Self-Employed – This is What You Need to Know About Saving For Retirement

If you’re self-employed you have to take it upon yourself to fund your retirement. That means time and expense spent investigating options and then setting up and managing a plan, as well as potentially making contributions to employee accounts, and much more.

Introduction

You’ve set out on your own on what can be a tough, lonely journey – being self-employed. While doing so brings on plenty of daily challenges in itself, you have to remember that one big part of the equation is that of financially securing your future. That’s no easy task, especially when it comes to saving for your own retirement versus relying on another entity.

Unlike the path most take of working for an employer and counting on them to provide a qualified plan they can contribute to (and the employer contributes too, hopefully), you have to do the hard part yourself, aside from acting as CEO to dishwasher in your own solo or small organization.

When it comes to putting a retirement plan in place for yourself and potentially employees (if you have them), while your goal appears simple – to put a plan in place – you’ll find there are all kinds of rules, laws, limitations and other regulations and provisions that you must make yourself aware of or you can actually get yourself in financial and even legal peril. Yikes!

Today we are going to examine what are probably your best options when it comes to establishing a qualified retirement vehicle that will allow you to save for your retirement safely while you work to operate and successfully grow your business.

Self-employed savings rule of thumb

Starting out, there’s a couple things you want to consider when it comes to safely saving for retirement.

First off, many experts suggest you save at least 10 to 15-percent each year of your adjusted gross income (AGI) as a general rule.

Second, whatever amount you save, most experts agree that you’ll need at least 70- to 80-percent of the salary you bring home during your final working years to pay your bills and sustain your standard of living when you do retire.

Regarding point number one, If you’re saving that percent now you are probably on track, but if not you likely need to step it up.

As for the second point, well, retirement ain’t cheap and you probably don’t want to lower your standard of living in retirement and live scared you’ll outlive your savings.

Solo 401(K)

The first type of self-employed plan you may want to consider is a solo 401(K), also known as an individual 401(K). There’s also a Roth version. These are geared toward individuals who are self-employed with no employees other than a spouse. This is a form of qualified account allowing tax deferred contribution and investment for self-employed individuals, of after-tax contributions in the case of a Roth solo 401(k).

These are popular because of the fact there is no age or income restriction. And for many self-employed  this type of plan provides the best opportunity for contributing the most qualified dollars each year.

In the case of the solo plan, you as the self-employed play the role of both employer and employee.

Confused?

While on the surface people often struggle a bit to understand the mechanics of a solo plan, the reality is they work just like those you might have had previously  (or currently still do) that are offered by an employer to their employees.

In the typical scenario, the employer sets up the 401(k) plan for their employees. An employee can contribute to the plan each year. The amount they can contribute is based on their personal situation – the combined contribution limits across all qualified accounts (IRAs, 401(K), etc) that are imposed by the IRS.

In a solo plan, you are able to contribute to your savings each year as both the employee making contributions (referred to as an elective deferral), up to your limit, as well as the employer (referred to as an employer non-elective contribution) who contributes to the employee’s (you) account.

Regarding the employer non-elective contribution, businesses often match a portion of their profits based on what the employee contributes (referred to as matching), which is a form of profit sharing. When contributed to the employee’s 401(k), which in this case is the solo or Roth solo 401(k), the amount contributed is tax-deductible for the employer, which is claimed on the business’s tax return.

The 2023 maximum contribution for you as the employer is up to 25-percent of the company’s earning, not to exceed $43,500 for 2023. In 2024 the employer non-elective limit rises to $46k, with the same 25-percent contribution rule.

As far as you the sole employee of the business (there is a spousal exception), according to the IRS, your total annual contribution limit (across all qualified accounts) would be $22,500 for 2023. If over 50 there is a catch-up provision allowing you to contribute an extra $7,500, bringing your total allowable contribution for 2023 to $30,000. Keep in mind the contribution limit is up to the $30k or 100-percent of your compensation, whichever is less. In 2024 that limit climbs to $23k, and with the $7,500 catch up provision (if 50 or older) the total is $30, 500.

