Retirement Plan Options for the Self-Employed

There are five main choices for the self-employed or small-business owners: an IRA (traditional or Roth), a Solo 401(k), a SEP IRA, a SIMPLE IRA or a defined benefit plan.
Financial Planning, Investing, Other Retirement Accounts, Retirement Planning
781956

Being self-employed gives you a certain measure of freedom, but it doesn’t give you an excuse to skip out on saving for retirement.

In fact, it makes putting money away that much more crucial: Unlike an employee, who might have access to a 401(k) or — much more rarely — a pension, you’re on your own. But getting started is unlikely to be high on the priority list: 42% of self-employed professionals and small-business owners are not preparing for retirement, according to a survey this year by FreshBooks, an accounting software firm.

Figuring out how much to save is the first step. You can do it with NerdWallet’s retirement calculator. With a number in mind, it’s time to decide where to put your savings. Self-employed workers have five main retirement account options:

1. Traditional or Roth IRA

QUICK FACTS

Best for: Open to everyone with earned income, though Roth IRAs have income limits. An IRA can be used in combination with other plans, but the amount of traditional IRA contributions you can deduct from your income taxes might be reduced. If you’re leaving a job to start a business, you can also roll your old 401(k) into an IRA.

IRA contribution limit: $5,500 in 2017 (plus $1,000 catch-up contribution for those 50 or older).

Tax advantage: Tax deduction on contributions to a traditional IRA; no immediate deduction for Roth IRA, but withdrawals in retirement are tax-free.

Employee element: None. These are individual plans. If you have employees, they can set up and contribute to their own IRAs.

THE DETAILS

Maybe you like to keep things simple. Or maybe you’re just starting your career — 1 in 4 millennials is an entrepreneur, according to the Kauffman Foundation, a nonprofit that focuses on entrepreneurship — and you don’t have a great deal of money to put away. In that case, an IRA might be a good option.

An IRA is probably the easiest way for self-employed people to save for retirement.

It’s probably the easiest way for self-employed people to start saving for retirement. You simply open an IRA at an online brokerage and report contributions on your tax return each year. There are no special filing requirements, and you can use it whether or not you have employees.

We’ve given in-depth coverage to the differences between traditional and Roth IRAs, but here’s a quick rundown of the basics:

  • A Roth IRA doesn’t reduce your taxes today, but after age 59½ you can pull out your money tax-free
  • A traditional IRA nets you a tax deduction on contributions for the year you make them, but the money is taxed as income when you pull it out — again, after 59½
  • Both accounts are designed to remain untapped until retirement, and there are penalties, with few exceptions, for early withdrawals. But the Roth IRA rules are more flexible — you can remove your contributions, but not your investment earnings, without penalty at any time.

The tax treatment of a Roth IRA might be ideal if it’s early days for your business — read: you’re not making much money — because your tax rate is likely to be higher in retirement, when you’ll be able to pull that money out tax free.

Have questions about Roths? Check out our Roth IRA explainer.

2. Solo 401(k)

QUICK FACTS

Best for: A business owner or self-employed person with no employees (except a spouse, if applicable).

Contribution limit: Up to $54,000 in 2017 (plus $6,000 catch-up contribution for those 50 or older) or 100% of earned income, whichever is less. To help understand the contribution limits here, it helps to pretend you’re two people: An employer (of yourself) and an employee (also of yourself).

  • In your capacity as the employee, you can contribute as you would to a standard employer-offered 401(k), with salary deferrals of up to 100% of your compensation or $18,000 (plus that $6,000 catch-up contribution, if eligible), whichever is less
  • In your capacity as the employer, you can make an additional contribution of up to 25% of compensation
  • There is a special rule for sole proprietors and single-member LLCs: You can contribute 25% of net self-employment income, which is your net profit less half your self-employment tax and the plan contributions you made for yourself
  • The limit on compensation that can be used to factor your contribution is $270,000 in 2017

Tax advantage: This plan works just like a standard, employer-offered 401(k): You make contributions pre-tax, and distributions after age 59½ are taxed

Employee element: You can’t contribute to a solo 401(k) if you have employees. But you can hire your spouse so he or she can also contribute to the plan. Your spouse can contribute up to the standard employee 401(k) contribution limit, plus you can add in the employer contributions, for up to an additional $54,000 total, plus catch-up contribution, if eligible. This potentially doubles what you can save as a couple.

A solo 401(k) is attractive for those who can and want to save a great deal of money in some years.

THE DETAILS

This plan, which the IRS calls a “one-participant 401(k),” is particularly attractive for those who can and want to save a great deal of money for retirement or those who want to save a lot in some years — say, when business is flush — and less in others. It’s easy to set up, although you’ll need to file paperwork with the IRS each year once you have more than $250,000 in your account.

Keep in mind that the contribution limits apply per person, not per plan — so if you also have outside employment that offers a 401(k), or your spouse does, the contribution limits cover both plans.

One other thing to know: You can also choose a solo Roth 401(k), which mimics the tax treatment of a Roth IRA. Again, you might go with this option if your income and tax rate are lower now than you expect them to be in retirement.

3. SEP IRA

QUICK FACTS

Best for: Self-employed people or small-business owners with no or few employees.

