For those who are self-employed, the question of how to save for retirement is a frequent one. Fortunately, the answer may not be that that difficult at all. In fact, being self employed may mean that you have more retirement planning opportunities than you otherwise would have access too.
This is because as the employee/owner of your company, you can choose a retirement plan that fits your specific wants and needs.
Looking to keep things simple and straightforward? There is an answer for that. Looking to max fund a plan as quickly as possible? There is an option for that, too.
Ultimately, the final decision on which retirement plan you choose will reflect your wants, needs, income, structure, growth, employees, and so on.
So while the options are plenty, the final decision takes a bit more consideration.
From Employee to Employer
As an employee, your retirement savings options may be limited by how much you (and your family) make and whether or not your company offers a retirement plan. The combination of these rules impacts how much you can contribute to a plan.
One of the more common retirement saving vehicles for employees is the 401(k) plan. On the surface, the 401(k) plan is straightforward (at least for an employee).
Upon becoming eligible for the plan, an employee can defer from payroll into a plan. It’s simple – once it has been decided how much to contribute to the plan, the employee completes the paperwork, and the company processes the deferral.
Furthermore, some employers encourage you to participate in the plan by offering company match and/or a profit share contribution.
While the rules for a 401(k) can be considerably more complicated past the surface, the concept of a enrolling in a plan and having your contributions deducted from your payroll is common to many.
Retirement Plans for the Self-Employed
As you transition from employee to self-employed business owner, the retirement savings world changes. You go from being offered a retirement plan by your employer, to choosing which retirement plan suits you best.
At your immediate disposal are several options, two of which we will highlight here.
- A SEP IRA
- A 401(k) and/or profit sharing plan (solo(k))
Which one you choose depends on a number of considerations. How much you make. Your business structure (Schedule C or S-Corp). How many employees you have. Expected changes in the business. Annual funding goals. And how easy or hard you want the plan’s administration to be.
For the purposes of today’s discussion, we will focus on retirement plans for self-employed individuals with zero employees. Basically, a one-person company. You.
Earned Income vs. Wages
The maximum annual retirement contribution you as a self-employed person can make is subject to how much income you earn and what type of retirement vehicle you are funding. Furthermore, these income calculations are dependent on your company structure. Commonly, structure is divided into two camps.
- Income that is reported on Schedule C of a personal tax return
- Income from an S-Corp in the form of wages and a dividend
While these individual structures have benefits and drawbacks, the scope of why one is right or wrong is a discussion for a different day.
What is important today is to know that with both a Schedule C and an S-Corp, the business owner has the option of implementing a SEP-IRA or a Solo(k) for retirement savings.
Maximum SEP-IRA Contribution
A SEP-IRA is simple and straightforward, and the amount a business owner can contribute is high. In fact, a business owner can contribute up to 25% of his/her earned income up to an annual maximum contribution of $56,000 (in 2019).
Additionally, a SEP-IRA may be attractive thanks to low administration expenses and ease of operation. However, what is gained in ease of administration is lost in contribution flexibility.
Using a hypothetical example, we can illustrate the maximum funding for a SEP-IRA based on various income levels and company structures. Let’s explore:
The chart below illustrates the maximum allowable contribution (25%) to a SEP-IRA assuming the various wages. The simplifying assumption in our hypothetical example is that $100,000 is the net Schedule C income and $100,000 is the S-Corp W2 wage.
Without detailing the specific calculations, you can see that the S-Corp allows for higher annual retirement plan contributions compared to a Schedule C, assuming the same wage.
Solo(k) and Profit Sharing Plan
A second option for the self-employed business owner is a Solo(k) and profit sharing plan.
A Solo(k) has additional features compared to its SEP-IRA counterpart, including higher contribution rates at lower income levels and the option for a ROTH 401(k) component. For this tradeoff in options, a Solo(k) and profit sharing plan have increased administration costs and increased complexity.
Continuing our example from above:
Schedule C – Solo(k) and Profit Sharing Plan (using 2019 figures)
|Catch up (age 50+)||$6,000||$6,000||$6,000|
S-Corp – Solo(k) and Profit Sharing Plan (using 2019 figures)
|Catch up (age 50+)||$6,000||$6,000||$6,000|
The rules regarding contributions to a Solo(k) are different than the SEP-IRA. Specifically, a business owner who implements a Solo(k) can defer from his/her salary up to $19,000 (in 2019) of earned income per year (plus an additional $6,000 if 50 years of age or older).
Simply stated – this deferral feature of the Solo(k) allows for a business owner to get money into the plan quicker than would be allowable via a SEP-IRA.
In addition to the $19,000 deferral, the business owner can add a profit-sharing component that allows him/her to contribute an additional 25% of earned income (for a total of $56,000, or $62,000 if 50 years of age or older).
Planning the SEP and Solo(k)
Comparing the SEP IRA to the Solo(k), we have illustrated that at lower wage levels, the Solo(k)/PSP substantially increases allowable annual contributions to a retirement plan.
A recap of the figures
|SEP – Schedule C||SEP – S-Corp||Solo(k) – Schedule C||Solo(k) – S-Corp|
As you can see, at “lower” income levels, the spread between the maximum allowable contributions is significant.
Specifically, if we compare the SEP Schedule C to the Solo(k) Schedule C for someone making $100,000, we can see an increased contribution of $25,000.
As the income levels increase from $100,000 to $150,000 and $200,000, the advantage of the Solo(k) becomes less and less. At some point, the advantage may become so small that the cost of administration and the complexity of the 401(k) plan may not be worth the trouble.
Other Factors to Consider
Just like most topics in financial planning, a comparison of a SEP-IRA vs. a Solo(k) is difficult. In fact, a full analysis will require addressing additional questions like the following:
- How much am I looking to save?
- Can I afford to save?
- Should I consider a ROTH option?
- What is fair and reasonable compensation for an S-Corp business owner?
- What other taxes should I consider?
- For how many years will I be saving?
Ultimately, it is important to have an adequate understanding of the available options and how much you can save. Because the difference between saving $18,000 per year or $42,000 per year over the course of 10, 20, or 30 years can be big.
The above figures are hypothetical and for illustrative purposes only and do not attempt to predict actual results of any particular investment.
401(k): Reduces current federal taxable income; Contributions grow tax deferred until withdrawn; Withdrawals taxed as ordinary income in the year received. Tax penalties and penalties for early withdrawal may apply if funds are withdrawn prior to age 59 1/2.
An individual retirement account (IRA) allows individuals to direct pretax income, up to specific annual limits, toward investments that can grow tax-deferred (no capital gains or dividend income is taxed). Individual taxpayers are allowed to contribute 100% of compensation up to a specified maximum dollar amount to their Traditional IRA. Contributions to the Traditional IRA may be tax-deductible depending on the taxpayer’s income, tax-filing status and other factors. Taxes must be paid upon withdrawal of any deducted contributions plus earnings and on the earnings from your non-deducted contributions. Prior to age 59½, distributions may be taken for certain reasons without incurring a 10 percent penalty on earnings. None of the information in this document should be considered tax or legal advice. Please consult with your legal or tax advisor for more information concerning your individual situation.
Contributions to a Roth IRA are not tax deductible and there is no mandatory distribution age. All earnings and principal are tax free if rules and regulations are followed. Eligibility for a Roth account depends on income. Principal contributions can be withdrawn any time without penalty (subject to some minimal conditions).