Retirement Plans for the Self-Employed
When you work for a company with a retirement plan as part of its benefit package, your options are pretty clear – largely because you have someone who can walk you through getting the account set up and scheduling contributions. You also have a regular income stream that doesn't wildly fluctuate.
If you’re self-employed, you have many of the same options, but according to a new study by Small Business Majority, a small business advocacy group, 40% of the self-employed population doesn't have a retirement account like an IRA or 401(k). When asked why, 38% said that they don't make enough and another 31% said they don't get paid regularly enough to set aside money.
But that could cause financial trouble later in life. Even the self-employed must find a way to save for retirement in part because they don't have an employer matching contributions like so many others do for their employee 401(k).
Even if you've already started putting money aside, take time to review your options as a self-employed worker and see if you could be saving more or in a more advantageous way. The advice below will give you guidelines, but be sure to get advice from a financial planner before you choose the route to take.
Simplified Employee Pension (SEP)
A SEP plan is similar to an IRA but with higher maximum contributions. You can contribute the lesser of 25% of your annual income or a maximum amount set by the IRS ($54,000 in 2017). However, your exact contribution limit may be lower. Use the worksheet in Chapter 5 of IRS Publication 560 to calculate your annual maximum.
Setting up the plan is simple. Find a financial institution that offers SEP plans, complete its paperwork or IRS form 5305-SEP, which outlines your rights and benefits under the plan. Decide how much you would like to contribute and set up a monthly system of withdrawing a set amount from your income.
A SEP plan normally has no IRS filing requirements and low administrative costs. In other words, once you're set up you won’t need a benefits expert to navigate all of the rules and policies. For more, see Investopedia's SEP tutorial.
There may be other pension options available to you. Talk to a financial adviser specializing in self-employed individuals for more information.
One-Participant 401(k) Plan
This 401(k) plan functions exactly like a 401(k) plan you would receive if you were covered under an employer’s defined contribution plan with a key exception: If you were covered by an employer, you would make contributions as a pre-tax payroll deduction from your paycheck and your employer would have the option of matching those contributions up to certain amounts.
With a One-Participant 401(k) plan, you have the advantage of being the employee and the employer. This allows you to contribute more than you could if you were under an employer’s plan.
Like the SEP Plan, use the table in IRS Publication 560 to calculate your contribution limit. And read Independent 401(K): A Top Retirement Vehicle for Sole Proprietors. Note that there are a variety of terms for this plan: A One-Participant 401(k) – the IRS term – is also sometimes called a Solo 401(k), Solo-k, Uni-k or Independent 401(k).
Savings Incentive Match Plan for Employees (SIMPLE IRA)
Just as the name says, the SIMPLE IRA is designed to be an easy, hassle-free way to save for retirement. The plan follows the same investment, rollover and distribution rules as a traditional IRA except for the contribution limits. According to the IRS, "You can put all your net earnings from self-employment in the plan: up to $12,500 in 2017, plus an additional $3,000 if you're 50 or older, plus either a 2% fixed contribution or a 3% matching contribution."
The table in IRS Publication 560 is also the way to calculate your contribution limit.
What if you could earmark a percentage of the company's income to employees' retirement plans, including your own? That's how profit sharing works. Instead of basing contributions on a percentage of income or other calculation, you could base it on company earnings. If you have employees, this provides incentive to go the extra mile and feel like a part of the company rather than simply an employee. Even better, you can still have other retirement plans as part of the package if you would like.
Profit-sharing plans still have to be set up through a financial institution. The contribution limit is the "lesser of 25% of [the employee's] compensation or $54,000 for 2017, subject to cost-of-living adjustments for later years)," according to the IRS. Profit-sharing plans may come with higher fees and costs than other retirement plans, but profit sharing can work well for companies with limited cash flow. For more information, visit the IRS website.
Money Purchase Plan (MPP)
An MPP is similar to profit sharing where the employer contributes money to an employee's savings plan. The amount is often based on the employee's contribution – much like a 401(k). But unlike a profit-sharing plan that doesn't require annual contributions, an employer must fund the MPP annually, as laid out in the employee agreement, regardless of the company's performance. As with profit sharing, the contribution limit is the "lesser of 25% of compensation or $54,000 for 2017, subject to cost-of-living adjustments)," according to the IRS.
As in other retirement vehicles, deposited money grows tax deferred. In the past, MPPs had a higher deductible limit than profit-sharing plans, but that is no longer the case. Read more about MPPs here.
The Bottom Line
If you’re self-employed, you’re busy – crazy busy, probably – but retirement saving has to be a priority for at least two reasons. First: Social Security will not be your primary source of retirement income. It wasn’t designed for that role.
Second, funding your retirement account is part of your company expenses just as it is at companies of all sizes. You have to work that expense into your pricing structure.
Start today. Make an appointment with a financial planner to put together a plan. The differences among these choices – and their tax ramifications – are complex.
Unless you are an accountant or planner yourself, this should not be a DIY decision; one of these plans could be considerably better suited to your resources and your income cycle. It's your future you're talking about and you need the best possible advice to shape it to fit you. Once you know what you need, making the payments should be straightforward.