Saving and planning for retirement as a self-employed person can be more difficult than for others. Company employees often have access to a 401(k) or other retirement savings account that lets them make automatic contributions pulled from every paycheck. Meanwhile, self-employed individuals must take their retirement savings into their own hands.
For individuals who are self-employed, finding the best retirement plan that offers tax advantages now and in the future can take time and effort. Multiple plan options are available, and it is important to carefully consider your options and research before committing. While it can be daunting, finding the right plan to fit your needs can help you ensure you are ready for retirement when the time comes.
How is a self-employed retirement plan different from a 401(k)?
You might be familiar with 401(k) plans and automatic payroll deductions at a traditional employer. However, the available options differ when you’re self-employed. There are key differences between a standard plan and a self-employed retirement plan. However, many have similar tax benefits and contribution limits, making understanding the process a little easier.
While each type of account has different contribution limits, pros and cons, they can all help you prepare for the future like an employer-sponsored 401(k) plan would.
It may be worth speaking with a certified financial planner to help you find the best plan for your business. Consider working with a fee-only or hourly planner to help you develop a plan. Just make sure the person is a fiduciary to ensure they’re offering solutions in your best interest.
What retirement plan is best for self-employed individuals?
Some of the best retirement accounts for those who are self-employed give you access to different tax advantages and contribution limits that help you save enough for the future.
Below are four of the most popular options to consider.
1. SIMPLE IRA
A SIMPLE IRA, or the Savings Incentive Match Plan for Employees, allows both employees and employers of small companies to contribute toward an employee’s retirement. SIMPLE IRAs are available as retirement plans for small businesses, generally with 100 or fewer employees, including self-employed individuals.
Under a SIMPLE IRA, the employer must make contributions each year, either a matching contribution of up to 3% of an employee’s compensation or a 2% contribution that is nonelective for each employee. Employees can, but aren’t required to, make contributions to this account. Under the nonelective clause, even if an eligible employee doesn’t contribute to the SIMPLE IRA, the employer must still contribute a percentage based on an annual salary cap, which is $330,000 in 2023.
Employer contributions are tax deductible in the year they are made. Employers can deduct contributions as a business expense. Employee salary reduction contributions are not tax deductible.
Contribution limit: $15,500 in 2023 and an additional $3,500 if you are over 50 as a catch-up contribution. If you also have an employer-sponsored plan, your total salary reduction contributions have a limit of $22,500 in 2023 across all retirement plans.
Pros: A SIMPLE IRA is easy to set up and use. Plus, both employers and employees are eligible to contribute to the plan. It works best for startups and small businesses that don’t have a traditional 401(k).
Cons: This type of IRA is inflexible and has lower contribution limits than other retirement plans.
2. Solo 401(k)
A Solo 401(k) is a one-participant 401(k), sometimes also called an individual 401(k) or a Solo-k. It is a traditional 401(k) plan that covers a business owner (and their spouse) with no employees. It has the same rules as more traditional 401(k) plans and can be one of the best retirement savings plans for self-employed people because it has such a high contribution limit.
Contributions are made pretax. The distributions taken after age 59½ are taxable, just like with a traditional 401(k). Participants will have to take the required minimum distributions (RMDs) starting at age 73. They may have to pay a 10% penalty, along with taxes, for any early withdrawals. Participants can roll over other retirement accounts, like SEP IRAs and traditional 401(k)s, into a solo 401(k).
Solo 401(k)s can also be set up as Roth accounts, using after-tax money to make contributions. This means withdrawals are generally tax-free in retirement. This can be a helpful option for individuals who expect their tax bracket to be higher in retirement than it is now.
A Solo 401(k) owner must file an annual report with the IRS if the account’s assets are over $250,000, which can be tedious.
Contribution limit: 100% of your compensation up to $22,500 a year as the employee, plus up to 25% of earned income as the employer, up to $66,000 total. People over 50 can contribute an extra $7,500 in catch-up contributions for a yearly total of $73,500.
