The benefits of running your own business far outweigh the constrictions of working in a corporate environment. Being your own boss allows you complete creative freedom and promises a greater sense of fulfillment. But running your own business also puts the burden of success squarely on your shoulders.
Self-employment makes saving for retirement more challenging as you’re missing out on employer-paid retirement contributions. That said, you do have access to several tax-advantaged retirement accounts that may help you save more because of your self-employed status.
When seeking out retirement funding, you have a few different options—a traditional IRA, Roth IRA, SIMPLE IRA, SEP IRA or Solo 401k. Each of these plans is complex and varied, so you’ll need to determine the best fit for your situation.
Let’s take a look at the rules surrounding each option.
Traditional or Roth IRA
According to Pew, 35% of private-sector workers don’t have access to an employer-based retirement plan, making an IRA a great starting place. Anyone with earned income can open an IRA. It’s one of the easiest ways to save for retirement when you’re self-employed.
Depending on which type of IRA you choose (traditional or Roth), you can pay taxes at the time of the contribution or later, when you withdraw funds. If you’ve recently made the jump to self-employment, you can roll over your 401k into an IRA. Just remember, you’re in charge of your IRA, and that means you’re in charge of selecting mutual funds and other investments.
Here are the differences and rules for each of these options.
When opting for a traditional IRA, the IRS allows you to deposit up to $6,000 per year if you’re under the age of 50 and $6,500 per year if you’re over 50. Your contributions are tax-deductible and are not taxed until you withdraw funds.
Traditional IRAs come with a great feature for non-working spouses. The breadwinner has the option to fund an IRA for their non-working spouse, allowing the non-working spouse to save for the future using a tax-advantaged retirement account. This is called a spousal IRA.
While there are no income limits dictating what you can contribute to a traditional IRA, there are limits as to what you can deduct from your taxes. However, since the limits are based on whether you’re covered by a qualified retirement plan at work (401k), these won’t affect you if you work for yourself.
A Roth IRA, on the other hand, comes with income and contribution limits.
As of 2019, single filers must have a modified adjusted gross income of less than $137,000. If you’re married and filing jointly, your adjusted gross income must be less than $203,000. And if you’re married and filing separately (and you lived with your spouse in the last year), your modified adjusted gross income must be less than $10,000.
If you exceed the limits that apply to your situation, you cannot contribute to a Roth IRA.
One of the big advantages of a Roth IRA over a traditional IRA involves the withdrawal fees. You can withdraw money contributed to a Roth at any time and for any reason without paying taxes or penalties. That’s because you paid taxes when funding the account. The annual contribution limit for 2019 is $6,000 if you’re under 50 and $7,000 if you’re age 50 or older.
When you reach age 70 ½, you will be required to withdraw a specified amount from a traditional IRA account each year. The amount you’re forced to withdraw is known as a Required Minimum Distribution (or RMD).
Some retirees opt to convert a portion of their retirement savings to a Roth IRA to avoid the RMD. According to Ed Slott, a nationally recognized professional speaker and author of numerous financial and retirement-focused books, the key factor in making this decision should be how soon you’ll need the funds.
“It doesn’t pay to convert to a Roth if you’re going to need the money in 10 years,” Slott explains. “As a business owner, you could need money to keep you afloat. Do a cost-benefit analysis because it’s not worth the tax cost if the conversion won’t parlay long term.”
In other words, if you’re going to need the money soon, don’t convert to a Roth IRA. The hit you’ll take paying taxes at the time of conversion will outweigh the benefit of potential growth.
It’s also worth noting that, technically, you can’t borrow money from your IRA. However, there’s an exception to the rule. If you only need the money for a short period of time—60 days or less—you’re allowed to withdraw the money provided you redeposit the funds within that 60 day window. This is known as the rollover rule.
A Solo 401k, also known as a One-Participant Plan, permits you to fund your plan from both your personal compensation and business income. This means your annual contributions could be significantly higher.
Solo 401(k)s work just like company-sponsored 401(k)s. The difference is they’re intended only for self-employed workers or individuals who employ no full-time workers (other than themselves and their spouses).
With a Solo 401(k), you can contribute up to 25% of your self-employment income per year until you reach the cap—$54,000 if you’re under 50 and $60,000 if you’re 50 or older.
According to IRA123.com, you must meet two eligibility requirements to benefit from a Solo 401(K):
- The presence of self-employment activity
- The absence of non-owner full-time employees
You (the business owner) and your spouse are considered “owner-employees” rather than “employees,” and as such can work full-time for the business.
The following types of employees typically don’t interfere with eligibility for a Solo 401(k):
- Employees under 21 years of age
- Employees who work less than 1,000 hours annually (full-time)
- 1099 contractors
- Some union and non-resident alien employees
Although it should only be used as a last resort, you may borrow from the funds in your Solo 401(k) plan. You can borrow up to 50% of the account value (not to exceed $50,000). The interest rate is low, at prime rate plus 1%. This can be a great help in case of financial problems.
Simple and SEP IRAs
SIMPLE stands for Savings Incentive Match Plan for Employees. These plans are designed for small business owners with under 100 employees and self-employed individuals who don’t have access to other retirement plans.
Any employee who has earned at least $5,000 in compensation from the participating company and who expects to make at least that much in the current calendar year is eligible. The employer is generally required to match each employee’s salary reduction contributions on a dollar-for-dollar basis up to 3% of the employee’s compensation.
SIMPLE IRAs have higher contribution limits than traditional and Roth IRAs, but contribution limits are lower than a Solo 401(k), with maximum contribution limits of $12,000 for those under 50 and $14,500 if age 50+.
SEP stands for Simplified Employee Pension. These plans allow business owners to make pre-tax retirement contributions for themselves and their employees. Unlike other workplace retirement plans, any employee enrolled in a SEP-IRA does not make contributions themselves. Instead, the employer makes contributions for them directly.
The employer can contribute up to 25% of an employee’s salary, or up to $56,000, whichever is less. Employers choose when to make contributions, and they don’t have to do it each year.
You have a couple of options as a small business owner who wants to help both yourself and your employees save for retirement. Just be sure to consider the key differences between each type of plan, as well as the qualifications.
Slott also recommends that you make sure you understand all the rules and identify any potential pitfalls that are unique to your business before you take the plunge.
Additionally, everyone on the Talus team is well acquainted with the unique challenges of running your own business. That’s why we provide resources like this one to help out. We’re here to make sure you’re as successful as possible.