In the past, I’ve received calls from clients who had already retired but decided to get back into the game and provide consulting services as an independent contractor. Part of the conversation was a discussion of the different approaches to consider in deferring income recognition and investing some of these newly earned funds in a tax efficient manner. Below we review some of the most common retirement savings strategies a self-employed person could utilize and explore the pros and cons of each.
A traditional IRA is a method to save for retirement with tax benefits. Contributions made to a traditional IRA may be deductible, depending on several different factors (age of client, earnings level, etc.). All earnings and gains in a traditional IRA are not taxed until distributed. Contributions are limited to $6,500 per year (under 2023 law), unless you are 50 or older, at which point the contribution limit is increased to $7,500.
Benefits of a traditional IRA include (potentially) deductible contributions and tax-sheltered growth.
Downsides to a traditional IRA include Required Minimum Distributions (RMDs) and penalties for withdrawing funds early. An RMD is a requirement that you must start taking out money from your IRA once you reach age 72 (73 if you reach 72 before December 31, 2022). If you choose not to or forget to take the distribution, you are subject to a 25% penalty of the amount of your RMD that year (which can be reduced to 10% if corrected quickly). You also will be penalized 10% for an early withdrawal, on top of having to pay the taxes. The only exceptions to this early penalty would be your first house purchase, education expenses, and certain medical expenses.
A Roth IRA is like a traditional IRA in many aspects but has some key differences. The biggest difference between a Roth and a traditional IRA is how and when you get a tax break. The tax advantage of a traditional IRA is that your contributions are tax-deductible in the year they are made, while the tax advantage of a Roth IRA is that your withdrawals in retirement are not taxed. Also, unlike a traditional IRA, you are not required to take an RMD, and may leave money in the plan.
A downside to the Roth IRA is that it is subject to income limitations. Even though with a traditional IRA you cannot get the deduction if you’re over the income limits, with a Roth IRA you cannot contribute at all if your income is over these limits. For 2023, full phase out begins at modified adjusted gross income greater than or equal to $153,000 (single) and $228,000 (MFJ).
A benefit of not being self-employed (or working for an employer) is access to an employer sponsored 401(k) plan. However, the one-participant 401(k) offers those benefits to self-employed individuals. A one-participant 401(k), often called a solo 401(k), is a retirement savings plan that covers a business owner with no employees or that person and his or her spouse. These plans have the same rules and requirements as employer sponsored 401(k) plans, but in the case of solo plans, you act as both “employer” and “employee” and can make contributions as both.
The contributions made as “employee” — known as elective deferrals — are limited to 100% of compensation (or earned income) up to $22,500 (under 2023 law). Individuals who are age 50 or older may make an additional $7,500 catch-up contribution (under 2023 law), for a maximum of $30,000 in elective deferrals. These maximums are adjusted for inflation every year. As “employer”, you may contribute up to 25% of compensation. The combined total of your contributions is capped at $66,000 in 2023. Both contributions as “employer” and as “employee” are tax deductible.
The solo 401(k) option offers similar features as other self-employed retirement savings plans such as the SEP IRA; however, unlike an SEP IRA, a solo 401(k) allows “employee” elective deferrals and catch-up contributions. Thus, owners of a solo 401(k) may be able to contribute more than they could in a SEP IRA given the same income level. In addition, some individual 401(k) plans allow you to take a loan against the account.
The biggest drawback of a solo 401(k) is the process of getting it started. You must file with the IRS to receive an employer number and there will be some paperwork to complete in order to set up the plan. Another drawback is your inability to hire employees, as doing so would disqualify you from participating in these plans.
Whether you are an employee or self-employed, you can establish a Simplified Employee Pension, also known as an SEP IRA. This plan offers business owners another simplified process to contribute toward their employees’ retirement, as well as their own retirement savings. Depending on your type of business, this might be the route you go if there are good and bad times throughout your business year, since the annual contribution amounts can be adjusted year to year. An SEP IRA account is very similar to a traditional IRA and follows the same investment, distribution, and rollover rules as traditional IRAs.
