Personal Finance Essentials

Retirement Plans for the Self-Employed

No Employer? No Excuses.

Powerful Retirement Tools Exist — but Only You Can Use Them

EntrepreneurRetirement

When you work for an employer, your retirement savings happen in the background — your company sets up the plan and contributes on your behalf. When you’re self-employed, that responsibility is entirely yours. The good news is that the government has created several retirement savings options specifically designed for self-employed individuals and the tax benefits are substantial.

If you have any self-employment income, even from a part-time side business, you may be able to shelter a significant portion of that income in a tax-deferred retirement account.

The SEP-IRA

The SEP-IRA (Simplified Employee Pension Plan) is one of the easiest retirement accounts available to self-employed workers. It operates much like a traditional IRA but with dramatically higher contribution limits. Instead of being limited to a small annual contribution, you can put away up to 25% of your net self-employment income. Contributions are tax-deductible and are treated as a normal business expense, which means they reduce your taxable self-employment income directly.

SEPs involve minimal paperwork and reporting requirements. You can contribute different amounts each year, and you can wait until your tax filing deadline, including extensions, to make the prior-year contribution. This flexibility makes the SEP-IRA particularly well-suited to self-employed individuals whose income varies from year to year.

One important technical detail: although the law states you can contribute up to 25% of your net taxable income, the correct effective rate works out to 20%. Here’s why. If your net self-employment income is $10,000 and you contribute $2,500 (25%), your new taxable income becomes $7,500 — and $2,500 is actually 33% of $7,500, which means you’ve over-contributed. The correct contribution is $2,000, which is 20% of $10,000 and 25% of $8,000. Use a tax advisor to make sure you calculate this correctly.

The SIMPLE IRA

The SIMPLE IRA (Savings Incentive Match Plans for Employees) is another option for self-employed workers, provided you don’t already have another qualified retirement plan in place. It allows for meaningful employee salary-reduction contributions each year, with catch-up provisions for workers age 50 and older. If you have employees, the SIMPLE IRA requires you to either match employee contributions dollar-for-dollar up to 3% of their compensation, or make a flat non-elective contribution of 2% of each employee’s compensation. The SIMPLE IRA is limited to employers with no more than 100 employees.

The Solo 401(k)

The Solo 401(k) — sometimes called the Sole-Owner 401(k) — was designed for self-employed individuals with no full-time employees, and it’s available whether your business is a sole proprietorship or a corporation. What makes it uniquely powerful is that you wear two hats: you are both the employee and the employer. As an employee, you can defer a significant portion of your income. As the employer, you can make an additional profit-sharing contribution on top of that, bringing total annual contributions substantially higher than what a standard IRA allows.

Because these contribution limits change each year and the calculations involve both roles, you should work with a tax advisor or financial planner to determine your maximum allowable contribution. Getting this wrong can create IRS problems.

Comparing Your Options

All three plans — the SEP-IRA, SIMPLE IRA, and Solo 401(k) — operate on similar principles: contributions are tax-deductible, growth is tax-deferred, and taxes are paid upon withdrawal in retirement. The right choice depends on your income level, whether you have employees, and your administrative preferences.

Regardless of which plan you choose, the strategy is the same: maximize your contributions every year. These accounts are among the most powerful tools available to self-employed individuals for reducing current taxes and building long-term wealth.

Never Use Retirement Savings to Fund a Business

It may be tempting, especially in the early stages of launching a business, to look at your 401(k) or IRA as a source of startup capital. Resist this temptation.

There is a legal mechanism called ROBS — Rollovers as Business Start-Ups — that technically permits the use of retirement funds to fund a business. The process involves hiring an attorney, forming a corporation in a specific legal structure and transferring retirement funds into the corporation in a precisely prescribed way. If any step is done incorrectly, the IRS will retroactively assess penalties and taxes, and you may not know you’ve made a mistake until years later.

The IRS has studied the outcomes of taxpayers who have gone through ROBS arrangements. Most violated at least one rule and ended up with tax problems. Even those who followed the rules correctly didn’t fare well: the majority experienced business failures, including high rates of personal and business bankruptcy, tax liens and corporate dissolutions. In most cases, the individuals lost both their businesses and their retirement savings.

If you want to start a business, look elsewhere for startup capital. Your retirement account has one job: fund your retirement. Don’t give it a second one.