Contribution limit: The lesser of $54,000 in 2017 or up to 25% of compensation or net self-employment earnings, with a $270,000 limit on compensation that can be used to factor the contribution. Again, net self-employment income is net profit less half of your self-employment taxes paid and your SEP contribution. No catch-up contribution.

Tax advantage: You can deduct the lesser of your contributions or 25% of net self-employment earnings or compensation — limited to that $270,000 cap per employee in 2017 — on your tax return. These function like traditional IRAs and 401(k)s in that distributions in retirement are taxed as income. There is no Roth version of a SEP IRA.

Employee element: Employers must contribute an equal percentage of salary for each eligible employee, and you are counted as an employee. That means if you contribute 10% of your compensation for yourself, you must contribute 10% of each eligible employee’s compensation.

SEP IRAs have a low administrative burden, and they require limited paperwork and no annual reporting to the IRS.

THE DETAILS

The SEP IRA rules make them popular with small businesses that have a few employees because they’re easier than a solo 401(k) to maintain — there’s a low administrative burden with limited paperwork and no annual reporting to the IRS — and they have similarly high contribution limits. Like the solo 401(k), SEP IRAs are flexible in that you do not have to contribute every year.

The downside for you, as the business owner, is that you have to make contributions for employees, and they must be equal — not in dollar amount, but as a percentage of pay — to the ones you make for yourself. That can be costly if you have more than a few employees or if you’d like to put away a great deal for your own retirement. You cannot simply use a SEP to save for yourself; if you contribute for the year, you have to make contributions for all eligible employees.

4. SIMPLE IRA

QUICK FACTS

Best for: Larger businesses, with up to 100 employees. Unlike the SEP IRA, the contribution burden isn’t solely on you: Employees can contribute through salary deferral.

Contribution limit: Up to $12,500 in 2017 (plus catch-up contribution of $3,000 if 50 or older). If you also contribute to an employer plan, the total of all contributions can’t exceed $18,000.

Tax advantage: Contributions are deductible, but distributions in retirement are taxed. Contributions made to employee accounts are deductible as a business expense.

Employee element: Employers are generally required to make either matching contributions to employee accounts of up to 3% of employee compensation, or fixed contributions of 2% to every eligible employee. Choosing the latter means the employee does not have to contribute to earn your contribution. The compensation limit for factoring contributions is $270,000 in 2017.

THE DETAILS

If you’re the owner of a midsize company with fewer than 100 employees, the SIMPLE is a fairly good option, as it’s easy to set up and the accounts are owned by the employees.

SIMPLE IRAs can be expensive if you have a large number of employees who participate.

SIMPLE IRA contribution limits are significantly lower than a SEP IRA or solo 401(k), however, which could limit how much you can save for retirement, and you may end up having to make mandatory contributions to employee accounts, which can be expensive if you have a large number of employees who participate.

The SIMPLE IRA is also inflexible, particularly early on: Early withdrawals, before age 59½, are treated the same as early 401(k) or IRA distributions, in that they are taxed as income and subject to 10% penalty. But if you make a withdrawal within the first two years of participation in a SIMPLE IRA, the 10% penalty is increased to 25%. That means you also can’t roll over a SIMPLE to another retirement account within that two-year period. Zing.

One other thing to know: There is a 401(k) version of a SIMPLE, which works in much the same way but allows participants to take loans from their accounts. This version requires more administrative oversight and can be more expensive to set up.

5. Defined benefit plan

QUICK FACTS

Best for: A self-employed person with no employees who has a high income and wants to save a lot for retirement on an ongoing basis.

Contribution limit: Calculated based on the benefit you’ll receive at retirement, your age and expected investment returns.

Tax advantage: Contributions are generally tax deductible, and distributions in retirement are taxed as income. An actuary must figure your deduction limit, which adds an administrative layer.

Employee benefit: If you have employees, you generally offer this plan to them and make contributions on their behalf.

The upside of a defined benefit plan is that you can stash a lot of cash in them.

THE DETAILS

We often lament the decline of pension plans, and this is exactly that: If you’re self-employed, you can set up your own pension — a guaranteed stream of income — in retirement by using a defined benefit plan.

So why wouldn’t everyone do it? They’re expensive, with high setup and and annual fees. If you have employees, that fee will likely go up, and you’ll need to contribute on their behalf. They carry a heavy administrative burden each year, and they require a commitment to fund the plan with a certain amount per year. If you need to change that amount, you’ll pay additional fees.

The upside is that you can stash a lot of cash in these, so if you’re fairly close to retirement, earning a high income that you know you’ll maintain and that allows you to save a significant amount per year — we’re talking $50,000 to $80,000 or more — you might consider using this plan to supercharge your savings efforts.

Where to open a retirement plan if you’re self-employed

Once you’ve decided to open one of these accounts, you’ll have to decide where to do it.

Most online brokers will allow you to open the four most common account types: IRA, solo 401(k), SEP IRA and SIMPLE IRA. The account providers in our analysis of the best IRA providers are all good choices. If you’re interested in a defined benefit plan, your options are more limited, but Charles Schwab offers these plans.

Each broker will walk you through the process of opening one of these accounts and explain any paperwork you may need to file with the IRS. But to be on the safe side, you may also want to work with an accountant.

Arielle O’Shea is a staff writer at NerdWallet, a personal finance website. Email: aoshea@nerdwallet.com. Twitter: @arioshea.

Updated April 24, 2017