Nothing quite beats the thrill of entrepreneurship. Whether it’s opening your own coffee shop, running the family business, or building the next great app, self-employment gives you an exhilarating amount of control over your life. You can do what you want, the way you want, when you want to. But…
Alongside all these freedoms, there are also a great many risks and responsibilities. Now more than ever, your financial success is on your shoulders. And so is having the foresight to save for retirement.
Knowing which retirement plan is the best fit for you can be complicated–especially when you add in your responsibilities as an employer. As with anything, the devil is in the details. That’s why many entrepreneurs work with a financial planner who can guide them in the right direction.
There’s plenty of ground to cover, so this post will focus on just the basics.
Let’s begin with the good, the bad, and the ugly.
Being self-employed means that you have a wide variety of retirement savings options. Employees of large companies are usually offered just one–the 401k.
While this is a solid retirement plan, it’s only one way to save and it can actually limit your savings potential.
Entrepreneurs have a much wider selection of plans to choose from–some of which will even help shrink your business’s tax footprint.
Sorting through all of these retirement plan options will require work. You have to take the initiative to research, choose, and implement the correct plan for your business.
Things get complicated quick.
Leverage your business network: financial advisors and CPA’s are your best friends now. They’re well-versed in this arena and can help you understand all the ins and outs of each plan.
Someone who has been hired at a large company usually receives a big welcome packet that contains information about healthcare, dental, and the 401k/403b. (They also receive nagging emails from the HR department constantly reminding them to enroll in a plan.) They have profit sharing contributions automatically added their retirement savings account–that means they boost their balance every month without having to take any action. It’s effortless.
Unfortunately, you don’t have it quite so easy.
Deciding on a plan, enrolling in it, and making these contributions is now your responsibility. And you’ll need to take an active role every step of the way.
There’s more work, but it’s manageable.
Once you’ve selected your retirement plan, be sure to set up automatic deposits to your bank or credit union so that you don’t have to think about it every week, month, and year.
All retirement savings plans are designed for the same purpose: to accrue and invest your money for retirement. But each approach also has certain benefits and constraints that you should be aware of.
You can do the research and decide it all for yourself, but many entrepreneurs don’t realize that their choice will have an impact on their individual taxes as well as their business taxes. A financial adviser or CPA can help you decide which option fits your business best. Making the right decision here is crucial.
Let’s look at your options.
SEP IRAs are the most common retirement plans for small business owners. That’s because they offer tax-deferred growth and tax-deductible employer contributions. These types of accounts do not have any administrative costs because they are directed by the SEP IRA owner themselves (i.e. you).
Most small business owners are eligible to put away up to $53,000 or 25% (whichever is less) of their income for 2016. You should be aware that if you open a SEP IRA for yourself, then you must also open one for all eligible employees.
Small business owners can also contribute to a Traditional IRA account, though annual contributions are limited:
Traditional IRAs allow you to deduct contributions from your personal taxable income, subject to certain income limitations*. Lowering your tax bill while saving for retirement? Sounds great! However, you will pay taxes when you eventually withdraw the money from this account in retirement.
Roth IRAs are a terrific option for small business owners. They offer the same contribution limits as Traditional IRAs, subject to certain income limits**.
The big difference is that Roth IRA contributions cannot be deducted from your personal income, meaning that contributions will not help lower your taxes in the year that you make the contribution (like Traditional IRA’s do). That may sound undesirable but, with a Roth IRA, when you withdraw the assets in retirement (hopefully as a much larger amount due to growth), they will come tax-free. This generally makes Roth IRAs a better option.
If your company has less than 100 employees, SIMPLE IRAs, or Savings Incentive Match Plan for Employees, may be a good fit.
They allow employers and employees to make pre-tax contributions to the employee’s retirement plan and enjoy tax-free growth.
Employees can contribute up to $12,500 annually ($15,500 if over 50) to their savings plan in 2016. When thinking about setting up a SIMPLE IRA, be aware that employers must match up the 3% of what their employees decide to contribute.
If you run an owner-only business or partnership (i.e. you have no W-2 employees), then a Self-Employed (or Solo) 401k may suit you best.
Like standard 401ks, these accounts allow for employee (you) salary deferral contributions and employer (your company) profit sharing/match contribution.
As an employee, your contributions limits for 2016 are:
As an employer, your company’s contribution is limited to 25% of your income as an employee. So if you pay yourself $100,000 per year, then your company can contribute up to $25,000 in profit sharing and/or match.
The combined contributions between employer and employee cannot exceed $53,000 in 2016 ($59,000 for individuals over 50). This is the best option for owner-only businesses looking to maximize their retirement savings.
Another advantage is that you have the ability to take tax-free loans against your solo 401k of up to 50% of the account value, capped at $50,000. The main disadvantage of these 401k’s is the administrative costs of setup and maintenance, but it may be worth it, depending on your situation.
I know that being self-employed is a big responsibility–I too am self-employed. I understand feeling pulled in a million different directions every day. I understand the never-ending to-do lists and pressure of taking care of people.
But believe me, you cannot ignore your retirement.
It’s easy to say, “I’ll start saving next year,” but that one year you weren’t saving could mean several more years of working. Do not wait. Make saving a priority. If you’re not sure which option is best for you, consult a financial planner. Your 65-year old self will thank you.
*For 2016, Traditional IRA income limits are $71,000 for single filers and between $98,000-$118,000 (phase-out) for joint filers. If MAGI (modified adjusted gross income from IRS Form 1040) is below the lower threshold, you can deduct 100% of your contribution from your income. If your MAGI is in the range, you can deduct a portion of your contribution. If your MAGI is above the upper threshold, you will not be able to deduct any of your contribution. See https://www.irs.gov/retirement-plans/ira-deduction-limits for more info.
**For 2016, Roth IRA income limits are $117,000-$132,000 for single filers and $184,000-$194,000 for joint filers. If your MAGI is below the lower threshold, you will be able to make a contribution to your Roth IRA. If your MAGI is in the range, you can contribute a partial contribution (see https://www.irs.gov/retirement-plans/plan-participant-employee/amount-of-roth-ira-contributions-that-you-can-make-for-2016 for exact amounts). If your MAGI is above the upper threshold, you will not be able to make a Roth contribution.