Pros: Self-employed individuals can contribute to this retirement plan as both an employee and employer, allowing them to save much more than with other accounts.
Cons: Only self-employed people and their spouses can contribute to a Solo 401(k). The requirements to maintain the account can be complicated.
3. SEP IRA (Simplified Employee Pension)
A Simplified Employee Pension, or SEP IRA, can be one of the best retirement plans for a self-employed person. SEP IRAs are traditional IRAs and follow the same investment, distribution and rollover rules, but the contribution limits are higher. They are generally easier to set up than a Solo 401(k) and don’t have any reporting requirements to the IRS.
SEP IRAs allow self-employed individuals to save a large amount for retirement with tax-deductible contributions. However, there are no catch-up contributions for individuals ages 50 and older, as there are with other retirement plans.
A word of warning for self-employed individuals who have any employees: Think carefully about opening a SEP IRA. According to the plan’s rules, any contributions made to the employer’s account must be matched equally for all employees as a percentage of their salary. For example, if 10% of the employer’s salary goes to a SEP IRA, 10% of an eligible employee’s salary must be contributed to their SEP IRA for that year’s plan.
Contribution limit: 25% of an employee’s compensation, or up to $66,000 in 2023, whichever is less. A salary cap of $330,000 is used to calculate contributions.
Pros: A SEP IRA is easy to set up and maintain and has lower administrative costs than other plans. It also allows you to vary the amount contributed each year, which can be helpful if cash flow is tight.
Cons: An employer must contribute equally to all eligible employees based on a percentage of pay, which can become expensive. Only employers can contribute to a SEP; employees are not eligible.
4. Traditional or Roth Individual Retirement Account (IRA)
A traditional or Roth IRA is one of the easiest ways for self-employed individuals to save for retirement. Traditional IRAs let individuals make pretax contributions like a traditional 401(k) does. It can benefit those who expect to be in a lower tax bracket when they retire. Contributions to a traditional IRA grow tax-deferred, meaning the participant will pay taxes on money withdrawn in retirement. Traditional IRAs have many of the same rules as a 401(k), including taking RMDs starting at age 73, so be sure to read and understand the requirements before signing up.
With a Roth IRA, the participant will pay taxes on the money contributed upfront, but that money grows tax-free. The participant won’t have to pay taxes on the principal or interest earned when money is withdrawn, as long as some basic requirements are met—like withdrawing funds after age 59½ and owning the IRA account for more than five years. Roth IRAs have income limits that reduce the amount an individual can contribute. Those income limits can prevent someone from qualifying to contribute to a Roth IRA altogether.
Contribution limit: $6,500 total in 2023 across all IRA accounts owned by an individual, or up to $7,500 for those ages 50 and older.
Pros: Traditional and Roth IRAs are popular retirement plans with different tax advantages. IRA holders can contribute even if they also have an employer-sponsored plan. However, the traditional IRA tax deduction might be limited based on employer-sponsored plan contributions.
Cons: IRAs have relatively low contribution limits. Each account also has income limits for high earners, so you may not be eligible to contribute if you earn more than the IRS threshold.
Bottom line of self-employed retirement plans
Choosing a retirement account to help you plan for the future takes time and consideration. While many options are available, a Solo 401(k) or SEP IRA can be great if you only employ yourself and possibly your spouse. Working with an experienced financial planner and retirement expert can help you make the best decision for your circumstances. This can be especially helpful with the passing of the SECURE 2.0 Act of 2022, which is designed to expand coverage, increase savings, and more. Many of these changes are set to begin in 2024, with others set to begin at the end of 2024.
Understanding what retirement plan is best when you’re self-employed can feel overwhelming, but don’t wait to save for retirement. The more you can contribute now and through your working years, the more prepared you’ll be for the future.
This article was updated October 2023. Photo by JLco Julia Amaral/Shutterstock.com