When you work for a company, saving for retirement tends to be more straightforward. Depending on the retirement plan, you may be able to automatically withdraw a specific percentage of each paycheck and put that money into a retirement account. If you're lucky, your employer might even match your contribution.
But when you're your own boss, building a financial cushion for retirement can get a little more complicated. Fortunately, there are ways small-business owners and freelancers can save for the future. Here are some options for your self-employed retirement plan.
Simplified employee pension (SEP) individual retirement accounts (IRAs) allow employers to contribute the lesser of $55,000 or 25 percent of each employee's salary (their pay, if they're small-business owners) into an account. Anyone who generates self-employment income is eligible for a SEP IRA, whether they're a solo entrepreneur, a small-business owner with just a few employees or someone working freelance jobs on the side.
Compared to traditional employer-based retirement plans, SEP IRAs are easy to set up, don't have high administrative costs and give small-business owners the flexibility to contribute different amounts each year for themselves and their employees, depending on the business's cash flow. It's important to note that employees aren't allowed to contribute to a SEP IRA, although they own the account.
For freelancers, the main advantage of a SEP IRA is that it allows them to contribute more for retirement each year. Traditional and Roth IRAs have a $5,500 annual contribution limit, but the annual contribution limit for SEP IRAs is the lesser of $55,000 or 25 percent of each employee's salary.
These contributions also are tax-deductible. Be careful about withdrawing money from a SEP account too early: If you do so before age 59 1/2, you'll be subject to an additional tax of 10 percent, according to the Internal Revenue Service (IRS).
Like with a SEP IRA, any small-business owner with 100 or fewer employees can open a savings incentive match plan for employees (SIMPLE) IRA for both themselves and their business's employees. The two plans do vary in several ways, however.
With a SIMPLE IRA, small-business owners are required each year to contribute either a matching contribution of up to 3 percent of each employee's salary or a 2 percent nonelective contribution equal to 2 percent of each employee's annual salary (up to $275,000), whether or not that employee contributes to the retirement plan.
Unlike with a SEP IRA, employees are actually allowed to contribute to a SIMPLE IRA. Employees of the business (including the owner) can contribute up to $12,500 a year to their retirement plan alongside their employer's contributions. If you're over 50, you also can make catch-up contributions of up to $3,000.
You can deduct any contributions you make to a SIMPLE IRA for your employees on your business's tax return. If you're a sole proprietor or a partner in the business, you can deduct contributions to your own SIMPLE IRA retirement plan — and any matching and nonelective contributions you've made for employees — on your personal tax return.
The one downside to a SIMPLE IRA is that, as an employer (and barring some exceptions), you can't have any other retirement plan. You'll also face additional tax penalties and fees, depending on when you withdraw money from this account.
However, the benefit of this IRA is that it allows you to save for retirement as a small-business owner while getting a tax deduction that will reduce your overall tax bill. This could free up money you could then reinvest back into the business — or save for retirement if you haven't already exceeded your contribution limit for the year.
A solo 401(k), or a one-participant 401(k) plan, is for small-business owners who have no other employees. A solo 401(k) covers you as a business owner, as well as your spouse (if he or she earns income from the business).
Under this retirement plan, you act as the employee and the employer and can make contributions as both. You can make elective deferrals of up to 100 percent of your earned income — up to $18,500 or $24,500 if you're age 50 or older.
You also can make employer nonelective contributions of up to 25 percent of compensation. The total amount you contribute cannot exceed $55,000, and contributions can be made pre- or after-tax. There's also an early withdrawal penalty on these accounts.
As a self-employed person, you'll likely need to do some math to determine your earned income, which the IRS defines as your net earnings after deducting half your self-employment tax and any contributions you make for yourself. Once you've figured out this number, you can use it to determine your annual contribution and deduction limits. If you're self-employed, your income will probably vary every year, so be sure to recalculate these numbers annually.
A Look Down the Road
There are nearly 1.4 million small businesses having fewer than 10 employees in the U.S., according to the U.S. Small Business Administration. And freelancers now make up 36 percent of the U.S. workforce, according to a study by the Freelancers Union and Upwork. What does this mean? Millions of Americans will have to decide how to craft their own self-employed retirement plan.
Even if you run a successful business, that business (and its liabilities) shouldn't be your only retirement asset. A SEP IRA, SIMPLE IRA or solo 401(k) could help you prepare for your financial future — and help ensure the years of hard work you put into your business pay off with a comfortable retirement.