When you’re self-employed, you’re the boss, the star employee, and the Employee Benefits department. So, you’re responsible for the company retirement plan, along with all the other work you do.
If you want to reduce your taxes and save for the future, there are several ways to do so, but you’ll have to make a plan and put it into action. Fortunately, professionals like CPAs can help with the tax aspects, and a skilled financial advisor can help you pick a plan and put things into action.
You have several options for a self-employed retirement plan. The right choice may become clear with the following questions in mind:
- How much do you intend to save each year?
- Do you want to make after-tax (Roth) contributions?
- How much does your business earn after expenses?
- Do you plan to add employees in the future, and how much are you willing to contribute toward their retirement?
A Solo 401(k) plan is often a good choice because it allows before-tax, Roth, and after-tax contributions. Plus, when your income is below certain levels, a Solo 401(k) makes it possible to save relatively more each year. But there are other options, and it’s helpful to understand the pros and cons of different alternatives.
Continue reading below, or get similar information from this video.
- Solo 401(k) plans
- Individual retirement accounts (IRAs), both Roth and Traditional
- Simplified Employee Pension (SEP) IRAs
- Savings Incentive Match Plan for Employees (SIMPLE) IRAs
Other options exist for those who want to contribute more than these plans allow. For example, defined benefit (pension) plans and other strategies may be helpful.
IRAs: Easy for Getting Started
An IRA is probably the easiest type of account to use. If you plan to save less than the annual limit—and your income allows you do to what you want—you might not need to look any further.
IRAs are not tied to your business, so the paperwork required to establish and maintain the account is minimal. You don’t need to provide corporate documents, and there’s no annual administration needed on your part. Technically, these arrangements are “individual” accounts, so they’re in your name as an individual taxpayer.
Contribution limits: IRAs have relatively low contribution limits, but you might not have the cash flow or desire to contribute above those limits. For 2023, the maximum IRA contribution is $6,500. For those over age 50, an additional $1,000 catch-up contribution is available.
Any saving is better than no saving at all, but to reach your retirement goals, you may eventually have to save more than an IRA allows.
Pre-tax and post-tax: IRAs can be established for pre-tax savings (traditional IRAs) and after-tax savings (Roth IRAs). However, you’ll need to ensure that your income doesn’t disqualify you from using those options. If you have a job with a retirement plan, that could also complicate matters.
Income restrictions: Your ability to take full advantage of an IRA may be limited by your income and other factors. If you earn too much, you might not be eligible to take a deduction for contributions to a traditional IRA. Likewise, your income (including a spouse’s income) can disqualify you from making Roth contributions. If you face those issues, a Solo 401(k) might solve your problems.
Solo 401(k): High Limits and Flexibility
Solo 401(k) plans may sound intimidating, but they’re quite easy to work with. With a single retirement plan, you can save a significant amount of money (pre-tax or after-tax), and you have extra features like the ability to take loans.
Contribution limits: Solo 401(k) plans allow self-employed individuals to save more than the other options listed on this page. You can add to your account in two ways:
- Salary deferral: For 2023, you can save up to $22,500 as a salary deferral contribution. Those over age 50 can make an additional catch-up contribution of $7,500.
- Profit-sharing (or “employer” contributions): You can make profit-sharing contributions on top of (or instead of) salary deferral contributions, up to limits set by the IRS. For 2022, that amount is $66,000 per employer, which includes any salary deferral contributions.
Solo 401(k) vs. SEP: A Solo 401(k), also known as an individual 401(k), allows you to save just as much as a SEP with profit sharing contributions. But a Solo 401(k) includes the option for additional salary deferral contributions. Also, SEP contributions are based on a percentage of your compensation. To make meaningful contributions, you need significant earnings. A Solo 401(k) allows you to make salary deferral contributions of up to 100 percent of your salary, so you can save more with relatively lower income levels.
For example, if you have $10,000 of earnings from a side gig, you can potentially put all $10,000 into an individual 401(k) plan.
Pre-tax and after-tax, regardless of income: Solo 401(k) plans allow you to make salary deferral contributions as pre-tax, Roth, after-tax, or a mixture of these contribution types. The annual limits are substantially higher than IRA limits, so these plans provide an opportunity to build retirement savings quickly.
Also, you’re allowed to make pre-tax or after-tax contributions to a 401(k) plan as long as you have sufficient compensation to support the contributions. If you’ve been unable to make deductible IRA contributions or Roth IRA contributions in the past, your situation might change with a Solo 401(k).
An individual 401(k) provides the opportunity to make “mega backdoor Roth” contributions. That’s relatively rare, and is one perk of being self-employed.
