Self-Employed Retirement Plans

By Calley Bjorkman, CPA | Feb 05, 2024 |

Self-employed individuals typically don’t have access to an employer-sponsored retirement plan, such as a 401(k) — and can be exempt from the tax benefits those plans offer. That’s a tough place to be when you’re looking to seal financial security and vocational freedom You need something specific. You need self-employed retirement plans. 

The self-employed lean on specialized retirement plans, including SEP IRAs, Solo 401(k)s, and SIMPLE IRAs,  to save for retirement and take advantage of potential tax benefits.  

Which self-employed retirement plan is right for me?

Choosing the right retirement plan as a self-employed individual involves considering several key factors that align with your financial goals and business structure.  

Here are some steps to guide your thinking: 

  • Assess your financial situation: Evaluate your income, expenses, and potential for future growth. Consider how much you can contribute to a retirement plan without compromising your business operations. 
  • Understand plan options: Research various retirement plans available for self-employed individuals, such as SEP IRAs, Solo 401(k)s, SIMPLE IRAs, or a traditional IRA. Compare each plan’s contribution limits, tax advantages, and administrative requirements to determine which best suits your needs. 
  • Consider employee considerations: If you plan to hire employees in the future, consider how your chosen retirement plan will accommodate them. Some plans, like SIMPLE IRAs, have specific requirements for offering employee benefits, whereas others, such as Solo 401(k)s, are designed primarily for self-employed individuals without full-time staff. 
  • Evaluate tax implications: Assess the tax benefits associated with each retirement plan option. Consider whether you prioritize tax deductions on contributions, tax-deferred growth, or tax-free withdrawals during retirement. 
  • Review contribution flexibility: Determine how much flexibility you need regarding contributions. Some plans allow for fluctuating contributions based on your business income, while others have more rigid contribution structures. 
  • Seek professional advice: Consult with a financial advisor or tax specialist

Traditional and Roth IRAs

While these IRAs are not designed exclusively for the self-employed, they still offer valuable benefits that can complement the retirement savings strategies of self-employed individuals. 

Traditional IRAs allow for tax-deductible contributions, which can help reduce taxable income in the contribution year. Contributions and earnings grow tax-deferred until withdrawal during retirement, at which point they are taxed as ordinary income. On the other hand, Roth IRAs are funded with after-tax dollars, meaning contributions are not tax-deductible, but qualified withdrawals in retirement are tax-free. 

Self-employed individuals can contribute to these IRAs based on their earned income, which may come from their business activities. However, suppose the self-employed individual has no other employees. In that case, they may also consider other retirement plan options designed specifically for the self-employed, such as SEP IRAs or Solo 401(k)s, which often offer higher contribution limits and additional benefits tailored to their business structure. Understanding traditional and Roth IRAs’ specific features and limitations can help self-employed individuals determine whether these options align with their retirement planning objectives.  

What is a SEP IRA, and how does it work?

A SEP IRA, or Simplified Employee Pension Individual Retirement Account, is a traditional IRA that allows small business owners and self-employed individuals to contribute toward their own and their employees’ retirement savings. SEP IRAs are relatively easy to set up and maintain and permit deductible contributions up to 20% of net business earnings, maxing out at $66,000 for 2023. 

Here’s how a SEP IRA generally works:  

  • Eligibility: Any business owner with one or more employees or anyone with freelance income can establish a SEP IRA. 
  • Contributions: The employer makes contributions to the SEP-IRA on behalf of the employees, including themselves, if they are self-employed. Contributions are made on a discretionary basis, meaning the employer can choose whether or not to contribute each year. The maximum contribution limit is typically higher than that of traditional or Roth IRAs, allowing for potentially larger retirement savings. 
  • Tax Benefits: Contributions made by the employer are tax-deductible. The contributions grow tax-deferred but are taxed as ordinary income at withdrawal during retirement.  
  • Employee Participation: Employees do not contribute to a SEP IRA; only the employer makes contributions. Employees benefit from contributions from their employer without having to contribute their own funds. 
  • Withdrawals: Withdrawals from a SEP IRA are treated as ordinary income and may be subject to an early withdrawal penalty if taken before the age of 59½, similar to traditional IRAs. 

 A SEP IRA, or Simplified Employee Pension Individual Retirement Arrangement, is a type of traditional IRA that allows employers to contribute to retirement savings accounts for themselves and their employees.  

What is a solo 401(k)/individual 401(k), and how does it work?

A solo 401(k), or individual 401(k), is a retirement savings plan designed for self-employed individuals or small business owners without employees other than a spouse. It operates similarly to a traditional 401(k) plan offered by larger companies but with some distinct features. 

