Breaking Down Your Options and the Potential Benefits
In the United States today, more than 30% of the workforce is currently made up of self-employed individuals.1 This number is expected to increase rapidly in the future as more and more people gravitate towards more independence and flexibility in their career model. But what about retirement savings for these individuals? In the corporate world, many large employers or organizations offer and sponsor some type of an employee retirement savings plan, such as a 401(k). From the employee perspective, it’s very easy to enroll and start setting aside money for retirement. Self-employed individuals lack the benefit and luxury of this infrastructure, and they’re instead left to do it on their own. Fortunately, there’s a handful of really good options for self-employed individuals to set up vehicles for their retirement savings. Technology makes it easy to set up and administer an account on an ongoing basis, and there’s also a lot of good tax planning features. So, if you are a self-employed individual – that is, someone that’s working for themselves, earning 1099 income – and you want to set up an account for your retirement savings, you’ve got a few different options.
Traditional or Roth IRA
One, you can always set up and start funding an IRA (Individual Retirement Account). The rules around IRAs are that if you have earned income, you can set one up. They’re very simple to do at just about any custodian out there. The rule is that if you’re under the age of 50, you can save $6,000 a year into an IRA. If you’re over the age of 50, you can set aside an additional $1,000 a year, $7,000 a year total. You simply take that from your earned income and tuck it into the IRA. Depending on what your income tax profile is, you could set this up as a traditional IRA where you put money in on a pre-tax basis, offsetting some of your income. Or, you also may be able to set up a Roth IRA, where you put money in after taxes, but then all of the growth and appreciation going forward does so on a tax-exempt basis. An IRA is an easy option that offers flexibility in terms of the tax nature of the account. Its biggest limitation relative to other types of employer retirement plans is that the contribution amounts are relatively low.
Simplified Employee Pension (SEP-IRA)
The rules around funding a SEP-IRA depend on how you’re set up as a self-employed individual. If you’re a sole proprietor or a single member LLC, which a lot of self-employed individuals are, you can defer up to 20% of your net income into the SEP-IRA. If you’re set up as a C corporation or an S corporation, and you pay yourself a salary or wages, you might be able to defer up to 25% of your net income. You can put up to these percentages of your net income into a SEP-IRA, up to a maximum of $61,000 a year. Depending on what your income is, it’s essentially the lesser of 20% or 25% of your net income up to $61,000 a year. There’s the potential to put significantly more into a SEP-IRA annually compared to a traditional or Roth IRA. One of the downsides of a SEP-IRA, however, is that there’s no Roth component. Everything that you put into a SEP-IRA is treated as a pre-tax contribution from the business itself.
Moving on down the spectrum of contribution limits and complexity, you could also explore what’s becoming really popular – a Solo 401(k) or an Individual 401(k). Most people are very familiar with the concept of a 401(k) – a company-sponsored plan where multiple employees are saving into it. A Solo 401(k) operates nearly identically to that, but it’s simply a 401(k) plan for your business as a self-employed individual. There’s a little bit more work to set up a Solo 401(k) compared to an IRA or a SEP-IRA, and there might be a little bit more expense involved. But, for that additional cost, there’s the ability to set aside even more money into this account. When you’re a self-employed individual, you wear two hats. You’re both the employer and the employee. Because of the dual nature of your role, you can put money into the Solo 401(k) via each of these avenues here. First, the Solo 401(k) allows you as a business owner to put money in as a form of employee salary deferral, similar to how you would if you were working for a large organization. In 2022, you can defer $20,500 of your net income as an employee deferral. If you’re over the age of 50, you can contribute an additional $6,500 for up to $27,000 of your net income. Then, you can put your hat on as the employer and make an additional contribution, similar to how a company might do it on behalf of its employees as a match or profit-sharing. The calculation for that contribution is similar to the SEP-IRA. So you’re going to get that 20% or 25% of net income on top of what you’re already putting in as an employee. Depending on what your income level is, there’s the potential for much greater contribution limits into the Solo 401(k). Now, it’s important to note that the same total contribution limits apply. So that’s $64,000 a year if you’re over the age of 50, and $61,000 a year if you’re under the age of 50. There’s still a cap on the total amount that you can get in. But, at lower income levels, you can put more money into the Solo 401(k). The Solo 401(k) also gives you the option of a Roth component for your employee deferrals.
For example, let’s assume that we have a 45 year-old self-employed individual with a single member LLC, and they’ve earned $100,000 in a given year. With a traditional IRA, very simple, that individual can set aside $6,000 for retirement. Depending on their income tax profile, they can do it pre-tax or maybe an after-tax Roth contribution. With a SEP-IRA, because they’re set up as a single member LLC, the calculation is going to be based on 20% of their net income (including an adjustment for self-employment taxes). The actual calculation is closer to 18.5%. In this case, that individual would be able to save $18,587 of their $100,000 into the SEP-IRA. Compared to the traditional IRA, that’s more than three times as much. All done on a pre-tax basis. With the Solo 401(k), however, the same individual, because they’re 45, could make a $20,500 dollar contribution in the way of an employee salary deferral. And then on top of that, as the employer, they could also contribute the same amount calculated for the SEP-IRA, $18,587. When we add that up, that ends up being $39,087. For the same individual setting up each of these different options, you can see we go from $6,000 to $18,000 to nearly $40,000. At this income profile, the Solo 401(k) offers both the flexibility and ability to put even more money aside for retirement. In the process, they can also use this amount (nearly $40,000) to offset their income that they report on their tax return. There are good features for all these accounts. They are simple and easy to set up, but some have more complexity involved. In exchange for that complexity, you gain the ability to set aside more money for retirement. We always recommend talking to your CPA or tax advisor to evaluate which option is most appropriate for you and confirm the contribution calculations. In sum, just because you’re self-employed doesn’t mean you have to abandon the ability to set aside a lot of money for retirement. And there’s also tax benefits to saving, as well. Creative Planning’s wealth managers help many self-employed clients save for their retirements and understand their overall financial picture. If you have questions about retirement planning, please schedule a call.
Visit www.IRS.gov for more information about taxes and retirement savings account contribution limits.