10 Retirement Planning Tips for the Self-Employed

It's rewarding to have your own business. But how do you save for retirement?  Jupiterimages/Creatas/Thinkstock
It's rewarding to have your own business. But how do you save for retirement? Jupiterimages/Creatas/Thinkstock

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"I want to be my own boss." It sounds great, doesn't it? Making your own hours, calling all the shots, and succeeding or failing on your own terms. Those are a few of the compelling reasons why more and more Americans are self-employed.

The Internal Revenue Service (IRS) defines self-employed workers as:

  • Sole proprietors or independent contractors
  • Members of a partnership that carries on a business
  • Other folks who work for themselves, including part-time businesspeople

According to the National Association for the Self-Employed, 77.6 percent of small businesses in the United States are self-employed. And the Bureau of Labor Statistics counted 15.3 million Americans, or 10.9 percent of all workers, as self-employed in 2009 [source: Hipple].

But there are some distinct advantages to working for "The Man," too. A lot of companies offer health care coverage for both employees and their families, paid vacation time, and perhaps most important of all, a retirement plan. As a self-employed worker, you are responsible for finding (and funding) all of your benefits, including planning for retirement.

The good news is that there are several IRS-approved retirement plans for the self-employed. The bad news is that the IRS doesn't do "easy and straightforward," so you will have to do your homework to find the plan that's best for you and your business. Here are some tips, starting with an overview of the top three self-employment retirement options.

10

Know Your Options

The solo 401(K) is a good option for a husband-and-wife team of business owners. iStockphoto/Thinkstock
The solo 401(K) is a good option for a husband-and-wife team of business owners. iStockphoto/Thinkstock

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There are a number of self-employment retirement plans out there; the three most popular include:

The Simplified Employee Pension IRA (SEP IRA) is the easiest to set up and incurs the lowest account management fees from banks and mutual funds. It's perfect for one-person businesses but can also be used if you have employees. Only the employer makes contributions. One of the best features is that there are no required minimum contributions and you can wait until April 15 to pay in. That way, you can put away more when business is good and less when times are tight.

Also called a "one-participant 401(k)," the Solo 401(k) is for a single business owner with no employees or a business owner and a spouse [source: IRS]. It works exactly like a conventional 401(k), with one major difference. In a traditional 401(k) plan, the employer matches a certain percentage of the employee's pretax contributions. Since solo businesses owners are both employer and employee, the IRS allows them to make extra contributions up to 25 percent of the business' earnings. Solo 401(k)s are harder to find, cost more to maintain and incur more rules than SEP IRAs.

The Savings Incentive Match Plan for Employees (SIMPLE) requires the employer to match each employee's contributions up to 3 percent of salary. Even if the employee doesn't make his or her own contributions, the employer has to contribute a fixed 2 percent of salary [source: Hill]. These plans are less attractive because they carry hefty annual fees and IRS penalties if employers don't keep up with contributions.

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9

Understand Contribution Limits

With the SIMPLE IRA, if you have employees, you must contribute either a fixed 2 percent of their salaries or match their contributions up to 3 percent of their compensation. iStockphoto/Thinkstock
With the SIMPLE IRA, if you have employees, you must contribute either a fixed 2 percent of their salaries or match their contributions up to 3 percent of their compensation. iStockphoto/Thinkstock

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Each of the three major self-employment retirement plans has its own contribution limit — the maximum amount of money you can invest every year. The IRS updates these numbers annually, but here are the figures for tax year 2013.

As we said earlier, the SEP IRA is the easiest to manage. One reason is its fixed contribution limit, which is 25 percent of "net earnings from self-employment" up to $51,000 [source: IRS]. Net earnings means gross income minus any "ordinary and necessary" expenses related to running the business [source: IRS]. Since you don't have to make any SEP IRA contributions until Tax Day, you can see what 25 percent looks like for the year and decide how much you want to put toward retirement.

There are two separate contribution limits for the Solo 401(k). First, there's a fixed limit of $17,500 a year, or up to $23,000 a year if you are 50 or older. Then you can make additional contributions of up to 25 percent of "earned income" from the business for a maximum contribution limit of $51,000 [source: IRS]. Note that earned income is not the same as "net earnings from self-employment." To calculate net earnings, you need to subtract both self-employment taxes and any 401(k) contributions you made for yourself [source: IRS].

