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A common piece of advice is to start saving for retirement early and do it through your employer plan, like a 401(k) plan or similar. Employer-sponsored plans are tax-advantaged and the employer typically matches at least a portion of your contribution. The common advice is great advice if you work for a company that offers such a plan. But what if you are self-employed or work for a company that does not offer a retirement plan? What can you do then?
Pay Yourself First
Before we consider various options, let’s reflect on a rule you probably heard before: pay yourself first. It means that before your income is used for current spending purposes, you should save it to pay yourself in retirement. This is how it normally works in a company-sponsored plan like a 401(k). Typically, the money is taken pre-tax, directly from the employer, and sent to your 401(k) account. You don’t even see the money, which avoids spending temptations, but your nest egg will grow over time thanks to your contributions, a company match, and compound returns. In addition, you typically have to make elections when you start employment. And many well-designed plans make some default elections even if you do nothing. This makes it easy to get started.
If you are self-employed or your company does not have a plan, you can accomplish the same goal on your own, with just a bit of planning. Make it a goal to start a retirement savings account as soon as you start your self-employment. If you haven’t started, the best time is now! Open one of the accounts we discuss below, and automate your deposits every pay period. As you get closer to retirement, you’ll be glad you did.
The IRA is for Everyone
Everyone with taxable compensation can contribute to an Individual Retirement Arrangement or IRA. There are two types, the traditional IRA and the Roth IRA.
Traditional
In a traditional IRA, your contributions can be deductible. This means that your contributions lower your taxable income dollar for dollar. This can be great if you are trying to reduce your taxable income while saving for retirement. If you are not covered by a 401(k), your contributions to a traditional IRA are fully deductible if:
- You are single; or
- You are married and your spouse is not covered by a 401(k).
If you are married filing jointly and your spouse is covered by a 401(k) plan, your contributions are deductible if your joint adjusted gross income (AGI) is less than $198,000 for 2021. With joint incomes between $198,000 and $208,000, your contributions are partially deductible, and with AGI greater than $208,000, your contributions are non-deductible.
Your contributions to an IRA will grow tax-free. Any dollar you withdraw over your non-deductible contributions will be taxed as ordinary income (there is a penalty for early withdrawals prior to age 59 ½). Each individual can contribute to an IRA up to $6,000 for 2021, or $7,000 if over the age of 50, and can make the contribution any time before the April 15 of the year following each tax year (April 15, 2022, for the tax year 2021). Many financial institutions offer IRAs. Opt for a provider that offers low-cost mutual funds or ETFs.
Roth Version
The Roth IRA has a different tax treatment. Your contributions to a Roth are taxable income. That is, while your traditional IRA contribution can reduce your gross income, your Roth contributions do not. However, your Roth contributions will grow tax-free, unlike traditional IRA contributions. You can use the Roth over the traditional IRA in years where your income is lower and you are paying a lower tax rate. The contribution limits are the same as the traditional IRA ($6,000 and $7,000). Because the contributions are after-tax, effectively the limits are higher than for the traditional IRA ($6,000 in a Roth is worth more than $6,000 in a traditional IRA. However, you don’t get the tax break when you contribute).
You can only contribute fully to a Roth IRA if your income is below $125,000 if you are single or $198,000 if you are married filing jointly. If you expect your income to increase over time and you fall below these thresholds, a Roth IRA may be a good option for you.
The SEP IRA and the Solo 401(k)
There are other attractive retirement plans for self-employed individuals, including the SEP IRA and the Solo 401(k).
The SEP IRA
The SEP IRA is an IRA account where the employer can contribute to their employees. If you own a business, you can establish a SEP plan and contribute to your own IRA account as an employee of the business. You can contribute up to 20% of your net earnings (net of the contributions) from self-employment, up to $58,000. The SEP IRA plan works like a traditional IRA from a tax perspective. Your contributions are tax-deductible, and your withdrawals are taxed as ordinary income. There is no Roth option with a SEP IRA. You can set up a SEP for a year as late as the due date of your business income tax return for the year you want to establish the plan. So, April 15 of 2022 for the tax year ending December 2021.
The Solo 401(k)
The Solo 401(k) is a 401(k) plan like the ones offered by larger companies, and it can be established by self-employed individuals. The maximum potential contribution to the solo 401(k) is $58,000 just as for the SEP IRA. However, you have more flexibility with 401(k) contributions.
As an employee, you can contribute up to $19,500 in 2021, plus an additional $6,500 in 2021 if you’re 50 or older, as long as your income is at least as much as the amount you contribute. If you make $80,000 and are 50, you can contribute $26,000 in a Solo 401(k) but only $16,000 in a SEP IRA. The employer portion can be 20% of your net self-employment income, up to a total (employer + employee) of $58,000. So, with a 401(k), you can always at least contribute to the employee limit, and go over that with the employer portion.
In addition, the Solo 401(k) can be traditional (funded with pre-tax contributions) or Roth (funded with after-tax contributions). The Solo 401(k) can also have a loan provision. However, the Solo 401(k) only covers the business owner with no employees, or the business owner and their spouse.
Both the SEP IRA and the Solo 401(k) can be rolled over to an IRA or a Roth IRA.
How Much Should I Save?
Most people should try to save between 10 and 20% of their income, depending on their income level. Start with 10% and increase that amount over time. If you think you cannot save at least 10%, save as much as you can, and plan to revise upward your savings as you get a raise or a bonus.
If you don’t have a company-sponsored 401(k) plan, know that you are not alone. Many startups and small companies do not offer a 401(k) plan. Many people, about 30 million or roughly 20% of the labor force, report some self-employment income, and that number has been growing over the last decade. However, a few hours of planning can get you started with your very own retirement plan. So get started today!
Until Next Time!
Massi De Santis is an Austin, TX fee-only financial planner and founder of DESMO Wealth Advisors, LLC. DESMO Wealth Advisors, LLC provides objective financial planning and investment management to help clients organize, grow, and protect their resources throughout their lives. As a fee-only, fiduciary, and independent financial advisor, Massi De Santis is never paid a commission of any kind, and has a legal obligation to provide unbiased and trustworthy financial advice.
