Being an entrepreneur working for yourself is awesome. Trying to figure out self-employed retirement plans is not so awesome.
In this article, I'll share the top five self-employed retirement plans and the pros and cons of each.
But first, we need to ask a simple question…
Why Create a Self-Employed Retirement Plan?
You already pay into your Social Security account each year based upon your net earnings.
However, believing Social Security can cover your retirement needs is a little like believing in Santa (click away now kids!), even if you're paying maximum taxes throughout your life.
The current maximum retirement benefit is $2,861 per month for an individual retiring at age 66.
This should show how limited Social Security benefits are. Depending upon Social Security retirement benefits alone will likely result in living less than your best life.
The government knows this is no bueno which is one reason why self-employed retirement plans are popular.
There are several types of self-employed retirement plans you can choose from to sock away money now for a more comfortable retirement down the road.
Self-Employed Retirement Plans Benefits
The largest benefit a self-employed retirement plan offers is more income (yay!) at retirement.
Usually, the income generated from a self-employed retirement plan is more than the Social Security benefits paid at retirement.
By consistently contributing to a retirement plan, you may even be able to enjoy a bigger income in your non-working years than you had during the working years.
However, even before you get to that age, a self-employed retirement plan can accrue immediate benefits for you.
Depending upon the type of self-employed retirement selected, a business owner can realize current tax benefits in two ways.
First, deducting each contribution from your taxable income.
And second, sheltering the earnings of the retirement plan investments from income taxation during its growth phase.
These benefits have an offset: when contributions are deducted and earnings sheltered, all withdrawals are fully taxable.
Finally, retaining control of any self-employed retirement plan gives the owner absolute control over their investment choices. And as income investors, that's exactly what we want.
Smart investors know that investing for total returns – capital gains AND income – is the best opportunity for solid, steady growth while minimizing risks.
We save a little room in the portfolio (about 20%) for growth and value investments, but the bulk pays us income so that we can benefit from compounded growth over the long-term.
Self-Employed Retirement Plan Types
Self-employed business owners have a lot of choices when it comes to establishing and funding a self-employed retirement plan.
Different retirement plans offer different benefits depending upon the state and health of the business. So, it's a good idea to carefully examine the types of self-employed retirement plans available to best determine which one best fits your situation.
Both self-employed business owners and employees working for other companies can contribute funds to a Traditional IRA.
For 2019, individuals under age 60 may choose to contribute as much as $6,000 to their IRA accounts. Individuals age 60 and older may contribute an additional $1,000 because as retirement gets closer, you should put away even more money if possible.
Traditional IRA Advantages
There are multiple benefits a Traditional IRA owner may realize through this arrangement:
- If you have earned income, you qualify to contribute to a Traditional IRA. However, you cannot contribute more than you earned in the year.
- Choose from a wide array of investment options. Many of them conservative and ideal for capital gains and generating income.
- Investment earnings remain tax-deferred, meaning you do not pay taxes on dividends and interest when it is earned.
- You can make non-deductible contributions which can be withdrawn without incurring taxes (since it was funded with after-tax dollars). Keep in mind that you should keep really good records identifying deductible and non-deductible contributions, since the burden of proof is on you.
- You have a full 15 1/2 months to contribute to your Traditional IRA (from January 1 to April 15 of the following year). Some people wait until the last minute to contribute, but smarter investors fund their traditional IRA early, putting their money to work immediately.
Traditional IRA Disadvantages
Owners of traditional IRAs should be aware of the following limitations or drawbacks:
- If you withdraw your Traditional IRA funds prior to age 59 1/2, prepare for a 10% early withdrawal penalty. This reduces your retirement assets and imposes a hefty penalty so it's only recommended for emergencies.
- You pay taxes on withdrawals (making up for deductions and sheltered earnings you received earlier).
- You must begin Required Minimum Distributions (RMD) by April 1 of the year in which you turn 70 1/2.
- Depending upon your tax bracket, you could end up paying higher taxes on your withdrawals.
- A Traditional IRA may limit the deductibility of contributions if the owner is also covered by another retirement plan.
- Certain investments (life insurance policies, precious metal, art, antiques, etc.) cannot be made in a Traditional IRA.
A Roth IRA is similar to the traditional IRA, but carries additional qualification requirements. For individuals qualifying for a Roth IRA, the contribution limits are identical to the Traditional IRA: $6,000 per year or $7,000 for those over age 60.
However, there are quite a few differences that should be understood.
Roth IRA Advantages
Persons considering a Roth IRA should be aware of the following positives:
- Unlike a Traditional IRA, contribution withdrawals from a Roth IRA are non-taxable.