The cap on SIMPLE IRA contributions is fixed $12,000 in 2013 plus $2,500 if you are 50 or older [source: IRS]. The extra money is called a "catch up" contribution, since it helps people stash away more money as they near retirement age. Remember, if you have employees, you are also required to contribute either a fixed 2 percent of their salaries or match their contributions up to 3 percent of their compensation.

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8

Go Roth

One perk of a solo 401(k) is the ability to pay both Roth and conventional contributions to the same 401(k) account in the same year. Jupiterimages/Photos.com/Thinkstock
One perk of a solo 401(k) is the ability to pay both Roth and conventional contributions to the same 401(k) account in the same year. Jupiterimages/Photos.com/Thinkstock

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One of the cool perks of a solo 401(k) plan is the option to put away money using "designated Roth contributions." What's the difference between a regular 401(k) contribution and a Roth contribution? It has to do with when the money is taxed, before you put it into savings or after you take it out.

With a conventional 401(k) plan, all contributions are "pretax." Basically, the money you invest in your 401(k) is deducted from your taxable income for the year. The flip side is that you will have to pay income tax on all of the money you withdraw from your 401(k) after you retire. A conventional 401(k) is a smart option if you expect to be in a lower tax bracket when you retire.

Roth contributions work in the opposite way. You pay income tax on the money before you put it into the retirement savings account, but you withdraw the money tax-free. In this way, Roth contributions are a good choice for people who expect to be in a higher tax bracket when they retire.

The interesting thing about a solo 401(k) is that you can have it both ways. Once you elect to make Roth contributions, you can make both Roth and conventional contributions to the same 401(k) account in the same year as long as the total does not exceed your contribution limit [source: IRS]. It's a level of flexibility that's not available in either the SEP IRA or SIMPLE IRA.

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7

Ways to Set Aside Money

The best way to save for retirement when you're self employed is to set up an automatic monthly contribution through the bank or broker that manages your retirement account. iStockphoto/Thinkstock
The best way to save for retirement when you're self employed is to set up an automatic monthly contribution through the bank or broker that manages your retirement account. iStockphoto/Thinkstock

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Saving is painful. That's one of the reasons 401(k) plans are so popular with employees at conventional businesses. Contributions to the plan are deducted directly from each paycheck so the employee doesn't have the extra trouble of remembering to make a contribution. And best of all, she doesn't miss the money, because she never knew she had it.

As a self-employed person, you probably don't have the luxury of a steady paycheck or an accounting department to "secretly" deduct your retirement contributions. Instead, you need to trick yourself into saving for the future. The best way is to set up an automatic monthly contribution through the bank or broker that manages your retirement account. You can have a fixed amount drawn from a checking or savings account and try really hard not to miss it each month.

If you have an SEP IRA, you don't have to contribute until April 15 for the prior tax year. A safe way to save would be to automatically transfer money out of your checking account into a savings account each month. At the end of the year, you can decide how much of those savings you want to contribute to the SEP IRA and how much you want to reinvest in the business.

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6

Understand How Social Security Works

Don't let this happen to you!  If you reduce your net earnings too much to avoid paying taxes, you could end up receiving little or nothing in Social Security benefits. iStockphoto/Thinkstock
Don't let this happen to you! If you reduce your net earnings too much to avoid paying taxes, you could end up receiving little or nothing in Social Security benefits. iStockphoto/Thinkstock

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Self-employed workers in the United States are entitled to Social Security benefits just like regular employees. That's because self-employed people pay an additional self-employment tax (SE tax) every year that covers contributions to both Social Security and Medicare. The downside of self-employment is that you pay the entire 15.3 percent Social Security tax yourself [source: Social Security Administration]. Conventional employees only pay half and the boss covers the rest (that's called the payroll tax).

How much money will you receive in Social Security benefits? That depends on how much money you earned and how many years you worked. The Social Security Administration requires a minimum amount of 40 "credits" (generally, 10 years). In 2013, you receive one credit for every $1,160 in net self-employment earnings, although the minimum earnings requirement is $4,640 (or four credits). Use this calculator to estimate your future Social Security benefit using your current earnings information. If you were born after 1959, you would have to wait until 67 to get your full benefit amount [source: SSA].

