Retirement Planning for the Self-Employed

January 23, 2017 — 12:54 PM EST

The joys of self-employment are many. You set the focus of your business, the dress code is up to you, the only upper-management breathing down your neck is your own conscience and, most of all, you're independent and responsible for the course of your financial well-being.

With the joys, however, come the stresses. High among those are financial unpredictability and the need to plan for retirement entirely on your own. You're in charge of creating a satisfying quality of life post retirement. And when it comes to building that life, the earlier you start, the better.

America’s Self-Employed Are Endangering Their Retirement

According to a survey by TD Ameritrade, there are currently more than 10 million self-employed Americans, a 14% increase since 2001. While the spirit of entrepreneurialism is to be applauded, less laudable is the fact that a substantial 40% of self-employed workers save for retirement only sporadically; by contrast, just 12% of traditionally employed workers are sporadic savers. Scarier still, 28% of the self-employed, versus 10% of traditionally employed workers, say they aren’t saving for retirement at all.

The reasons given for not saving towards retirement won’t be a surprise to anyone who is self-employed. The most common include:

  • Lack of steady income
  • Paying off major debt
  • Healthcare expenses
  • Education expenses
  • Business costs

Still, when your future is your own, you need to make the investment in yourself, even if it means living more frugally while you’re still working. (See our tutorial: Budgeting Basics.)

“Self-employed individuals, just like anybody else, need to save for retirement. By not saving enough of their income, they are susceptible to the same problems that employees face in terms of not being prepared for retirement. The same rules apply,” says Mark Hebner, founder and president of Index Fund Advisors, Inc., in Irvine, Calif., and author of “Index Funds: The 12-Step Recovery Program for Active Investors.”

To get started, you'll need to understand the various retirement plans best suited to the self-employed.

Retirement Savings Options for Self-Employed Workers

There are three retirement savings options favored by the self-employed. They are:

With all three, your contributions are tax-deductible, and you won’t pay taxes as they grow over the years (until you cash out at retirement).

Solo 401(k): Also called an independent 401(k), one-participant 401(k) or individual 401(k), this plan is similar to a traditional 401(k), but is reserved for sole proprietors with no employees, other than a spouse working for the business. With a solo 401(k), you get to contribute as both the employee and the employer, giving you a higher limit than many other saving plans.

“Generally, 401(k)s are complex plans, with significant accounting, administration and filing requirements,” says James B. Twining, CFP®, founder and wealth manager of Financial Plan, Inc., Bellingham, Wash. “However, a solo 401(k) is quite simple. Until the assets exceed $250,000, there is no filing required at all. Yet a solo 401(k) has all the major tax advantages of a multiple-participant 401(k) plan: The before-tax contribution limits and tax treatment are identical.”

As the employee, you can sock away up to $18,000 or $24,000 if you are over 50. As the employer, you can add an additional 25% of your net income, to a maximum of $54,000 as of 2017 – $60,000 if you’re 50 or older. To avoid penalties, you’ll need to leave your savings in the account until you are 59½, although there are exceptions, including:

  • Purchasing your first home
  • Disability
  • Education expenses

SEP IRA: Standing for Simplified Employee Pension, a SEP IRA is easy to establish and operate. You can open one at just about any bank or brokerage firm. Suitable for both individual entrepreneurs and businesses with employees, you can contribute up to 25% of each employee’s income, to a maximum of $54,000 for 2017. “You can contribute more to a SEP IRA than a solo 401(k), excluding the profit sharing, but you must make enough money since it’s based on the percentage of profits,” says Joseph Anderson, CFP®, president of Pure Financial Advisors, Inc., based in San Diego, Calif.

In a SEP IRA, the employer contributes to the fund, not the employees. So although you do not have to contribute to the plan each year, when you do contribute, you will need to contribute for all of your eligible employees. This makes the plan most desirable for one-person businesses. Remember that you will be hit with a 10% fine, along with taxes, if you withdraw money from your SEP IRA before you are 59½ years old.

SIMPLE IRA: Savings Incentive Match Plan for Employees (SIMPLE) IRAs are similar to SEP IRAs, but with the SIMPLE, employees can contribute along with employers. As the employer, however, you are required to contribute dollar-for-dollar up to 3% of each eligible employee’s income to the plan each year that the employee contributes to the fund; and 2% of the eligible employee’s income if he/she does not contribute that year.

While a SIMPLE IRA is easy to establish and operate, the limit of $12,500 ($15,500 if you are over 50) annual contribution, plus the requirement to match employee’s contributions, makes a SIMPLE IRA best for those with no employees and an annual income of less than $45,000. There is a 10% penalty for withdrawals if you are under age 59½.

It's important to note that you are allowed to participate in more than one of the available retirement savings options for self-employed individuals, though the contribution limit means you can't triple your contribution limit by participating in all three. The limit of the amount of annual compensation you can take into account for determining how much you can contribute to retirement plans is $270,000 in 2017 ($265,000 in 2016). The IRS rules for this are complicated; check with a tax accountant before making contributions as there are penalties for contributing more than permitted.

The Bottom Line

While running your own business provides many benefits, including the freedom to make your own decisions, follow your own course and establish your personal financial priorities, it also means that you are on your own when it comes to saving for retirement. Though many self-employed Americans report saving little to no money for retirement, you can avoid this costly financial mistake. If you start saving as early as possible, understand the common savings plans available to self-employed workers, and choose the one best suited to your needs, you’ll be on your way to a happy, well-funded retirement. (For more, check out Delay in Retirement Savings Costs More in the Long Run.)