There are plenty of benefits to self-employment – you can create your own schedule, maintain creative control over your work, and pursue your passion more efficiently. However, a disadvantage is that you do not have a pension plan from the employer to ensure your financial future.
According to the US Census Bureau, 49% of Americans aged 55-65 are financially unprepared for retirement. Women, in particular, account for most people without a 50% retirement savings.
As a self-employed person, you must set aside sufficient money for your future pension. Fortunately, there are options to help you achieve adequate savings even without a traditional 9-to-5 career.
Why should you save for your retirement?
We can get used to a certain lifestyle during our working life. In addition to providing a roof over our heads, our income allows us to enjoy the simple pleasures of life, such as dining out, entertainment, travel, gift giving, shopping and more. When we retire, many of us only have the savings in our bank accounts and our Social Security benefits. For many people who choose not to contribute to a retirement plan, living their golden years requires significant sacrifices and the potential for financial hardship.
You can make up excuses for not investing in your future after retirement, but there are plenty of reasons why you should reconsider your stance, such as the following:
- Social security benefits are often not enough to maintain your current lifestyle.
- You don’t want to burden your children with your financial problems.
- A retirement plan gives you access to a tax-deferred retirement account that lowers your taxes.
- By investing in your retirement account, you can enjoy your non-working years more comfortably and with fewer worries.
For self-employed people who think their Social Security benefits will help them make ends meet after retirement, the Social Security Administration (SSA) is begging to be different.
The SSA states that Social Security benefits only amount to: 40% of your highest income in 35 years at retirement age. In addition, financial advisors agree that you probably need about 70% of pre-retirement income — including Social Security, personal savings, investments and other retirement accounts — to live comfortably without income.
4 Retirement options for the self-employed
Saving for retirement is critical, especially if you’re self-employed. Sole proprietors have plenty of options, but these four savings plans are the most common.
Company employees may have the option to participate in a 401(k) retirement plan. Self-employed can still contribute to a 401(k) – it’s only for one participant, though.
A one-participant 401(k) works the same way as a workplace retirement plan, meaning you pay pre-tax contributions that are taxed when you start withdrawing from 59 1/2. Some people may refer to these 401(k) plans as individual 401(k), solo 401(k), uni-401(k), or standalone 401(k).
Contributing to a solo 401(k) is possible regardless of age or income. From 2022, private individuals can contribute up to $61,000while anyone over 50 can add a $6,500 contribution to catch ups.
Self-employed individuals may consider the following benefits of opening a 401(k) account for a single participant:
- Some contributors can save more than with other retirement plans.
- You can contribute 100% of your net adjusted self-employed income — up to the maximum — for the year as an employee or 25% of the wage as a self-employed person as an employer.
- You can borrow up to 50% of your 401(k) on a loan, but you must repay the amount in five years.
- A Roth solo 401(k) is also possible for tax-free retirement withdrawals.
The time you start recording your solo 401(k) determines how much taxes or fines you will receive. The Internal Revenue Service (IRS) requires you to start distributions received at age 72whether you are retired or not.
Meanwhile, the IRS can tax up to 10% on early distributions unless it meets a qualifying exemption, such as a disability, medical deduction, or if it goes to a beneficiary after a death.
Traditional and Roth Individual Retirement Accounts (IRAs) are excellent savings plans to consider contributing if you are self-employed. However, their eligibility, tax and distribution rules differ.
A traditional IRA is independent of a workplace retirement plan and tax-deferred, meaning you won’t be taxed on your contributions until you start withdrawing money from your account at federal retirement age. Like a 401(k), you have to make your first withdrawal no later than 72 years – however, you can continue to contribute until your 70th birthday.
To qualify for tax deductions on contributions to your traditional IRA, you must meet specific criteria regarding your income, filing status, and whether you are covered by a workplace retirement plan. For example the maximum tax deduction for self-employed filers in 2022 are as follows:
- Single filers without pension coverage in the workplace: Eligible for a maximum tax deduction of $6,000 on any adjusted adjusted gross income (AGI) or $7,000 if you are over age 50
- Joint Filers Without Workplace Retirement Coverage: Eligible for a maximum tax deduction of $6,000 on any modified AGI or $7,000 if you are over 50
- Joint filers without a workplace retirement plan whose spouse has coverage: Eligible for $6,000 if combined income is $204,000 or less.
Filers earning between $204,000 and $214,000 may qualify for a reduced tax deduction on their traditional IRA. Otherwise, income over $214,000 is ineligible.
Unlike traditional IRAs, contributions to Roth IRA accounts are pre-taxed and accrue tax-free the longer the money is in the account. You will also receive tax-free benefits when you reach retirement age. However, if you withdraw money before you turn 59, the withdrawal may be subject to fees and other penalties.
Another crucial difference between traditional and Roth IRAs is that you can contribute to the latter all your life without taking out money if you don’t want to.
Depending on your annual salary, you may or may not be able to use a Roth IRA for retirement planning. From 2021, joint applicants can contribute up to $6,000 annually unless they have an adjusted AGI of $208,000. Likewise, single filers cannot contribute if they have a modified AGI of $140,000 or higher.
A Roth IRA allows you to invest in assets that can benefit you in your retirement years. For example, some account holders use their IRA accounts to deposit money into rental properties. Of course, there are several restrictions on what you can do with an IRA-owned rental unit.
Prohibited transactions — doing business with disqualified individuals, using the property as a personal retreat, or doing maintenance and repairs yourself — have serious financial consequences.
The property may also be subject to income taxes, such as unrelated corporate income tax (UBIT) for: cases conducted within the IRA or unrelated debt-financed income (UDFI) when you use leverage to take out a loan for the purchase of real estate. You also risk terminating your Roth IRA account, at which point the IRS may penalize you.
Simplified Employee Pension (SEP) IRA
Self-employed or business owners may want to open a SEP IRA, in which investments are tax-deductible until retirement. At that point, income tax will apply to any withdrawals.
A SEP IRA is ideal for business owners with only a few employees, as the IRS requires employers to: contribute an equal percentage of their compensation on behalf of their employees. For example, if you plan to invest 15% of your compensation, you must contribute 15% of your employee’s compensation to their plan.
If you supervise employees, the IRS requires all participants to be 21 years of age or older, have worked for you for three of the past five years, and have earned at least $650 from you by 2021.
Since an employer is the only person contributing to a SEP IRA, those who do business for themselves may like the flexibility and ease of managing this particular retirement savings plan.
The contribution limits of a SEP IRA are much higher than traditional and Roth IRAs. In 2022, sole proprietorships contribute up to $61,000 up to a SEP IRA or no more than 25% of their income.
An Employee Savings Incentive Match Plan (SIMPLE) IRA is another retirement option for the self-employed, but it may be more beneficial for small business owners.
Like a traditional IRA, SIMPLE account holders contribute to pre-tax income and pay taxes only upon withdrawal at retirement age.
the 2022 individual contribution limit is $14,000 for SIMPLE IRAs – in comparison, a 401(k) allows a maximum contribution of $20,000, while Traditional and Roth IRAs limit you to $6,000. You can also catch up if you are over 50.
Entrepreneurs must employ fewer than 100 employees to qualify. In addition, owners and sole proprietors may not: contributed to other pension plans in the past calendar year.
SIMPLE IRAs are easy to set up, but remember that other retirement plans have much higher contribution limits that you can meet.
No better time to save for your retirement than now
Being in control of your career and time is great, but securing your financial future by creating a retirement plan is critical. If you are not currently saving, start now. The more you contribute to your golden years, the more comfortable you will be.