Notice that credits are based on net self-employment earnings. There is a potential trap here. Since self-employed folks pay 15.3 percent in Social Security tax, a lot of people try to lower their taxable income as much as possible by deducting a lot of business expenses. Be careful! If you reduce your net earnings too far, you may not earn the 40 credits to qualify for Social Security benefits [source: Humphreys].

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5

Don't Quit Your Day Job

Before you go on your own full-time, determine if it's worth it to lose your employer's health and 401(k) plans. Pixland/Thinkstock
Before you go on your own full-time, determine if it's worth it to lose your employer's health and 401(k) plans. Pixland/Thinkstock

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Not everyone is ready to cut ties with a steady paycheck. Many self-employed people are part-timers, perhaps freelancing on the side or running a small business out of their home. There are some huge benefits to keeping your day job, including any health insurance coverage you receive through your employer and your company's 401(k) plan.

This is another big advantage of the SEP IRA. Only the SEP IRA allows you to contribute the maximum amount to both your employer's 401(k) and your self-employment retirement plan [source: Lankford]. You could contribute up to $51,000 on your SEP IRA and up to the maximum allowable on your employer 401(k) (a further $17,500).

But you can't max out two different 401(k) plans. If you have both a solo 401(k) and an employer 401(k), your total contributions to both can't exceed the $17,500 limit. You can, however, still tap the extra 25 percent of net earnings that come through the business.

There is no doubling down on SIMPLE plans, either. The IRS rules for SIMPLE retirement plans state that a self-employed business owner cannot have any other simultaneous retirement plans [source: IRS].

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4

Choose the Best Plan for Employees

If you run a small business, you could set up a SEP IRA or a SIMPLE plan for your employees.  Each has pros and cons. Polka Dot Images/Thinkstock
If you run a small business, you could set up a SEP IRA or a SIMPLE plan for your employees. Each has pros and cons. Polka Dot Images/Thinkstock

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If you're a self-employed business owner with employees, there is more riding on your choice of retirement plan. Depending on which plan you choose, you will be responsible for matching or, in some cases, funding the entire retirement contributions of your employees. Let's see how each plan stacks up.

By definition, the Solo 401(k) plan is only for one-person companies or a business run by a husband and wife.

The SEP IRA is potentially the most expensive of the two remaining plans, because an SEP IRA is completely employer-funded. According to the IRS, if you are a self-employed business owner and want to contribute 25 percent of your compensation to a SEP IRA, then you need to contribute 25 percent of each of your employees' salaries to their SEP IRA as well [source: IRS]. The employees don't pay a dime.

The SIMPLE IRA is available for businesses with 100 employees or fewer. As we discussed earlier, there are two options for managing employee contributions. The first is to match employee contributions dollar for dollar up to a maximum limit of 3 percent of the employee's annual salary. In that case, the responsibility falls to the employee to contribute enough to receive the maximum match.

The second SIMPLE option is called a "nonelective" contribution [source: IRS]. Under this formula, the employer must contribute a minimum of 2 percent of the employee's salary to the plan, whether or not the employee contributes anything herself. An employer looking to save money will have to figure out if his or her employees are the type to maximize their contributions or not.

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3

Maximize Your Tax Deductions

The three most common self-employment retirement plans all use pre-tax dollars, which lowers your taxable income. iStockphoto/Thinkstock
The three most common self-employment retirement plans all use pre-tax dollars, which lowers your taxable income. iStockphoto/Thinkstock

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One way to save more money for retirement is to give less of it back to Uncle Sam. Remember, all three of the most common self-employment retirement plans — solo 401(k), SEP IRA and SIMPLE IRA — are pretax plans. That means that every cent you save for retirement is deducted from your taxable income. In fact, contributions to retirement plans are the No. 1 tax deduction for self-employed business owners [source: TurboTax].

Pay attention to the contribution limits that we talked about earlier. If you have enough income to put the maximum away, you can personally deduct up to $51,000 with both an SEP IRA and a solo 401(k). But with an SEP, you can also deduct the contributions you make to employee accounts up to an additional $51,000 each. The limit for a SIMPLE plan is considerably lower at $12,000 for employees under 50, but if you have employees you can also deduct any contributions you make on their behalf.

