When it comes to self-employment and retirement, myths and misconceptions abound. Fortunately, I’ve got the details on some of the most popular retirement options for self-employed workers. Today’s post is a response to a reader question on how to maximize retirement contributions when you’re self-employed.
Reader Shane asks:
“I’m self-employed so I don’t have the luxury of having a 401(k). I do have a Roth that I contribute the maximum amount to each year. My question is, are there any other ways I could put money away for the future that would give me a better return?”
Which Retirement Options Work Best for Self-Employed Workers?
First off, this is a smart question for any self-employed individual to ask. Since self-employed workers are largely on their own when it comes to retirement, it’s crucial to put in the leg work.
For all my self-employed people out there, listen up. Since I’m self-employed, I’m right there with you. The path I’m about to describe is the exact path I took to secure my own retirement savings.
As Shane mentioned, he has a Roth IRA already. Whether you are self-employed or working for someone else, it’s smart to invest in a Roth IRA provided you are eligible. Of course, you could consider the traditional IRA as well. With either account, you can contribute whether you are self-employed or working for someone else. And if you work for a traditional employer, you can contribute to either type of account in addition to the money you put in your traditional 401(k) plan.
But, which account should you choose?
If you’re younger, I would definitely gravitate towards the Roth IRA.
Why? Because we all love tax-free money.
Pretty sweet, huh?
Whichever type of IRA you choose, you can put up to $5,500 across both types of accounts in 2016. Since this cap usually increases every year or two, you should check with the IRS for updates as you execute your retirement plans.
Now, $5,500 isn’t bad, but that is the most you can put in a traditional or Roth IRA each year. If you’re making more money and want to contribute a lot more, you need to look for additional ways to save for retirement on your own.
Option 1: Consider the SEP IRA
The first option I gravitated to as a self-employed person is called the SEP IRA. In case you’re wondering, “SEP” stands for simplified employee pension.
With the SEP IRA, you’re allowed to stash away up to 25 percent of your total compensation with an annual cap of $53,000. If you’re earning a lot, this is a huge chunk of money you can save and deduct on your taxes right away. And although you won’t get an employer match since you work for yourself, this is the closest thing to a 401(k) you can expect to find.
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The best part is, the SEP IRA is not an ERISA-governed account. What this means is, you don’t have to file a lot of confusing paperwork to contribute to this account over time. Better yet, you don’t have to pay an additional fee to become compliant with ERISA standards.
While I started saving for retirement in a Roth IRA, the SEP IRA is the account I gravitated to once I started earning more. Not only is the SEP IRA simple to set up and easy to use, but costs are minimal.
Option 2: Consider the Solo 401(k)
If you’re at the point where you could save more than 25 percent of your total compensation, you can always consider the Solo 401(k) instead. Typically speaking, you need to be self-employed or have one other business partner to take advantage of this account.
With a Solo 401(k), you can defer the first $18,000 of your salary to this account in 2016. Beyond that initial amount, you can contribute 20-25 percent of your business earnings with a total contribution limit of $53,000.
If you are on the higher end of the earnings scale, the Solo 401(k) can clearly help you save more. At the end of the day, that’s one of the beautiful things about using a Solo 401(k). If you’re a high earner, this account lets you maximize retirement in a tax-advantaged way.
The downside to the Solo 401(k), however, is that this is an ERISA-governed plan. By and large, this means that you’ll have to fill out more paperwork. Every single year, you can expect to file specific forms that list your income and contributions with the IRS. What this also means is, you may need to pay a fee for someone to file this paperwork on your behalf. To get your plan set up – and to pay someone to administer it – you could spend between $500 – $1,500 per year.
In simple terms, a Solo 401(k) can cost more to operate over the long run. It can be well worth it since it lets you save more over time, but the extra costs and time spent filling out forms are worth noting.
What Should Shane Do?
I love the fact that Shane wrote in with this question, and I truly believe he’s on the right path. If I were him, I would start looking into a SEP IRA first. With low operating costs and the ability to contribute up to 25 percent of his income, Shane may find this plan entirely sufficient.
If his income grows to the point where he wants to contribute more, Shane could also consider the Solo 401(k). This plan requires a little more legwork and higher ongoing costs, but offers higher caps on contributions in return.
At the end of the day, the best plan for one person isn’t the same for the next. We all have to decide how much we want to save, and which plan works best for our needs.
If you’re a member of the Good Financial Cents community and have a question, make sure to email us. I would love to turn your reader question into a blog post or a video, so don't hesitate to reach out!
How are you saving for retirement as a self-employed person? Do you use one of these accounts? Why or why not?