Self-employment is a dream for many who crave the flexibility and sense of autonomy being your own boss provides. No more worrying about taking those long lunches or running out of vacation days. On the flipside, it also means youâ€™re on your own when it comes to saving for retirement. There are no company-sponsored plans or matching funds, and no human resources department to consult about your best options â€” itâ€™s all up to you.
The good news is there are a host of great investment tools to help you plan for your future and build a solid nest egg for retirement, many of which have similar benefits as employer-sponsored plans. Here are six of the most common retirement plans for self-employed individuals.
There are several types of Individual Retirement Accounts (IRAs) you can establish if youâ€™re self-employed. First up is a traditional IRA, which allows you to deposit money in an investment account before paying taxes on it. Your funds then grow â€” tax-deferred â€” over the years until you reach retirement, at which point you will have to pay taxes on the funds as you withdraw them.
IRAs are more flexible than 401(k)s in that you can withdraw money from them at any time without paying a penalty to cover certain costs, including higher education, buying your first home and medical costs. You will, however, need to pay taxes on the funds in the year in which theyâ€™re withdrawn with a traditional IRA. You also canâ€™t leave your funds in an IRA forever. Required minimum distributions begin at age 70 and a half.
You can invest up to $6,000 in a traditional IRA in 2021. If youâ€™re over the age of 50, you can contribute an additional $1,000 a year as â€ścatch-upâ€ť contributions. Note: This is the total yearly limit for all Roth and traditional IRA contributions.
Some additional limitations may apply depending on your income and you or your spouseâ€™s participation in other work-sponsored retirement plans.
A traditional IRA allows you to invest the maximum amount for growth (as opposed to paying taxes up front, which is the case with a Roth IRA) because the funds arenâ€™t taxed until after theyâ€™re withdrawn.
Your contributions may also be fully or partially tax deductible in the year in which you make them, so that may also decrease your taxable income.
Typically, traditional IRAs are a good option if youâ€™re currently in a higher tax bracket and expect to be in a lower one when you retire. Theyâ€™re also an attractive option if you want the ability to access funds before retirement for certain expenses without paying a penalty.
A Roth IRA works much like a traditional IRA, but thereâ€™s one big difference: when you actually pay taxes. With a Roth IRA, you pay taxes on your contributions in the year in which theyâ€™re made. Those funds then grow tax-free over the years until you reach retirement. When youâ€™re ready to withdraw them â€” as long as youâ€™ve reached the age of 59 and a half â€” theyâ€™re yours, tax-free.
IRAs are more flexible than 401(k)s in that you can withdraw money from them at any time without penalty to cover certain costs, including higher education, buying a home and paying for medical costs. There are no required minimum distributions.
You can invest up to $6,000 in a Roth IRA in 2021. If youâ€™re over age 50, you can contribute an additional $1,000 a year. Note: This is the total yearly limit for Roth and traditional IRAs combined.
Contributions to a Roth IRA arenâ€™t tax-deductible, so you donâ€™t get a tax break in the year theyâ€™re made. However, because you pay taxes up front, those funds are not counted as taxable income when you retire.
In general, Roth IRAs are a good option if youâ€™re currently in a lower tax bracket and expect to be in a higher one when you retire. Theyâ€™re also good if you want the ability to access your funds before retirement for certain expenses without paying a penalty or paying taxes on the funds when needs arise.
A solo-401(k), also referred to as a one-participant 401(k) plan, works much like a traditional, employer-sponsored 401(k); however, itâ€™s designed for individual business owners or the owner and their spouse. It allows you to invest funds in a retirement savings account that then grows tax-deferred â€” traditional solo-401(k) or tax-free (Roth solo-401(k) â€” over the years until you withdraw them at retirement.
Penalties apply for early withdrawal if the account is less than five years old and you havenâ€™t reached the age of 59 and a half. However, you may be able to take out a loan from your 401(k).
Like a traditional 401(k), you can contribute up to $19,500 in 2021. If youâ€™re over the age of 50, the limit increases to $26,000 in 2021.
