5 Retirement Options When You’re Self-Employed

If you’re self-employed, a freelancer, or work part time, investing for retirement can seem challenging. A Money Girl reader named Shawnna is worried about her future. She says:

“I run a daycare from my home and only make enough to pay bills. I plan to continue my daycare for the next 7 or 8 years until my youngest child is half way through college, when I’ll be in my late 40s. Will that be too late to start saving for retirement—and what’s the best way to invest when you’re self-employed?”

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Just because Shawnna doesn’t have a traditional day job with a 401k doesn’t mean that she doesn’t have great options to save for the future.

In this post, I’ll cover five of the best retirement accounts to consider when you’re self-employed. Using them could make the difference between having a comfortable, happy lifestyle in retirement—or just scraping by.

Free Resource: Laura’s Recommended Tools—over 40 of the best ways to earn more, save more, and accomplish more with your money!

What Is a Retirement Account?

If you’re a regular Money Girl reader or podcast listener, you know that I love retirement accounts. I recommend them because they come with fantastic tax breaks that save huge amounts of money. But they’re all a little different, so I want to make you comfortable with the basics of some of the most popular types.

A common mistake that many people make is thinking that a retirement account itself is an investment. That’s not the case. It’s a special financial “bucket” where you hold investments or cash that get special tax treatment.

Once you contribute money to a retirement account you might choose to invest it in vehicles like stocks, bonds, mutual funds, or exchange-traded funds. Or you can even keep it in a money market fund or certificate of deposit (CD) within a retirement account.

Some of the most common retirement account rules include having to pay a 10% penalty if you take early withdrawals before reaching age 59½ and limits on the amount you can contribute each year.

Depending on your work and financial situation, you may qualify for several different types of retirement accounts all at once. The more accounts you contribute to, the bigger the nest egg you can accumulate for retirement.

Free Resource: Retirement Account Comparison Chart – handy one-page PDF download showing retirement account rules and best places to get them!

Here are five types of retirement accounts you should be familiar with when you work for yourself or don’t have a retirement plan at work:

Account #1: Traditional IRA

An IRA is short for Individual Retirement Arrangement, which means it’s a plan for individuals only. You can’t own it with another person, not even a spouse. You manage every aspect of an IRA, such as opening the account, sending contributions, and deciding how to allocate your money.

With any type of “traditional” retirement account, your contributions are tax-deductible. For instance, if you earn $50,000 and contribute $5,000 to a traditional IRA, you’re taxed on $45,000 of income only—not on $50,000.

Plus, all investment gains in a traditional IRA are never taxed until you take a distribution. On the other hand, investment gains in a regular, taxable brokerage account get taxed every year.

Who can use it: Anyone with earned income under the age of 70½, including the self-employed and minors who have jobs. Even non-working spouses who file taxes jointly with a working spouse qualify for a spousal traditional IRA.

Pro: A traditional IRA allows you to save for retirement and cut your taxes in the current year.

Con: If you (or a spouse) also participate in a workplace retirement plan—like a 401k or 403b—some or all of your contributions to a traditional IRA may not be tax deductible. Another negative is that it has a low annual contribution limit compared to other retirement options for the self-employed.

2015 Maximum Contribution: You can contribute up to $5,500, or $6,500 if you’re age 50 or older, to an IRA, as long as you have that much earned income.

See also: 10 IRA Facts Everyone Should Know

Account #2: Roth IRA

A Roth IRA is subject to all of the major rules that apply to a traditional IRA—except when it comes to taxes and withdrawals. Your contributions to a Roth IRA are taxed up front, but your withdrawals during retirement are completely tax free.

And speaking of withdrawals, you don’t have to take any money out of a Roth IRA as long as you live. With a traditional IRA, on the other hand, you’re required to start drawing down the account after you reach age 70½.

Additionally, you can withdraw contributions to a Roth IRA before retirement without triggering tax or penalties. However, this doesn’t apply to earnings in the account, which would be subject to tax and the 10% early withdrawal penalty if you’re younger than age 59½.

Who can use it: Anyone with earned income, including the self-employed and non-working spouses, qualifies for a Roth IRA.

Pro: A Roth IRA allows you to save for retirement and avoid paying tax on decades of earnings and growth in the account. You get the full tax benefit even if you (or a spouse) participate in a retirement plan at work.

Con: A Roth IRA has contribution limits based on your income and tax filing status. If you make over a certain amount, you may not qualify to contribute. However, in 5 Steps to Create a Backdoor IRA, I explain how you may still be able to convert money into a Roth IRA even if you do earn more than the limit.

2015 Maximum Contribution: You can contribute up to $5,500, or $6,500 if you’re age 50 or older. This is the total limit for all IRAs. For example, you could contribute $2,000 to a traditional IRA and $3,500 to a Roth IRA in the same year, but not $5,500 to both IRAs.

See also: 7 Pros and Cons of Investing in a Retirement Plan at Work

Account #3: Solo 401k

While you’ve probably heard of a 401k plan offered by big companies, you might not know that you can also have one when you work for yourself.  They go by different names, such as a solo 401k, an individual 401k, or a one-participant 401k. You can have a traditional or a Roth solo 401k.

As both the employer and the employee in your business, you can make both kinds of contributions to a solo account. That allows to you contribute more with a solo 401k than any other type of retirement account.

Who can use it: Anyone who is self-employed with no employees other than a spouse.

Pro: Since a solo 401k offers high contributions limits, it’s perfect when you have high self-employment income. Unlike a Roth IRA that imposes income limits, you can contribute to a Roth solo 401k no matter how much you earn.

