When you work for yourself, saving for retirement can feel like an uphill battle. Since you are not a part of a company retirement plan, you cannot take advantage of common company perks like matching 401(k) contributions. Instead, you have to take the lead on retirement planning using nothing but your own income.
For the self-employed, it is crucially important to start saving as soon as possible and to pick the right retirement plan. Fortunately, there are several good options for those building a self-employed career.
Individual Retirement Accounts
One of the easiest ways to save for your retirement is through an Individual Retirement Account, or IRA, which you can open at any time with IRA Services.
An IRA offers the same types of tax benefits you’d receive in a 401(k) through an employer. IRAs delay taxes on your investment earnings until you withdraw money which, ideally, will not be until retirement.
There are a few types of IRAs, each with different benefits and tax schedules. With a Traditional IRA, contributions are tax deductible, while Roth IRAs feature tax-free investment earnings, as long as you withdraw your earnings after you turn 59 ½.
For both types of accounts, you are allowed to contribute up to $5,500 a year if you are younger than 50, and up to $6,500 a year if you are 50 or older.
It’s important to note that there are income restrictions on these accounts. If you are single and your adjusted gross income is over $132,000 annually, you cannot use a Roth IRA. If you are married, the joint adjusted income limit rises to $194,000.
For Traditional IRAs, income restrictions only apply if you are married and your spouse has a retirement plan at work. In this case, contributions are not deductible if your joint adjusted gross income is over $184,000. However, you can still add money to a Traditional IRA to take advantage of tax-deferred investment growth.
Keep in mind that while it may be tempting to use IRA accounts as a “back-up” fund for your business, it is not financially wise. Since IRAs are meant for retirement savings, early withdrawals come with a penalty. No matter what type of IRA you have, you will owe income tax plus an extra 10% penalty on any withdrawals made before you turn 59 1/2. While there are circumstances in which you may avoid the extra penalty, business expenses do not qualify, so be sure that you have enough money on-hand to run your business before contributing to your IRA.
Self-directed IRAs are a different class of IRA that offer a wider variety of investment options. Unlike other types of IRAs, with a self-directed account you can invest in alternative assets like real estate and precious metals.
For some business owners, these accounts are especially attractive because they allow you to invest in closely-held, small businesses. But, while it is possible to use a self-directed IRA to invest in a business that you partially own, it can be very complicated. There are many restrictions – for example, you are not allowed to invest in any business in which you own more than 50%.
There are repercussions for breaking these rules. The IRS can force you to remove the value of the business from your account, which would lead to income tax plus the 10% early withdrawal penalty on the total value. It is much safer to fund your business through alternate means and invest your IRA funds in companies that you do not personally own or manage.
While a regular IRA can help provide a head start for retirement savings, contribution limits are frustratingly low compared to a 401(k). With a 401(k), employees younger than 50 years old can invest up to $18,000 a year, or $24,000 for those 50 or older.
For self-employed workers looking for more ambitious contributions limits, a Simplified Employee Pension Individual Retirement Arrangement, or SEP IRA, is a good option
A SEP IRA – which is specifically for self-employed workers – is similar to a Traditional IRA, except that you can contribute up to 25% of your annual earnings, to a maximum contribution of $53,000 a year. The higher contribution limit can be especially helpful if you want to use a self-directed IRA to invest in real estate. SEP IRAs allow you to save up enough money for a down payment on a property in a fraction of the time of a regular IRA.
The downside of a SEP IRA is that if you have full-time employees through your business, you must make contributions on their behalf every time you add money to your account.
If you’re the only employee of your business, a self-employed 401(k) is another great choice. As the name implies, these plans are designed for businesses where the only employees are the owner and his or her spouse. You cannot use a self-employed 401(k) if your business has additional employees. This design makes the filing paperwork much simpler and the plan less expensive.
The self-employed 401(k) offers straightforward paperwork and lower plan fees, and it also has the same annual contribution limit as the SEP IRA. In addition, it has the unique benefit of allowing you to take loans through the plan and borrow up to $50,000 of your retirement savings to run your business.
Finally, if you set up your self-employed 401(k) with a broker that handles self-directed IRAs and alternative assets, they can design your 401(k) so that you can also invest in alternative assets.
The downside of a self-employed 401(k) is that if your company expands and starts hiring employees you can no longer use the account. In this scenario, you could upgrade to a regular 401(k), but this is quite expensive and usually not cost-effective for most small businesses.
To read more about how to make the most of your retirement savings and plan for a successful future, read our article about diversifying your retirement plan with a self-directed IRA.