One benefit to an SEP IRA is that this plan is available to any size business and is not limited to a company with a certain number of employees. An SEP also does not have startup costs or operating costs, nor is there a filing requirement for the employer, which makes it an affordable and effortless option for business owners. As stated above, the annual contributions are flexible, which is useful if cash flow within your business is an issue.
The downsides to SEP IRAs are that elective salary deferrals and catch-up contributions are not allowed in this type of plan, unlike the traditional IRA and solo 401(k) plans. As an employer, you must also make a proportional contribution for all qualified employees who are sponsored on your plan. Finally, employers are the only ones allowed to make contributions to the SEP IRA and they may contribute up to a maximum of the lesser of 25% of the employee’s compensation, or $66,000 (under 2023 law). If you are self-employed, you would act as the employer and make contributions to your account in the same fashion that the business employer would for their employees.
A SIMPLE (Savings Incentive Match Plan for Employees) IRA is a specific IRA geared towards companies with 100 employees or less. It is very easy to create a SIMPLE IRA compared to other retirement savings vehicles. SIMPLE IRAs also do not have start-up or operating costs.
Benefits include a higher contribution limit compared to a traditional IRA, easy maintenance, and accessible rollover of the SIMPLE IRA. The employee contribution is $15,500 (under 2023 law), while employees over the age of 50 could be permitted to include a $3,500 catch-up. Another pro of the SIMPLE IRA is that it is exclusive to smaller companies. This vehicle makes saving for retirement easy and accessible. As an employee, you would be happy to have this plan used since your employer is required to match a percentage of the money you put in each year. You have the option to make contributions but are not required to (although you should!). Additionally, after the initial two-year period, you can make tax-free rollovers from SIMPLE IRAs to other types of IRAs (if it is not a Roth IRA).
Downsides to a SIMPLE IRA include lower contribution limits than other company retirement vehicles and a larger early withdrawal penalty of 25% (as compared to 10% for a Traditional IRA) if withdrawn within the first two years of participation.
Defined Benefit Plan
A defined benefit plan is a pension plan for the self-employed. This retirement plan option offers a fixed annual benefit amount during retirement, usually based on how much you made and how long you worked. Contributions and distributions to a defined benefit plan are determined on an actuarial basis. You would need to work with an enrolled actuary to determine your annual retirement benefit. Once that is determined, the actuary will calculate your maximum annual contribution based on factors such as how much you earn, your age, and the expected return on investment.
Defined benefit plans can be very complicated and costly to establish and maintain. You must commit to funding the minimum contribution amount each year and must ensure you do not over-contribute to avoid potential taxes or fines. Another downside to a defined benefit plan is having to offer every employee the same benefit no matter if you have two employees or 50 employees. This can be very pricey since you must fund every employee with the same benefit.
However, if you have the resources, they can offer significant advantages in your retirement planning. The only limit applied to defined benefit plans is that the maximum annual retirement benefit cannot exceed $265,000 (under 2023 law). Aside from that, defined benefit plans offer vast opportunities to put away money for retirement. Your contributions are tax deductible as a business expense and will grow, tax-deferred, until you receive them in retirement. As a holder of a defined benefit plan, you may also hold other retirement accounts to maximize your savings even more. If you are a high income earning self-employed individual looking to maximize retirement income and you don’t necessarily need the money presently, a defined benefit plan may be the right option for you.
As you can see, there are many methods for a self-employed individual to save for retirement, and many factors to consider when deciding which is best for your unique circumstances. If you would like any further information or would like to discuss any of these strategies in greater detail, please do not hesitate to reach out to your Wealthspire advisor.
For more on Roth IRAs, see our blogs: Pre-tax or Roth 401(k) Contributions—That is the Question, Converting to a Roth IRA: When Does it Make Sense and What are the Benefits?
For more on saving for retirement, see our blogs: How Much Do You Need For Retirement?, Common Retirement Mistakes to Avoid, SECURE Act: Changes May Be Coming Soon to Retirement Savings