In total, the limit for contributions between employer and employee in 2023 is $66k, plus an additional $7,500 if you are age 50 and older. In 2024 the maximum limit increases to $69k, with an additional $7,500 catch up provision if you’re 50 or over.

We mentioned the spousal exception, which can be quite lucrative if available. In order to be eligible your spouse would have to work for your company. If so, they are eligible as an employee for the same elective contribution as previously listed (same rules and limitations), and the company can make a non-elective contribution to the spouse’s solo 401(k) account, with the same rules and limitation as listed above.

In effect, while you and your spouse each have separate solo 401(K) accounts, you can potentially double your combined household retirement contributions each year.

One last point is that the solo 401(k) works just as any other, in which employee contributions are made on a pre-tax basis for that year, which effectively lowers your taxable income as an employee – same for your spouse, if applicable. In the case of the Roth solo 401(K), the employee contribution to the plan is made with after-tax dollars.

With a solo plan, when you start taking withdrawals from the plan the distributions will be treated as ordinary income and taxed accordingly for that year. If instead you use a Roth solo 401(K) plan, distributions will be tax-free when taken, with some exceptions.

Keep these things in mind:

• Loans – allowable up to 50-percent and repayments must be made within five years
• Early distributions prior to age 59 1/2 are penalized 10-percent plus the taxes owed, unless it meets an excepted exemption (qualifying medical care, disability, etc.)
• Required minimum distributions (RMDs) must start once you reach age 72 (or 73 if you reach age 72 after Dec. 31, 2022) or there is a 50-percent penalty for the amount not taken as a distribution, in addition to the taxes owed
• Roth solo 401(K) plans are not subject to RMDs

IRAs

While they generally have lower caps in terms of annual contributions, Individual Retirement Accounts (IRSs) are still great vehicles for self-employed individuals. And you may be able to contribute to these types of qualified individual retirement accounts even if you do go with a solo or Roth solo 401(K), subject to annual contribution limits.

Traditional – this is a straightforward plan that offers a lot of flexibility in terms of investments options and is generally easy to set up through assorted types of financial institutions. Eligible contributions are made on a pre-tax basis, growing tax-deferred until distribution, and they reduce your taxable income for the year.

According to the IRS, for 2023 the annual contribution limit for a traditional IRA is $6,500, and if 50 or older you can contribute up to $7,500. In 2024 those limits rise to $7,000 and $8,000 for those 50 and up, respectively. Those limits are across all personal IRAs – if you have a traditional and a Roth IRA, the limit is across both, not for each separately.

There’s no income restrictions if you or your spouse don’t invest in any other employer-sponsored retirement plan, such as a solo 401(K), but if you do there are limits that may decrease the maximum amount that can be contributed each year, according to the IRS:

Keep in mind the following:

• You can continue to contribute up to any age
• Early distributions prior to age 59 1/2 are penalized 10-percent plus the taxes owed, unless it meets an excepted exemption (qualifying medical care, disability, etc.)
• Required minimum distributions (RMDs) must start once you reach age 72 (or 73 if you reach age 72 after Dec. 31, 2022) or there is a 50-percent penalty for the amount not taken as a distribution, in addition to the taxes owed

Roth – this is a straightforward plan that offers a lot of flexibility in terms of investments options and is generally easy to set up through assorted types of financial institutions. Eligible contributions are made on a post-tax basis, so they grow on a tax-free basis, with no taxes a due on distribution (contributions and gains) as long as the account is at least five years old.

According to the IRS, for 2023 the annual contribution limit for a Roth IRA is $6,500, and if 50 or older you can contribute up to $7,500. In 2024 those limits rise to $7,000 and $8,000 for those 50 and up, respectively. Those limits are across all personal IRAs – for example, if you have a traditional, Roth or SEP IRA, the limit is across all, not for each separately.

Keep in mind the following:

• You can continue to contribute up to any age
• Early distributions prior to age 59 1/2 and prior to the account being open for a minimum of five years are penalized 10-percent plus the taxes owed, unless it meets an excepted exemption (toward purchase of first home, birth of a child, qualifying medical care, disability, qualified educational expense, and mor)
• Required minimum distributions (RMDs) do not apply

SEP – A Simplified Employee Pension plan or SEP IRA can be ideal for a small business owner with only a few employees. They are relatively inexpensive and easy to set up and manage, which is part of their appeal.

