The joys of self-employment are many, but so are the stressors. High among those is the need to plan for retirement entirely on your own. You are in charge of creating a satisfying quality of life post-retirement. When it comes to building that life, the earlier you start, the better. Luckily, there are several retirement plans for those who are self-employed.

Key Takeaways

  • For self-employed workers, setting up a retirement plan is a do-it-yourself job.
  • There are four available plans tailored for the self-employed: one-participant 401(k), SEP IRA, SIMPLE IRA, and Keogh plan.
  • Health savings plans (HSAs) and traditional and Roth IRAs are two more supplemental options.

Growth in Self-Employment

A 2019 study conducted by the Freelancers Union and Upwork estimates that there are 57 million freelancers in the U.S., an increase from 53 million reported in 2014. According to the report, this represents more than 35% of the country's entire workforce.

While this entrepreneurial spirit is to be applauded, less laudable is the fact that 30% of those who are self-employed save for retirement sporadically while 15% aren’t even saving at all. That is a problem. If you are self-employed, you are busy but retirement savings must be a priority.

Why Saving Is Hard for the Self-Employed

The reasons for not saving toward retirement won’t be a surprise to any self-employed person. The most common include:

  • Lack of steady income
  • Paying off major debts
  • Health care expenses
  • Education expenses
  • Costs of running the business

Setting up a retirement plan is a do-it-yourself job, just like everything else an entrepreneur undertakes. No human resources (HR) staffer is going to walk you through the company-sponsored 401(k) plan application. There are no matching contributions, no shares of company stock, and no automatic payroll deductions.

You’ll have to be highly disciplined in contributing to the plan and, because the amount you can put in your retirement accounts depends on how much you earn, you won’t know until the end of the year how much you can contribute.

Still, if freelancers have unique challenges when saving for retirement, they have unique opportunities, too. Funding your retirement account can be considered part of your business expenses, as is any time or money you spend on establishing and administering the plan. Even more important, a retirement account allows you to make pretax contributions, which lowers your taxable income.

Many retirement plans for the self-employed allow you, as a business owner, to contribute more money annually than you could to an individual IRA.

Self-Employed Retirement Saving Plans

There are four retirement savings options favored by the self-employed. Some are single-player 401(k) plans, while others are based on individual retirement accounts (IRAs). They are:

  • One-participant 401(k)
  • SEP IRA
  • SIMPLE IRA
  • Keogh plan

With all four of these options, your contributions are tax-deductible, and you won’t pay taxes as they grow over the years (until you cash out at retirement). Their complexity and suitability vary, depending on the size of your business, both in terms of personnel and earnings. Let’s look at each in more depth.

To avoid penalties with any of these plans, you’ll need to leave your savings in the account until you are 59½ although there are certain hardship exemptions.

One-Participant 401(k)

A one-participant 401(k), as it’s officially dubbed by the IRS, also goes by the names solo 401(k), solo-k, uni-k, or individual 401(k). It is reserved for sole proprietors with no employees, other than a spouse working for the business.

How a Solo 401(k) Works

The one-participant plan closely mirrors the 401(k)s offered by many larger companies, down to the amounts you can contribute each year. The big difference is that you get to contribute as the employee and the employer, giving you a higher limit than many other tax-advantaged plans.

So if you participate in a standard corporate 401(k), you would make investments as a pretax payroll deduction from your paycheck, and your employer has the option of matching those contributions up to certain amounts. You get a tax break for your contribution, and the employer gets a tax break for its match. With a one-participant 401(k) plan, you can contribute in each capacity, as an employee (called an elective deferral) and as a business owner (an employee non-elective contribution).

Elective deferrals for 2021 can be up to $19,500, or $26,000 if age 50 or older. Total contributions to the plan cannot exceed $58,000, or $64,000 for people age 50 or older as of 2021. If your spouse works for you, they can also make contributions up to the same amount, and then you can match those. So you see why the solo 401(k) offers the most generous contribution limits of the plans.

