Are you a young and mid-career professional starting a business? After accumulating some experience and education, you are confident you can provide value with your talents. Starting your own business can be an attractive option to build the life you wish to live. With being self-employed, you may be asking yourself, "How do I save for retirement?"
If you are self-employed and have no employees, you shouldn't forgo retirement savings because you think a retirement plan can be expensive or complicated to set up and maintain. There are options specifically for solo-self-employed business owners. Those options include:
Savings Incentive Match Plan for Employees (SIMPLE) IRA.
Simplified Employee Pension (SEP) IRA.
Solo 401(k).
Traditional and Roth IRAs.
Taxable Accounts.
Pensions
If your business has no employees (other than yourself), you may want to investigate either a traditional IRA, Roth IRA, SIMPLE IRA, SEP-IRA, Solo 401(k), or taxable accounts. It would be best if you considered the plans' similarities and differences. In this blog piece, I introduce you to the details of each option. These details can help you evaluate which is best for your pursuit.
SIMPLE Plans are Simple
Setting up a SIMPLE IRA is simple and comes down to completing a form. Banks, savings and loan associations, insurance companies, regulated investment companies, federally insured credit unions, and brokerage firms can maintain the SIMPLE IRA for you. You can invest in stocks, mutual funds, ETFs, and similar investments within the SIMPLE IRA. Investment options depend on the choices provided by the financial company maintaining the account.
This plan is easy and inexpensive to set up and maintain, and it provides an accessible avenue for retirement savings. However, the plan has lower contributions limits than other retirement plans. You can save away more cash each year in a Solo 401(k) plan or SEP-IRA.
SIMPLE-IRA Contributions & Features
The SIMPLE IRA enables you to contribute to a pre-tax IRA. Contributions are not subject to federal income tax withholding. Your contributions provide a tax benefit the year you contribute, and the earnings grow tax-free. In retirement, you will pay income tax when you withdraw funds from the account, and you will be subject to a required minimum distribution when you reach age 72. SIMPLE plans cannot offer Roth provisions. With a SIMPLE IRA, you cannot have any other retirement plan.
As a solopreneur, you are both the employee and employer. As the employee, you can put all of your self-employed net earnings into the SIMPLE IRA up to $14,000 (2022 limit), plus an additional $3,000 catch-up if you are over 50. You can contribute another 2% flat or a 3% matching amount of your net earnings. As a self-employed business owner with no employees, you are always 100% vested in all the SIMPLE IRA funds.
You may not use a SIMPLE IRA as collateral for a loan. And if you withdraw funds, it will come at a cost. Any withdrawal is income (income tax rates apply), and the IRS adds a 10% tax penalty if you are younger than 59 & 1/2. If you withdraw funds within the first two years of participating in the SIMPLE plan, the IRS bumps up the 10% additional tax to 25%.
Establishing a SIMPLE IRA
Setting up a SIMPLE IRA is relatively straightforward compared to other options for the self-employed. Complete the following to create a SIMPLE IRA:
Complete either IRS form 5304 or 5305 SIMPLE or an IRS-approved prototype SIMPLE IRA plan provided by a financial institution.
Open a SIMPLE IRA with your chosen financial institution.
Choosing a SEP-IRA Plan
Simplified Employee Pension (SEP) plans can provide a significant source of retirement income by allowing you to save money in retirement accounts for yourself. SEPs lack the start-up and operating costs of other conventional retirement plans.
SEP-IRA Contributions & Features
Like a SIMPLE IRA, SEPs enable you to contribute on a pre-tax basis. Contributions are not subject to federal income tax withholding. Your contributions provide a tax benefit the year you contribute, and the earnings grow tax-free. In retirement, you will pay income tax when you withdraw funds from the account, and you will be subject to a required minimum distribution when you reach age 72. There are no Roth options for SEP-IRAs.
SEPs allow for a contribution of up to 25% of your earnings. But as a solopreneur, you need carefully follow what the IRS determines as your earnings. You'll need to calculate your net self-employment income, which is your net profit minus half your self-employment tax. You need to carefully account for the self-employment tax to determine how much you may contribute. Your contributions to your SEP are flexible. Annual contribution limits for a SEP are typically higher than traditional IRAs, and SEP contributions are vested right away.
Like a traditional IRA or SIMPLE IRA, you cannot take a loan against a SEP-IRA or use it as collateral for a loan. Doing so triggers income tax and penalties. Additionally, you are subject to taxes and costs associated with early withdrawals from the SEP. So, carefully consider the IRA withdrawal rules before taking money out of the account!
Establishing a SEP
Setting up a SEP is different than establishing a SIMPLE. You first have to choose a financial institution to serve as trustee of the SEP-IRA that will hold your retirement plan assets. These accounts will receive the contributions made to the plan.
There are four steps to establishing a SEP:
Choose the financial institution to serve as a trustee.
