Being your own boss has a lot of perks. Unfortunately, having a workplace retirement plan and an 401(k) match isn’t one of them.  Even if you’re running the business of your dreams and never planning to fully retire, everyone wants the “option” to stop working (or working so hard) someday. But how does retirement planning work when you’re self-employed?

What Options Do You Have?

There are actually quite a few different savings vehicles available for the self-employed to start saving for retirement. Here are a few to consider:

  • Traditional/Roth IRA
  • SEP IRA
  • SIMPLE IRA
  • Solo 401(k)
  • Defined benefit plans

Each of these savings vehicles comes with its own set of unique benefits and limitations. Depending on what your retirement savings goals are, your annual income, and the total amount you’re interested in contributing each year.

Individual Retirement Accounts

Individual retirement accounts, or IRAs, are often the default savings vehicle for the self-employed. This is usually because, in the case of Traditional and Roth IRAs, they make it really straightforward for people to start saving immediately. You don’t have to fill out any specific forms, your business doesn’t need to be attached to the account in any way – it’s solely dependent on you and your willingness to fund your retirement savings goals. However, there are several different types of IRAs. Not all of them are set up and funded in the same way, so it’s important to understand the difference.

Traditional

A Traditional IRA is connected to you as an individual and is funded with pre-tax dollars. This means you’ll pay taxes on any distributions you take during retirement. The current IRA contribution limit is $5,500 (plus a $1,000 catch-up bonus contribution if you’re age 50 or older).

If you contribute to a Traditional IRA, you may be able to exercise a tax deduction if you don’t contribute to any workplace retirement plans from a traditional employer. However, if you or your spouse are contributing to a workplace retirement plan, this may reduce the total amount of your contribution you can deduct each year (or phase it out entirely). These deduction limits are adjusted annually, so it’s worth checking in with the IRS if you’re considering opening a Traditional IRA.

Roth

Roth IRAs are funded with after-tax dollars, and withdrawals aren’t taxed during retirement. There aren’t any tax deductions available for contributions to your Roth IRA.

Roth IRAs have a few more restrictions to keep in mind. For example, they have the same $5,500 annual contribution limit that Traditional IRAs have, but they also only allow individuals below a certain income bracket to contribute.

For 2018, if you’re single, you need to have a modified adjusted gross income (MAGI) of under $135,000 to contribute, and your ability to contribute is reduced if you make $120,000 or over. If you’re married and filing jointly, you need to have a MAGI of less than $199.000, and reduction in contribution allowances begins at $189,000.

SEP

A SEP IRA is different in that it’s connected to your business, not just you personally. This account type is easy to set up and closely resembles a Traditional IRA with a few additional stipulations.

All contributions are tax-deductible for either the business or the individual contributor, and you’re limited to contributing the lesser of $55,000 or up to 25% of net self-employment earnings (with a $275,000 limit on earnings calculated) in 2018. This is a huge step up from the contribution limits for both a Traditional and a Roth IRA.

However, SEP IRAs have one key drawback that scares many self-employed business owners away: you have to contribute the same percentage to each of your employees’ accounts as you do to yours. For example, if you own a small coffee shop in Brooklyn that employs two other individuals who each work full time, and you choose to contribute 10% of your compensation to your SEP IRA, you also have to contribute 10% of their compensation to their accounts. Your employees don’t contribute at all, only the business can contribute.

This can get fairly expensive rather quickly if you employ multiple people. But if you’re a solopreneur looking to catch up on your retirement savings, it may be a good fit.

SIMPLE

SIMPLE IRAs are intended for businesses that are a bit bigger. You can contribute up to $12,500 each year (plus a $3,000 annual catch-up contribution if you’re age 50 or older). If you also contribute to an employer’s retirement plan (like a 401k) you can’t contribute more than $18,500 to your SIMPLE IRA.

The difference between a SIMPLE IRA and a SEP IRA is that employees can contribute to a SIMPLE IRA. This eases the pressure on an employer, but there is still some obligation for them to contribute. Typically, employers are expected to contribute 2% of an employee’s compensation to their SIMPLE IRA, or match contributions up to 3%. Again, the compensation limit here for factoring contributions is $275,000 in 2018. Distributions during retirement are taxed, and this account is funded with pre-tax funds. Additionally, any contributions an individual makes are tax deductible, and contributions an employer makes to an employee’s account are also tax deductible for the business.

Solo 401(k)

Solo 401(k)s are intended for solopreneurs and their spouses. The IRS calls this plan the “one-participant 401(k)” because it’s ideal for an individual, self-employed person to contribute a large portion of their self-employed income when the business is doing well, and less when revenue (and income) is tighter. A Solo 401(k) views you as two separate people – the employee and the employer.

As the employee, you’re allowed to contribute just like you would to a 401(k) at a traditional employer. You’re permitted to contribute up to $18,500 each year (plus a $6,000 catch-up contribution if you’re age 50 or older).

As the employer, you’re permitted to contribute an extra 25% of your compensation. If you’re a single-member LLC or a sole proprietor, you can contribute 25% of your net income, which is:

Profit – ½ (self-employment tax + any plan contributions you’ve made as an individual) = Net Income

All contributions to a Solo 401(k) work exactly as a traditional 401(k) would. They’re pre-tax when you contribute, and distributions are taxed when you’re eligible to take them after age 59½.

Defined Benefit Plans

Defined benefit plans are often similar to the old-school pension plans that some companies still use (but have largely fallen by the wayside in favor of 401(k)s and other defined contribution plans). Defined benefit plans for self-employed individuals have several benefits. First, they have higher-than-average contribution limits (sometimes up to $100,000/year). They also offer lower taxes on the distributions you take when you retire. However, defined benefit plans for the self-employed can be costly to set up and run, and you have to offer the plan to any employee you bring on in the future.

Weigh Your Options

These tend to be the most popular options for retirement savings, but it’s important that you weigh your options against your individual retirement savings goals and current financial situation. If you need help opening a self-employed retirement savings account, or have questions about which type of account is right for you, let’s talk. We’re here to help you navigate this sometimes confusing process and answer any questions you may have!