Con: The only downside to a solo 401k is that if your long-term business plan is to hire additional staff, you’d have to complete IRS paperwork to convert it into a regular 401k.

2015 Maximum Contribution: On the employee side of a solo 401k, you can contribute as much as 100% of your salary up to $18,000 or up to $24,000 if you’re 50 or older.

As the employer, you can contribute up to 25% of your net earnings, as long as your total contributions (including your salary deferrals) don’t exceed $53,000, or $59,000 if you’re age 50 or older.

Be aware that if your business is a side-hustle—like doing freelance writing or weekend photography—and you also participate in a 401k at a second company, the total employee contribution you can make to both plans is $18,000 or $24,000 if you’re age 50 or older.

You can also have a solo 401k in addition to a traditional IRA or a Roth IRA. However, depending on your income and tax filing status some or all of your contributions to a traditional IRA may not be tax deductible. 

See also: Should You Contribute to Both a 401k and an IRA?

One of the easiest and least expensive retirement plans to administer is the SEP-IRA, which stands for Simplified Employee Pension. It’s an option for any size business or those who are self-employed with no employees.

Account #4: SEP-IRA

But what if you’re a small business with employees? One of the easiest and least expensive retirement plans to administer is the SEP-IRA, which stands for Simplified Employee Pension. It’s an option for any size business or those who are self-employed with no employees.

With a SEP-IRA, contributions can only come from an employer. Employees can never contribute their own money.

So, as the business owner, you choose the amount to contribute each year. However, you must give all employees the same percentage.

For example, let’s say you have a small web design business with one employee named Jack. If you choose to contribute 15% of your pay to your own SEP-IRA, you’d also have to contribute 15% of Jack’s pay to his SEP-IRA.

But if you have a bad year with little profit, you can choose not to make any contributions. Employees are always vested in their SEP-IRA account, which means if Jack leaves your employment, he can take his retirement money with him.

Just like with a traditional IRA, when you take money out of a SEP-IRA before age 59½, you’re subject to income tax plus an additional 10% early withdrawal penalty.

Who can use it: Anyone who is self-employed without or with employees, no matter if you’re set up as a sole proprietor, partnership, or a corporation.

Pro: The major advantage of a SEP-IRA is the flexibility to make contributions in years when your business cash flow allows it, and to opt out when money is tight.

Con: The main downside to a SEP-IRA is that you must contribute an equal percentage of income to all employees. Also, there isn’t a Roth option or a “catch-up” provision that allows you to contribute more when you’re over age 50.

2015 Maximum Contribution: You can make SEP-IRA contributions for each of your employees (including yourself) up to 25% of each employee’s compensation for a maximum amount of $53,000.

You can also have a SEP-IRA in addition to other retirement accounts, such as a traditional IRA or Roth IRA. You can even have a 401k or 403b with another employer. However, the total amount you can contribute to an employer plan plus your SEP-IRA is limited to 100% of your compensation up to $53,000.

Account #5: SIMPLE IRA

A SIMPLE IRA is another retirement account option for any size business. It’s an acronym for Savings Incentive Match Plan for Employees.

Unlike with a SEP-IRA, employees can put their own money in a SIMPLE IRA through payroll deductions. In addition, the employer must contribute to their workers’ accounts each year as either matching funds or as nonelective contributions.

Here’s how the matching option works: The employer must match what the employee contributes on a dollar-for-dollar basis up to 3% of their compensation.

The nonelective option means that the employer has to pay up regardless of whether the employee contributes any of his or her own money. The employer is required to give the employee 2% of their compensation up to a limit each year.

For instance, if you make $50,000, the employer would be obligated to kick in 2% or $1,000 ($50,000 x 2%), regardless of the amount you contributed. Again, the employer gets to choose between these 2 options—they never have to pay both matching and nonelective contributions.

You’re always 100% vested in (or have full ownership of) all the contributions you and an employer make to a SIMPLE—and you can stop making contributions at any time during the year.

Who can use it: Anyone who is self-employed without employees or with fewer than 100 employees, no matter if you’re set up as a sole proprietor, partnership, or a corporation.

Pro: The major advantage of a SIMPLE IRA is that it’s generally easier to administer than a regular 401k.

Con: The major drawback to a SIMPLE IRA is that if you do have employees, you’re generally required to contribute to their accounts. Also the contributions limits aren’t as high as other retirement options for the self-employed.

2015 Maximum Contribution: A SIMPLE IRA is funded by both employee and employer contributions. As an employee, you can contribute $12,500, or $15,500 if you’re age 50 or older. And as I mentioned, from the employer side, you must choose to make contributions as either a flat 2% of compensation or up to a 3% matching contribution.

If you use a SIMPLE IRA for your business you can also contribute to a traditional IRA or a Roth IRA, or to a retirement plan at another company.

The retirement plans that I’ve covered are the most common, but this isn’t a complete list. Check out IRS Publication 590, Individual Retirement Arrangements and Publication 560, Retirement Plans for Small Business to explore options for your business endeavors.

If you’re like Shawnna and are having trouble saving for retirement because your business is just getting started or has irregular income, it’s still important to get in the habit of saving as early as possible. Open up one of the retirement accounts I covered here and begin setting aside even a small amount on a regular basis.

While it’s never too late to begin investing for retirement, you’ll thank yourself later on if you get a head start now!

If you need help setting up a retirement plan or aren’t sure how to use multiple retirement plans properly, be sure to contact a qualified tax accountant. Paying a professional to help you maximize tax benefits for your business and retirement accounts will pay off.

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