Loans: It’s best to leave your retirement savings alone. However, sometimes needs arise, and your 401(k) may be your only source of funding. Solo 401(k) plans, like other 401(k)s, can allow loans—if you and your vendor decide to make loans available. With that option, you can take the lesser of 50 percent of your account balance or $50,000 as a loan. There’s no tax due unless you default on the loan, and you can repay over several years.
Deadline: The deadline for establishing an individual 401(k) can be tricky.
- If you want to make employee (salary deferral) contributions, sign the documents to set up the plan by 12/31. Salary deferral contributions need to be identified before year-end.
- If you only want to make an employer contribution, you generally have until your tax filing deadline (plus timely filed extensions) the following year.
Solo 401(k) plans are relatively easy to work with after you establish them, but there are a few pitfalls to be aware of.
SEP IRAs: A Classic Approach
SEP IRAs might be the first thing your accountant recommends when you discuss options to reduce your tax bill. That’s no criticism of you accountant—SEPs have been, and continue to be, a perfectly good strategy for many clients. Clients who have high incomes and want to save roughly 25 percent of compensation (or less) find SEPs to be a simple and inexpensive solution.
Contribution limits: SEP IRAs allow you to contribute up to 25 percent of your compensation. The calculation to arrive at your maximum is a bit more involved than taking 25 percent of profits, but your accountant can help you find the exact number. For businesses earning just a few thousand dollars per year (maybe you’re doing a side gig or just starting out), you may find that you can save more money in a Solo 401(k) plan than you can with a SEP. But if you earn hundreds of thousands of dollars, you’ll be able to contribute a decent amount to a SEP—until you hit maximum limits, which may steer you toward other plans.
Pre-tax contributions only: A SEP is designed for pre-tax contributions that reduce your current income taxes. Deductions are always nice, and that may be exactly what you need right now. But you’ll have to pay income taxes at some point. Whether or not that works out favorably depends on several factors, some of which are impossible to predict. If you’d like the option to save after-tax (with at least a portion of your assets), you’ll need to use other accounts to supplement your SEP.
A Solo 401(k) plan is often an excellent choice for one-person businesses, and when opened with the right providers, might not cost more than a SEP IRA. Let me know if you want to talk about this!
SIMPLE IRAs: Decent Limits, but Less Flexibility
SIMPLE IRAs make it easy to save more than standard IRAs, but the limits are lower than Solo(k) limits.
Contribution limits: SIMPLEs allow you to save up to $15,500 as a salary deferral contribution for 2023, putting them in between IRAs and Solo 401(k) plans. Savers over age 50 can make an additional catch-up contribution of $3,500.
Employer contribution: SIMPLEs require an annual employer contribution. When you’re self-employed, that may be confusing since you’re both the employee and the employer. You get to choose one of two types of employer contributions:
- A matching contribution of 3 percent of your salary deferral contributions. In other words, you match the first 3 percent.
- A nonelective contribution of 2 percent of your net self-employment earnings, up to certain limits. Nonelective contributions are contributions you must make whether or not there are any deferral contributions.
Pre-tax only: As with SEP IRAs, all contributions to a SIMPLE are pre-tax.
Restrictions on other plans: SIMPLEs limit your ability to use other types of retirement plans. For example, if you use a SIMPLE in a given year, your business cannot use a 401(k) plan during that same year.
Important Information
This is just a general overview of retirement plans for self-employed individuals, and it’s intended to help you start the conversation with your accountant and financial advisor. It is not written with any knowledge of your circumstances, goals, tax situation, or liabilities. As a result, it’s crucial that you to consult with a local professional who can better understand your needs before taking any action. Justin Pritchard is a Certified Financial Planner™ practitioner, but is not a Certified Public Accountant who can provide advice on tax avoidance. Justin can help with plan selection, vendor evaluations, and implementation when giving one-on-one advice using a formal agreement.
Disclosure: For a comprehensive review of your personal situation, always consult with a tax or legal advisor. Approach Financial, Inc. may not practice in legal or tax areas. Distributions from traditional IRAs and employer-sponsored retirement plans are taxed as ordinary income and, if taken prior to reaching age 59 ½, may be subject to an additional 10% IRS tax penalty. Converting from a traditional IRA to a Roth IRA is a taxable event. A Roth IRA offers tax-free withdrawals on taxable contributions. To qualify for the tax-free and penalty-free withdrawal of earnings, a Roth IRA must be in place for at least five tax years, and the distribution must take place after age 59 ½ or due to death, disability, or a first time home purchase (up to a $10,000 lifetime maximum). Depending on state law, Roth IRA distributions may be subject to state taxes. All investing involves risk, including the possible loss of principal. There is no assurance that any investment strategy will be successful.