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2

Late Bloomer? Try a Defined Benefit Plan

Defined benefit plans are attractive to high-income earners who start saving for retirement later in life . iStockphoto/Thinkstock
Defined benefit plans are attractive to high-income earners who start saving for retirement later in life . iStockphoto/Thinkstock

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We haven't talked about defined benefit plans because they much less common than solo 401(k)s, SEP IRAs and SIMPLE IRAs. According to the IRS, there are only 38,000 active defined benefit plans in the United States, and many are holdovers from the 1980s, when the plans were in fashion for larger corporations [source: IRS].

What is a defined benefit plan? Essentially, it's a pension plan. First, the self-employed business owner figures out exactly how much money he or she wants in retirement benefits per year. The next step is to work with an actuary to determine how much must be put aside each year to achieve that benefit. The loophole of defined benefit plans is that the maximum contribution limit is super high: $205,000 in 2013 [source: IRS].

This is why defined benefit plans have become attractive to high-income earners who started saving for retirement later in life [source: Sullivan]. If you have a lot of disposable income, you can stash away more than $2 million in 10 short years, enough to guarantee an annual retirement benefit of around $200,000.

There's another reason defined benefit plans are for high-rollers only; it is the most costly plan to administrate, the most complex to manage and triggers an excise tax if minimum annual contributions aren't met [source: IRS].

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1

In a Bind? Borrow from Your 401(k)

When you run your own business, there are times when you have cash flow issues.  Fortunately, you can borrow from your 401(K), depending on how it is set up. iStockphoto/Thinkstock
When you run your own business, there are times when you have cash flow issues. Fortunately, you can borrow from your 401(K), depending on how it is set up. iStockphoto/Thinkstock

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IRS rules are pretty strict about when you are allowed to withdraw money from your retirement plan. If you do it before you reach 59½, you usually have to pay a 10 percent early withdrawal penalty plus income tax on the distribution. But what if you really need that retirement nest egg to pay off credit card debt or put a down payment on a home? If you have a 401(k), you can actually lend the money back to yourself.

Yup, most 401(k) plans allow you to loan yourself up to half the total value of your savings up to $50,000 (but not the SIMPLE and the SEP IRA) [source: IRS]. Interest rates vary, but they are typically much lower than a traditional bank loan and they are many times lower than the rate on your credit card debt [source: Wall Street Journal]. In some cases, it makes very good sense to borrow from your 401(k) to pay off high-interest debt. Use this calculator to figure out what it will cost to pay back a 401(k) loan and compare it to the interest payments on your credit card balance.

401(k) loans have their own rules. They must be paid back in five years, unless the money is used to buy a primary residence for the borrower. Otherwise, you can use the loan for whatever you want, as long as you pay up on time. If you default, the loan will be treated as an early withdrawal, triggering the 10 percent penalty and income taxes [source: IRS]. Conventional wisdom says to borrow only as much as you need, not as much as you can get [source: Wall Street Journal].

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Author's Note: 10 Self-employment Retirement Tips

I am one of the 15.3 million Americans who are self-employed. I love the flexibility of being my own boss and the ability to deduct all manner of expenses from my taxable income. What I don't love are the high monthly premiums for awful health insurance coverage, the panic of trying to balance a household budget with irregular paychecks, and the sinking feeling that we are failing to save enough for our future. I chose the self-employed lifestyle, but not everyone is so lucky. One of the reasons for the boom in the self-employed workforce is because regular jobs are so hard to come by. For construction workers who have been labeled "independent contractors" to avoid payroll taxes, or moms watching the neighbors' kids for extra cash, "being your own boss" means barely scraping by. I applaud the independent American spirit, but fear that we are substituting "self-employed" for "underemployed."

Related Articles

Sources

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  • Hipple, Steven F. "Self-employment in the United States." Bureau of Labor Statistics. September 2010. (April 12, 2013) http://www.bls.gov/opub/mlr/2010/09/art2full.pdf
  • Humphreys, Nancy K. "Self-Employed Social Security Nightmare." The Huffington Post. Feb. 18, 2013. (April 12, 2013) http://www.huffingtonpost.com/nancy-k-humphreys/self-employed-social-secu_b_2712265.html
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Finance Planning Tips

Here are some tips to help you with generating income and planning for the future.

Presented by United Way of Greater Atlanta Powered by SunTrust Foundation