Self-Employed Retirement Plan Options

Who is Self-Employed?

It might seem obvious, but it’s still worth clarifying. A self-employed individual is a sole proprietor or independent contractor, a solopreneur, someone who reports self-employment income. Even if it’s a “side hustle” outside of your regular “9 to 5” and fits this description, you are considered self-employed.

Why is the Distinction Important?

You’re a business owner! And as such, you have a variety of retirement savings options available to you – more options than you’d otherwise have at your disposal if you were simply a W-2 employee. While some of them can also be utilized for a small business with multiple employees, this brief overview will strictly focus on how these plans present themselves for the solo business owner.

IRA

Most you can contribute: $6,000 per year (or $7,000 for those age 50 and older)
Tax treatment: Can be pre-tax (Traditional) or post-tax (Roth)
Deadline to set up: Tax deadline (typically April 15th)
Deadline to contribute: Can make prior tax year contributions up until tax deadline

The IRA is a tool that can actually be utilized by anyone as long as they have earned income, whether they’re strictly a W-2 employee or a business owner. It can often-times be easier to establish and operate than the other plans described here, though it also comes with the lowest contribution limit. Those who elect to use an IRA need to be aware of income limitations for the Roth option and tax deductions for the Traditional route may even be off the table based on income and the availability of an employer-sponsored plan.

Distribution Rules (Traditional IRA): Penalty-free distributions occur after age 59½, or in the event of disability, death, unreimbursed medical expenses that exceed 10% of AGI, qualified education expenses, first time home purchase (up to $10,000). Minimum distribution is required by April 1st following the year participant turns age 72. All distributions are taxable. (Note: with a Nondeductible IRA, cost basis portion of distribution is tax free and earnings portion is taxable.) Early withdrawals are taxable and subject to an additional 10% penalty.

Distribution Rules (Roth IRA): Penalty-free distributions occur after the first five years, after age 59½, in the case of disability, death, unreimbursed medical expenses that exceed 10% of AGI, qualified education expenses, first time home purchase (up to $10,000) and qualified births or adoptions. Contributions can be withdrawn any time, tax free. A 10% penalty is assessed for nonqualified distributions unless an exception applies. Qualified withdrawals (including earnings) are distributed income tax free and penalty free.

SIMPLE IRA

Most you can contribute: $13,500 per year ($16,500 for those age 50 and older)
Tax treatment: Pre-tax only
Deadline to set up: October 1st of the current tax year
Deadline to contribute: Contributions can only be made for the current tax year

It’s mentioned here because it’s an option. However, the SIMPLE IRA tends to be better served for a business with employees (typically 100 or less) because it allows for salary deferral and has options for employer matching. It also comes with a couple extra restrictions that business owners should be aware of. The rules don’t currently allow for a rollover from this type of account to another retirement plan within the first 2 years of the SIMPLE IRA being established. The usual 10% early withdrawal penalty on retirement funds pulled before age 59 ½ is also increased to 25% within the first 2 years of this plan.

Distribution Rules: Same as Traditional IRA above.

SEP IRA

Most you can contribute: $57,000 per year, but no more than 25% of compensation
Tax treatment: Pre-tax only
Deadline to set up: Tax deadline
Deadline to contribute: Can make prior tax year contributions up until tax deadline

The SEP IRA is a relatively easy plan to set up and maintain. It also comes with a much higher contribution limit than an IRA or SIMPLE IRA. For tax planning purposes, it does provide a little more flexibility than the SIMPLE as well. This option could provide challenges if the business grows beyond the solo business owner and hires employees. Contributions to a SEP are technically made by the employer and an equal percentage of salary must be made to an account for each employee.

Distribution Rules: Same as Traditional IRA above.

Solo 401(k)

Most you an contribute: $57,000 per year, but no more than 100% of compensation ($63,000 for those age 50 and older)
Tax treatment: Can be either pre-tax (Traditional) or post-tax (Roth)
Deadline to set up: December 31st of the current tax year
Deadline to contribute: Can make prior tax year contributions up until tax deadline.

Note that there are TWO types of contributions. The business owner must elect to make a “salary deferral” by the end of the calendar year. However, the actual contribution can be made up until the tax deadline. A “profit sharing” contribution can also be made up until the tax deadline.

As you can see above, the Solo 401(k) offers a great deal of flexibility in terms of contribution amount and the tax type of the savings. While the plan, itself, must be established within the calendar year for which you’d like to start contributing, there’s still some flexibility of timing for funding the plan as well. This type of retirement account does come with a higher paperwork and administration load than the other play types. There are also guidelines that must be followed carefully for acting in the role of “employee” and “employer” for the Solo 401(k).

Distribution Rules: Same as Traditional IRA and Roth IRA rules above.

Bonus: Defined Benefit Plan

A Defined Benefit Plan is a less common option for the solopreneur, but certainly carries its share of potential benefits. While it’s much more complex plan than the others discussed here, it can be utilized to make contributions that far exceed any limits mentioned above. This route is typically for someone who needs to put a significant amount of savings away or maybe has less time on their side.

Keep in mind that the rules and guidelines around these plans change on a regular basis. The information here is accurate for the tax year 2020. This is also a summarized overview of the different retirement plan options. They each have additional nuances that are important to understand before making any decisions. Be sure to consult any financial/tax/legal advisors to determine which option is most suitable for your situation.

Edward F. Jurgielewicz III

President

SMRU #1861102