Here’s how a solo 401(k) works: 

  • Eligibility: This plan is available to self-employed individuals, such as freelancers, consultants, and small business owners with no full-time employees other than a spouse. 
  • Contributions: The plan allows for both employer and employee contributions. As the employer, you can contribute up to 25% of your compensation (20% if you operate as a sole proprietor or single-member LLC) as an “employer” contribution, in addition to the regular employee deferral contribution. The combined contribution limit for 2023 is $66,000 (or $73,500 if age 50 or older, including catch-up contributions). 
  • Tax Benefits: Contributions to a solo 401(k) are generally tax-deductible, reducing taxable income. The funds within the account grow tax-deferred until withdrawal during retirement, at which point they are taxed as ordinary income. 
  • Investment Options: Solo 401(k) plans typically offer a wide range of investment options, including stocks, bonds, mutual funds, and more, allowing for greater flexibility in building a diversified retirement portfolio. 
  • Withdrawals: Withdrawals from a solo 401(k) are generally subject to ordinary income tax and, if taken before the age of 59½, may also be subject to an early withdrawal penalty.

What is a SIMPLE IRA, and how does it work?

A SIMPLE IRA (Savings Incentive Match Plan for Employees Individual Retirement Account) is a retirement plan for small businesses with 100 or fewer employees. It allows both employers and employees to make contributions toward retirement savings. Here’s how a SIMPLE IRA typically works:  

  • Eligibility: Businesses with up to 100 employees who have received at least $5,000 in compensation in the previous year are eligible to establish a SIMPLE IRA. 
  • Contributions: Employees can make contributions through salary deferrals, and employers must make a matching contribution of up to 3% of the employee’s salary or a non-elective contribution of 2% of each eligible employee’s compensation. In 2023, the maximum employee contribution for a SIMPLE IRA is $15,500, while individuals aged 50 and above are eligible to make an extra catch-up contribution of $3,500. 
  • Tax Benefits: Contributions made by employees are tax-deferred, meaning they are not taxed until withdrawal during retirement. Employer contributions are tax-deductible business expenses. 
  • Withdrawals: Withdrawals from a SIMPLE IRA are taxed as ordinary income and, if taken before the age of 59½, may be subject to an early withdrawal penalty. 

SIMPLE IRA vs. traditional IRA

The SIMPLE IRA and the traditional IRA serve distinct purposes.  

The SIMPLE IRA allows employees and employers to contribute with higher contribution limits and simplified administration. The traditional IRA permits only individual contributions within lower limits and is relatively straightforward to manage.  

Both accounts have penalties for early withdrawals before 59½: withdrawals are taxed as ordinary income.   

SIMPLE IRA vs. 401(k)

A SIMPLE IRA and a 401(k) retirement plan differ in their target user groups and contribution structures.  

The SIMPLE IRA primarily caters to small businesses with 100 or fewer employees, allowing employers and employees to contribute with lower contribution limits and simplified administration. The 401(k) plan is typically offered by larger companies, enabling employees to make pre-tax contributions directly from their salary, often with employer matching contributions, and generally featuring higher contribution limits and more complex administrative requirements. 

What is a defined benefit pension, and how does it work?

A defined benefit pension plan is a type of retirement plan in which an employer promises to pay a specified monthly benefit to employees during their retirement years. This promised benefit is usually based on factors such as the employee’s salary history and the duration of their employment. Here’s how a defined benefit pension plan typically works: 

  • Benefit Calculation: The employer calculates the retirement benefit using a formula that often considers the employee’s salary and years of service. This formula is predetermined and communicated to employees when they join the plan. 
  • Employer Responsibility: The employer bears the investment risk and ensures enough funds to meet the promised benefit obligations. They typically contribute regularly to a pension fund invested to generate returns and fund future pension payments. 
  • Retirement Payouts: Employees who retire receive a monthly pension payment, typically for the rest of their life. The amount is usually predetermined based on the formula and does not depend on investment returns or employee contributions. 
  • Vesting: Employees usually become vested in the plan after a certain number of years of service, which guarantees their right to pension benefits upon retirement, even if they leave the company before retirement age. 

Defined benefit pension plans offer the advantage of providing retirees with a predictable and stable income stream during their retirement years. 

Retirement plans for self-employed individuals offer tax benefits through deductible contributions or tax-free withdrawals, fostering long-term financial security and wealth accumulation. With greater control over investment options, self-employed individuals can align their retirement savings with their risk tolerance and financial objectives. 

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