According to the IRS. investments are tax-deductible until retirement, at which point income tax applies to any withdrawals.

Remember that the employer is the contributor to these plans, not the employee. If you go that route your company (you as the employer) will have to contribute an equal percentage to qualified employees as you do for yourself. Example, if your company (you as the owner) wants to contribute 15-percent of your salary as an employee, the company has to contribute 15-percent of your employees’ compensation to their plan.

Regarding contribution limits, in 2023 you can contribute up to 25-percent of your compensation (as an employee of the company), up to a maximum of $66,000, and in 2024 that limit rises to $69,000.

Keep in mind the following:

• The maximum compensation that can be considered for contributions in 2023 is $330,000 and in 2024 it’s $345,000.
• A qualifying employee must be at least 21, have worked for you for three of the last five years and earned at least $750 from you in 2023.
• Early distributions prior to age 59 1/2 are penalized 10-percent plus the taxes owed, unless it meets an excepted exemption (toward purchase of first home, birth of a child, qualifying medical care, disability, qualified educational expense, and more)
• Required minimum distributions (RMDs) do apply, as explained above

SIMPLE – A Savings Incentive Match Plan for Employees IRA (SIMPLE) is a tax-deferred employer-sponsored plan allowing both employer and employee contributions for companies with less than 100 employees. These are generally easier and cheaper to set up than a 401(k), so they can be appealing to some self-employed individuals.

The plan works much like a 401(K), with the employer matching contributions and employees able to make tax-deferred contributions (which lowers their taxable income for the year) that aren’t taxed until distributed after age 59 1/2 (same rules and penalties for early distribution as with other plans), but unlike a 401(K), their contribution limits are lower.

The employee contribution limit in 2023 is $15,500, with an additional $3,500 catch-up contribution for those 50 and older. The 2024 limit rises to $16k and the catch-up provision remains $3,500.

Regarding the mandatory employer contribution, according to the IRS, there are two options:

• Contribution match up to 3-percent of the employee’s pay, with no annual compensation limit
• Non-elective contribution match equal to 2-percent of the employee’s compensation based on a maximum salary of $$330,000 in 2023 and $345,000 in 2024.

An important additional consideration for a self-employed individual is the preclusion of owners/sole proprietors from contribution if they contributed to other retirement plans within the last calendar year.

Keep in mind the following:

• Employer contribution is mandatory with this plan, but optional for an employee
• Loans are not allowed
• Early distributions prior to age 59 1/2 are penalized 10-percent plus the taxes owed (25-percent if taken within first two years of first contribution), unless it meets an excepted exemption (toward purchase of first home, birth of a child, qualifying medical care, disability, qualified educational expense, and more)
• Required minimum distributions (RMDs) do apply, as explained above

Conclusion

As you can tell, there are different options when it comes to ensuring you are maximizing your ability to save and invest as a self-employed individual.

And all kind of laws, rules, regulations, limitations, preclusion that must be considered… You have to wonder who can manage all of that stuff and still successfully run a business.

Frankly, you shouldn’t attempt to do so on your own, just as you wouldn’t attempt to do surgery on yourself, act as your own legal counsel (unless you are a damn good lawyer), or engage in other activities that generally fall under the umbrella of the famous cliche regarding working with a pro when the situation calls for it versus winging it and going it on your own.

Bottom line, you need to work with a professional planner to ensure you do things right and avoid the plethora of potholes and pitfalls that are inherent when it comes to saving for retirement in general, and more so when you are running your own shop!

Here at Oak Harvest we can assist you with this. We can advise you as to your options and help you create your self-employed plan. Beyond that, we can assist you in creating a  holistic, comprehensive retirement plan addressing relevant issues, utilizing strategies that cover taxes, income, spending, social security, healthcare, LTC, legacy, and more, customized to your family’s specific scenario.

A plan created with the goal of ensuring you have the best opportunity of living out the retirement you and your family envision.

If you are ready to take the next step and talk to a team of retirement planners who can advise on all your retirement needs, and who will put your interests first, Schedule a call today!