Striking out on your own professionally can be incredibly liberating. You don’t have a boss to report to or someone dictating what you do. Being self-employed gives you control over your schedule, career, and income. But it also means fully funding benefits an employer would at least partially cover, such as health insurance and retirement.
Planning and saving for retirement get especially challenging for the self-employed. There isn’t someone else to match your contributions to your retirement savings. You also must weigh the pros and cons of different types of plans and the income tax implications. Your net income, business setup, and goals for your golden years can influence which choices are best. Below are four tips to help entrepreneurs plan for their future retirement.
1. Open a Solo 401(k) Account
Business owners may be under the impression that 401(k)s are only for those on someone else’s payroll. Giving up a conventional job means you’re limited to individual retirement plans or IRAs. However, this isn’t true if your business doesn’t have full-time employees. You can open a 401(k) if it’s just you, your spouse, or a few part-time employees participating in the business.
While IRAs only allow $6,000 in annual contributions when you’re under 50, a solo 401(k) lets you save more. Current rules cap an entrepreneur’s yearly savings at $20,500 or $27,000 if you’re at least 50 years old. That’s a big difference between an IRA, and it can help self-employed individuals stash away a bigger nest egg.
However, the savings potential doesn’t end there. Because you’re also your employer, solo 401(k)s let you make additional business contributions. You get to put in an additional 25% of your net income after deductions. Those deductions include 50% of your self-employment taxes and individual contributions. The maximum combined individual and business contribution is $61,000. This can have significant positive impacts on your income taxes and retirement savings.
2. Take Advantage of a Roth IRA to Reduce Future Tax Burdens
You may have heard of a Roth IRA and some of its benefits. Like a traditional IRA or 401(k), you can set aside money for retirement each year up to the IRS’s limits. But with conventional retirement plans, your contributions are tax-deductible. You get to reduce your current income taxes in exchange for being taxed on your withdrawals later. Once you reach retirement age and start taking money out, you pay Uncle Sam.
However, Roth accounts work in the opposite fashion. You pay income taxes on your contributions now since you can’t deduct them. The benefit is that you don’t pay the IRS once you start withdrawing your savings. A solo Roth 401(k) or Roth IRA is a way to hedge against your future retirement tax burden.
Roth options are more attractive if you believe you’re earning substantially less now than you will as you age. In theory, the less you earn, the fewer taxes you fork over. Paying fewer taxes now on the money you’ll use later means you can stretch your retirement dollars further. That being said, the IRS sets up adjusted gross income limits for Roth accounts. Whether you can contribute to a Roth plan and how much depends on your income and filing status.
3. Set Up a Defined Benefit Plan
Entrepreneurs who earn higher-than-average incomes might feel restricted by some of the IRS’s contribution limits. You want to save more for your retirement than what those caps allow while you’re bringing in the big bucks. Luckily, there are defined benefit plans that use other criteria.
Your annual contribution limit is determined by your age and what you can expect to earn on your investment. Other factors include your current income and how long you’ve been in business. What you save in a defined benefit plan is usually tax-deductible. However, you’ll pay taxes once you start making withdrawals.
While defined benefit plans help high-income earners save more, they come with a cost. An administrator or actuary must determine your contribution and withdrawal limits. There may be higher costs or fees for a defined benefit plan. But if you want to set aside six figures a year, these plans can be the way to go.
4. Use Multiple Accounts
Some entrepreneurs have full-time jobs that come with conventional retirement plans. When they’re not busy with their main gigs, these business owners devote time to their side hustles. Operating a business or freelance operation part-time allows them to earn additional income for expenses or retirement. However, these business owners can’t contribute self-employed income to their employer’s plan.
What these individuals can do is open a separate 401(k) or IRA for their earnings from self-employment. They’re golden as long as they don’t exceed the annual contribution limits for each account. Consider someone working a staff job and making the maximum contributions to their employer’s 401(k). They can still have an IRA, save $6,000 a year, and make catch-up contributions if they’re over 50.
The IRS does impose some caveats for dual account holders, though. Income limitations determine whether you can deduct IRA contributions from your taxes. Also, you can’t go over the maximum contribution limits across IRA or 401(k) accounts. Say, for example, that you have two IRA accounts. If you’re under 50, your total combined annual savings cannot exceed $6,000.
Retirement Planning for the Self-Employed
When you’re self-employed, you can take charge of your income potential. With this freedom comes the responsibility of planning and funding your retirement. Although this may seem hard, it’s a hurdle that can be overcome. Knowing your options, including solo 401(k)s, can help you realistically reach your goals without becoming too overwhelmed.