One notable upside to this plan is youâ€™re allowed to contribute additional funds because you act as both the employer and employee when youâ€™re self-employed. Total contributions canâ€™t exceed $58,000 for 2021, unless youâ€™re over the age of 50, when there are allowances for â€ścatch-upâ€ť contributions.
Like IRAs, you can choose either a Roth or a traditional solo-401(k). With a traditional solo-401(k), taxes are deferred on the money you contribute to your account until you withdraw funds in retirement.
If you choose to designate some of your funds as Roth contributions, however, you will pay taxes on them up front, with tax-free withdrawals in retirement. Contributions to a traditional solo-401(k) arenâ€™t counted as taxable income in the year they are made, while Roth solo-401(k) contributions are.
A solo-401(k) is a good option if your income surpasses the IRA limits and you want to invest more for your future.
Traditional and Roth IRAs are funded entirely by employee contributions, whereas SIMPLE IRAs allow contributions from both the employer and employee, which means youâ€™re playing both roles if youâ€™re self-employed.
Like with other IRAs, there are penalties for early withdrawal (before the age of 59 and a half), and there are exceptions for many expenses, including education, health care costs and buying a first home. If you withdraw funds before your plan is two years old, however, that withdrawal is subject to a hefty 25 percent tax penalty.
You can contribute up to $13,500 in 2021 to a SIMPLE IRA, but not more than the amount you earn. Additional â€ścatch-upâ€ť contributions up to $3,000 can be made if youâ€™re 50 or older.
As the employer, you can also contribute dollar-for-dollar matching funds up to 3 percent of your net earnings or make an additional non-elective contribution equal to 2 percent of your income, up to $290,000 in 2021.
Contributions to a SIMPLE IRA arenâ€™t taxed in the year in which they are made, but they are taxed when theyâ€™re withdrawn in retirement. Contributions are also tax deductible by the employer in the year in which they are made.
A SIMPLE IRA is a good option if you want to contribute funds in excess of the limits of traditional and Roth IRAs. Theyâ€™re also worth considering if you have 100 employees or less, as theyâ€™re easy to set up and donâ€™t come with the same startup and operating costs that other plans may have.
Like other IRAs, a SEP IRA allows you (as the employer) to invest funds, tax-deferred, until you need them in retirement. There are penalties for early withdrawal (before the age of age 59 and a half) and there are minimum distribution requirements.
There are two primary differences that set the SEP IRA apart from others:
1. A SEP IRA has higher contribution limits than traditional and Roth IRAs, and;
2. If you have employees who meet certain qualifications, you must make contributions to their SEP IRA in equal amounts for all employees. Contributions are only made by the employer (which is you) if youâ€™re self-employed.
You can contribute up to 25 percent of your net earnings to a SEP IRA, up to a certain limit. In 2021, the limit is $58,000. Thereâ€™s no extra allowance for catch-up contributions as there is with other retirement accounts.
Contributions to a SEP IRA are tax deductible, as funds are taxed when theyâ€™re withdrawn in retirement. Thereâ€™s no Roth option to pay taxes up front, as the contributions are made by the employer.
A SEP IRA is a good option if youâ€™re self-employed and want to save a large amount of money for retirement. Itâ€™s also a good option if you have 100 employees or less and want to establish a retirement plan without the associated costs of other plans.
Like an employer-sponsored pension, an individual defined benefits plan lets you put away a certain amount of money for a guaranteed return in retirement. The amounts are based on a formula that takes into account the number of years youâ€™ve worked and how much you earn. You must enlist the help of an actuary to help determine your contribution and benefits.
The amount you may contribute is based on a formula and will vary from person to person. Generally, however, the annual benefit canâ€™t be more than the highest salary they were paid for three years in a row, or surpass the annual limit of $230,000 in 2021.
Taxes are deferred up front and paid on the funds when theyâ€™re withdrawn during retirement. The contributions are tax deductible in the year in which they are made.
A defined benefits plan may be a good option if youâ€™re a high earner and want to save aggressively for retirement.
To open any of these retirement plans, there are numerous online brokerages that can help, or if you prefer a more personal approach, you can seek out a financial advisor in your area. Banks can also help you establish some of these accounts as well. It may also be wise to work with an accountant to make sure you file the proper forms and pay the correct amount of taxes.