Fill out IRS form 5305-SEP or complete IRS-approved prototype plan documents.
Set up a SEP-IRA account through your chosen financial institution.
Establish the plan as late as the due date of your income tax return.
The Solo 401(k)
The IRS allows the Solo 401(k) to provide retirement options for solo business owners, which has many characteristics of an employer-sponsored plan. A Solo 401(k) can also be called an individual 401(k) or uni-401(k).
Solo 401(k) Contributions & Features
Like SIMPLEs and SEPs, a Solo 401(k) enables you to contribute on a pre-tax basis. Contributions are not subject to federal income tax withholding. Your contributions provide a tax benefit the year you contribute, and the earnings grow tax-free. In retirement, you will pay income tax when you withdraw funds from the account, and you will be subject to a required minimum distribution (RMD) when you reach age 72.
Depending on the 401(k) provider you select to manage the plan, you may have access to a Roth 401(k). Roth 401(k)s allow you to contribute on an after-tax basis (contributions are subject to income tax). With the Roth, the assets grow tax-free, and when you retire, you will not be subject to RMDs.
Now, what about Solo 401(k) contributions? The IRS states that the business owner is simultaneously the employee and employer. You contribute to the 401(k) as both the employee and employer. Thus, you can contribute both:
Employee Elective deferrals:
As the employee, you may defer up to 100% of your earned income up to the annual limit: of $20,500 in 2022. If you are over 50, you may defer $27,000 in 2022.
Employer non-elective contributions:
As the employer, you may contribute profit-sharing funds of up to 25% of net self-employment income (net profit minus half your self-employment tax and the plan contributions you made for yourself).
You must use the $305,000 compensation limit when determining the employer contribution.
Total contributions to your account, not counting catch-up contributions for those age 50 and over, cannot exceed $61,000 in 2022. Your spouse may participate in the individual 401(k) if they work in the business.
Establishing and Maintaining the Solo 401(k)
Establishing and maintaining a uni-401(k) requires more work than IRAs. So, when installing an individual 401(k), determine the following:
Review if it is appropriate to have a Solo 401(k) and your eligibility.
Select an individual 401(k) provider. You will want to review costs, investment options, features, and management services.
Draft plan documents and disclosures. The 401(k) provider should provide prototype documents for you to complete.
Open your account with the 401(k) provider.
Begin contributions and make investments.
The IRS will require you to complete Form 5500 if your 401(k) balance grows to be greater than $250,000. Form 5500 outlines Employee Retirement and Income Security Act's (ERISA) reporting and disclosure requirements. This form is typically straightforward for solo 401(k)s, but it is another task you don't want to forget each year.
Traditional and Roth IRAs
Traditional IRAs and Roth IRAs are easy to set up and manage. If you have excess cash for retirement savings but don't want to add complexity to your financial picture because you cannot save more than $6,000 per year, it may make sense to use either a traditional or Roth IRA. You will want to investigate if your tax filing status and household income allow you to contribute to individual IRAs. But simply using either what you already have or choosing the more straightforward option can save you time and money, especially if you are not going to use the benefits provided by SIMPLEs, SEPs, or Solo 401(k)s.
Don't Forget Taxable Accounts
Taxable accounts offer two items: flexibility and no limits. These accounts are your individual or joint accounts you can open at a bank or broker. You can keep cash in them or invest the funds in stocks, bonds, CDs, ETFs, etc.
If you just started your business and don't know your cash needs for the next several years but want to be saving with excess cash flow, a taxable account can provide you flexibility. Although IRAs and 401(k)s can offer significant tax benefits, early withdrawals can result in unwanted taxes and penalties. So as a business owner, you need carefully consider the risk of locking the money in a tax-preferred account. A taxable account provides you the ease of access to those funds that IRAs and 401(k)s don't.
Next, taxable accounts have no contribution limits. The essential item to consider with a taxable account is managing capital gains and income taxes. Using low-cost, tax-efficient securities within a taxable account can help you manage some of the tax benefits lost. So, if you need flexibility or someplace to park excess money, consider a taxable account.
Some Thoughts on Pensions
You can also investigate pensions such as money-purchase and defined benefit plans. However, these plans are typically more complex and expensive to maintain. Money-purchase and defined benefit plans require your business to have a stable cash flow. These plans don't usually make sense for young and mid-career self-employed individuals. The options listed above will likely be better alternatives to pensions.
The Bottom Line
If you want a way to save for retirement, there are a few options. You can choose between a SIMPLE IRA, SEP-IRA, Solo 401(k), traditional or Roth IRA, or a taxable account. Each of these options provides its pros and cons. Need help determining what option is best for you? Feel free to place a commitment-free 30-minute meeting on my calendar. We can discuss your retirement and begin best optimizing your financial plan in that meeting.
Have something on your mind?
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