Setting Up a Solo 401(k)

Some paperwork is required, but it’s not too onerous. To establish an individual 401(k), a business owner has to work with a financial institution, which may impose fees and limits as to what investments are available in the plan. Some plans may limit you to a fixed list of mutual funds, but a little bit of shopping will turn up many reputable and well-known firms that offer low-cost plans with a great deal of flexibility.

“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. “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.”

SEP IRA

Officially known as a simplified employee pension, a SEP IRA is a variation on a traditional IRA. As the easiest plan to establish and operate, it’s an excellent option for sole proprietors, though it also allows for one or more employees.

How a SEP IRA Works

The employer alone contributes to a SEP IRA—not employees. So, unlike the solo 401(k), you’d only contribute wearing your employer hat. You can contribute up to 25% of your net earnings (defined as your annual profit less than half of your self-employment taxes), up to a maximum of $58,000 in 2021.

The plan also offers flexibility to vary contributions, make them in a lump sum at the end of the year, or skip them altogether. There is no annual funding requirement.

Its simplicity and flexibility make the plan most desirable for one-person businesses, but there’s a catch if you have people working for you. Although you do not have to contribute to the plan each year, when you do contribute, you need to do so for all of your eligible employees—up to 25% of their compensation, limited to $290,000 annually.

While SEP IRAs are simple, they are not necessarily the most effective means of saving for retirement. “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.

Setting Up a SEP IRA

The account is simpler to set up than a solo 401(k). You can easily open a SEP IRA online at brokerages such as TD Ameritrade or Fidelity Investments.

SIMPLE IRA

Officially known as the savings incentive match plan for employees, a SIMPLE IRA is a cross between an IRA and a 401(k) plan. Although available to sole proprietors, it works best for small businesses. Companies with 100 or fewer employees that might find other sorts of plans too expensive.

How A SIMPLE IRA Works

The SIMPLE IRA follows the same investment, rollover, and distribution rules as a traditional or SEP IRA, except for its lower contribution thresholds. You can put all your net earnings from self-employment in the plan, up to a maximum of $13,500 in 2021, plus an additional $3,000 if you are 50 or older.

Employees can contribute along with employers in the same annual amounts. As the employer, however, you are required to contribute dollar for dollar up to 3% of each participating employee's income to the plan each year or a fixed 2% contribution to every eligible employee's income whether they contribute or not.

Like a 401(k) plan, the SIMPLE IRA is funded by tax‑deductible employer contributions and pretax employee contributions. In a way, the employer's obligation is less. That's because employees make contributions even though there is that mandated matching. And the amount you (as the employer) can contribute for yourself is subject to the same contribution limit as the employees.

Early withdrawal penalties are hefty at 25% within the first two years of the plan.

Setting Up a SIMPLE IRA

As with other IRAs, you must open these plans with a financial institution, which have rules as to what kinds of investments can be purchased. They may also charge plan administration and participation fees. The process is similar to a SEP IRA, but the paperwork is more complicated.

Keogh Plan

The Keogh or HR 10 plan (more commonly referred to today as a qualified or profit-sharing plan) is arguably the most complex for self-employed workers. But it also allows for the most potential retirement savings.

How a Keogh Works

Keogh plans usually can take the form of a defined-contribution plan, in which a fixed sum or percentage is contributed every pay period. In 2021, these plans cap total contributions in a year at $58,000. Another option, though, allows them to be structured as defined-benefit plans. In 2021, the maximum annual benefit was set at $230,000 or 100% of the employee’s compensation, whichever is lower.

A business must be unincorporated and set up as a sole proprietorship, limited liability company (LLC), or partnership to use a Keogh plan. Although all contributions are made on a pretax basis, there may be a vesting requirement. These plans benefit high earners, especially the defined-benefit version, which allows greater contributions than any other plan.

