifies you from doing an Individual 401k, so let’s move onto some other options, starting with the #2: SEP-IRA.

A SEP-IRA is probably most fitting for those of you with a small number of employees. And I say that because the catch with a SEP is that as the employer, you must contribute an equal percentage of salary for each eligible employee, including yourself. And actually, employees themselves don’t contribute at all—it’s purely funded by you as the employer. So you sort of have to think about all of your employees in the same way you think about yourself, because whatever percentage YOU yourself want to put away, you have to do for each of your employees. You’re not required to fund it every year though—so in that sense, you have total control over when you make contributions, so maybe you base it off the business’s success and cash flow each year. The contribution limit mimics that of the solo 401k, so it’s possible to fund a SEP-IRA with as much as $58,000 annually. This could be a really attractive incentive to your employees, and another perk is that all of the contributions you make as the employer are tax-deductible.

Alright. So, what if you want your employees to be able to contribute, as well, so that you’re not bearing the burden all yourself as the employer?

Then a #3: Simple IRA might be a good option.

A bit of a misnomer, it’s not exactly simple to set up from a paperwork perspective, but here we are. A Simple IRA is a great option for mid-sized companies. The annual contribution limit is $13,500, so not bad. Unlike the SEP IRA, the contribution burden isn’t solely on you: employees can contribute, too—b`ut as the employer you’re required to either make matching contributions of up to 3% of employee compensation, OR fixed contributions of 2% to every employee. The fixed contribution means that even if an employee doesn’t contribute, you still have to contribute 2% of their pay, whereas the match means you only have to contribute if the employee does. Once again, contributions are deductible, and the contributions you make to employee accounts can be counted as a business expense.

Lastly, I’d be remiss to not mention #4: IRAs and Roth IRAs. They’re not employer retirement plans—rather, they’re individual retirement plans, but they are certainly tax-efficient vehicles that would be solid options for self-employed individuals. So, a couple things to understand: IRA contributions are tax-deductible and earnings grow tax-deferred, whereas Roth IRA contributions are not deductible because they’re made with after-tax dollars, but the contributions then DO grow tax-free. Basically, there are almost opposite perks to both scenarios, and your individual circumstances matter. Maybe you’re in a lower tax bracket now than you think you’ll be when you withdraw the funds in retirement—then it might make sense to do a Roth IRA and get the taxes out of the way now. But maybe the opposite is true—and you’re a high earner now who will likely drop tax brackets in retirement. Then, an IRA could be a better choice. Regardless of whether you go with an IRA and a Roth IRA, it’s important to understand that there is an income phase-out, after which your contributions to an IRA are not tax deductible, and contributions to a Roth IRA are not allowed at all. So, step one is to make sure you have earned income. Step two, is to make sure your AGI, or adjusted gross income, which you can get from your tax return, makes you eligible for an IRA or a Roth. Then, understand that unless you’re over 50, the maximum annual contribution is $6000, and could be slightly less if your income is towards the top of the phaseout range. This is where working with an accountant, in addition to a financial planning professional at H&R, is critical.

Okay, I know it’s a lot. But, sometimes the biggest hurdle really is just committing to getting started! All of the accounts I’ve described are quite painless to open on your own, and you can do so with most established brokers online.  As always, we recommend using Charles Schwab or Fidelity. But again, this is what WE’RE here for, so please don’t hesitate to reach out to Howe & Rusling. We’ll take the guesswork out of it, and you can rest assured you’re doing your part to invest in your tomorrow. Thanks for tuning into StreetSmarts today, and I’ll see you next time.