Setting Up a Keogh

Keogh Plans have federal filing requirements, which can mean complex paperwork. As a result, it's best to seek professional help from an accountant, investment adviser, or financial institution. Your options for custodians may be more limited than with other retirement plans, which means you'll probably need a brick-and-mortar institution rather than an online-only service. Charles Schwab is one brokerage that offers and services these plans.

A Keogh is best suited for firms with a single high-earning boss or two and several lower-earning employees as in the case of a medical or legal practice.

Health Savings Account (HSA)

As a freelancer, you may have to pay for your health insurance. The deductibles for individual medical plans tend to be high. If that’s your situation, consider opening a health savings account (HSA). Though created for medical expenses rather than retirement years, an HSA can function as a de facto retirement account.

How a Health Savings Account Works

HSAs are funded with pretax dollars, and the money within them grows tax-deferred as with an IRA or a 401(k). While the funds are meant to be withdrawn for out-of-pocket medical costs, they don’t have to be, so you can let them accumulate year after year. Once you reach age 65, you can withdraw them for any reason. If it’s a medical one (either current or to reimburse yourself for old costs), it’s still tax-free. If it’s a non-medical expense, you are taxed at your current rate.

To open an HSA, you have to be covered by a high-deductible health insurance plan (HDHP). For 2021 and 2022, the Internal Revenue Service (IRS) defines a high deductible as $1,400 per individual and $2,800 per family.

Also, the annual out-of-pocket expenses, including deductibles, co-payments, but not premiums, must not exceed $7,000 for self-only coverage or $14,000 for family coverage for 2021, but for 2022, not exceed $7,050 for self-only coverage or $14,100 for family coverage.

The annual contribution limit for 2021 is $3,600 for individuals and $7,200 for families. However, the 2022 contribution limit is $3,650 for individuals and $7,300 for families. People age 55 and older are allowed a $1,000 catch-up contribution.

Traditional or Roth IRA

If none of the above plans seems a good fit, you can start your own individual IRA. Both Roth and traditional individual retirement accounts (IRAs) are available to anyone with employment income, including freelancers. Roth IRAs let you contribute after-tax dollars, while traditional IRAs let you contribute pretax dollars. In 2021, the maximum annual contribution is $6,000, $7,000 if you are age 50 or older, or your total earned income, whichever is less. 

Most freelancers work for someone else before striking out on their own. If you had a retirement plan such as a 401(k), 403(b), or 457(b) with a former employer, the best way to manage the accumulated savings is often to transfer them to a rollover IRA or a one-participant 401(k).

Rolling over allows you to choose how to invest the money rather than being limited by the choices in an employer-sponsored plan. Also, the transferred sum can jump-start you into saving in your new entrepreneurial career.

Managing Your Retirement Funds

It's important to start saving for retirement as soon as you begin earning income, even if you can't afford to save that much at the beginning. The sooner you begin, the more you'll accumulate, thanks to the miracle of compounding.

Let's say you save $40 per month and invest that money at a 3.69% rate of return, which is what the Vanguard Total Bond Market Index Fund earned across a 10-year period ending in December 2020. Using an online savings calculator, an initial amount of $40 plus $40 per month for 30 years adds up to just under $26,500. Raise the rate to 13.66%, the average yield of the Vanguard Total Stock Market Index Fund over the same period, and the number rises to more than $207,000.

As your savings build, you may want to get the help of a financial advisor to determine the best way to apportion your funds. Some companies even offer free or low-cost retirement planning advice to clients. Robo-advisors such as Betterment and Wealthfront provide automated planning and portfolio building as a low-cost alternative to human financial advisors.

The Bottom Line

Creating a retirement strategy is vitally important when you are a freelancer because there’s no one looking out for your retirement but you. That’s why your mantra should be pay yourself first.

Many people think of retirement money as the money they put away if there is any cash left at the end of the month or year. “That’s paying yourself last,” says David Blaylock, CFP, director of financial planning at Kindur. “Paying yourself first means saving before you do anything else. Try and set aside a certain portion of your income the day you get paid before you spend any discretionary money.”