- Better than a Traditional IRA, early withdrawals of contributions (not their earnings) are allowed without incurring a penalty.
- Earnings from invested funds are tax-deferred, just like a Traditional IRA, and are only taxed upon withdrawal.
- A Roth IRA has no mandatory RMD (Required Minimum Distributions), so funds can continue to grow tax-deferred as long as you want.
Some possible disadvantages with a Roth IRA include:
- If you earn too much, you may not qualify for a Roth IRA or be limited in your annual contributions (a single person earning more than $139,000 in 2020 does not qualify; earning between $124,000 and $138,999 limits your contribution. Caps are slightly higher for married tax filers).
- You can incur a 6% penalty by contributing too much in one year, so being aware of income limits is important. The good news is you can withdraw the excess funds (and its attributed earnings) to avoid the penalty, even after filing your tax return (by filing an amended return).
- You are using after-tax dollars for your Roth IRA contributions, meaning if you are in a 20% tax bracket and can contribute the full $6,000, you must earn $7,500 to make your investment (paying 20%, or $1,500, in taxes, leaving $6,000 to invest).
For higher-earning individuals, the Roth IRA is the best way to go, because you are given more flexibility at retirement.
If your other investments have done well and you do not need the income from your Roth IRA, you can let it keep growing with earnings remaining tax-deferred until withdrawn.
Solo 401(k) Plan
Establishing a Solo 401(k) Plan gives you much more latitude in contributions (as much as $62,000 for 2019), but also only applies to certain business owners; as the name implies, you cannot have any employees in your business (i.e., you work “solo”) other than your spouse.
Also, contributions are made both by the individual (as a worker) and by the business (as the employer), with the “worker” able to contribute $19,000 or 100% of total income (whichever is less) and the business side contributing up to $37,000; those over age 50 can add another $6,000 to their account.
Solo 401(k) Advantages
Creating a Solo 401(k) Plan can yield the following benefits:
- Substantial amounts of money can be added to the account each year, up to $62,000.
- If a couple works for the same small business, each can potentially contribute $62,000 to their accounts in 2019.
- The Solo 401(k) Plan can be structured to either allow contributions to be deductible (like a Traditional IRA) or to contribute using after-tax dollars (like a Roth IRA).
Solo 401(k) Disadvantages
A Solo 401(k) plan has disadvantages similar to both IRAs, mainly concerning tax consequences and penalties for early withdrawals or improper contributions.
Also, this self-employed retirement plan is only for those without employees.
While the Solo 401(k) has recently gained popularity, the original self-employed retirement plan, SEP IRA, still remains a solid choice for the small business owner.
SEP IRA Advantages
I personally use a SEP IRA for these benefits:
- A maximum contribution of $56,000 is possible.
- Up to 25% of compensation can be earmarked for the retirement fund.
- All contributions are by the business, making them pretax contributions.
SEP IRA Disadvantages
Again, you will find similar disadvantages in comparison to both IRA Plans and the 401(k) Plan.
The only other difference between the SEP IRA and the 401(k) is the lack to opt for a Roth-style arrangement, where contributions are made with after-tax funds.
Most people prefer to take the current tax benefits and avoid the Roth structure. Also, at any point, a new Solo Roth 401(k) can be created if the desire to make after-tax contributions arises.
An acronym for “Savings Incentive Match Plan for Employees Individual Retirement Account,” the SIMPLE IRA functions similarly to a 401(k) Plan. However, it is limited to businesses with less than 100 employees.
The company matches contributions made by employees, up to 3% of their income.
SIMPLE IRA Advantages
- All contributions are made using pretax dollars.
- Matching contributions are fully vested, unlike 401(k) plans with graded vesting schedules.
- Employees can contribute up to $13,000 of their 2019 income and another $3,000 if over age 50.
- Simpler and less expensive to operate and manage.
SIMPLE IRA Disadvantages
- Contribution amounts are smaller than with a Solo 401(k) Plan.
- This is no Roth-type option to contribute after-tax dollars.
- All employees are included in the plan and matching contributions are made for all employees (to a maximum of 3%).
Self-Employed Retirement Plans and Investments
Well, there you have an overview of the different self-employed retirement plans!
You probably have a better sense of what best fits your situation. However, it is important to remember that whatever plan you choose, it's the investments you make within any of these retirement plans that makes the ultimate difference.
That's where we come in. Our researched ideas and investment coaching in the Income Investors Academy will help you put together a retirement to fund your dream lifestyle when you stop working.
At Income Investors Academy, you will learn the ropes and discover how to identify high-yielding, low risk investments that keep on producing income.
You can create cash cows to milk off income as long as you want. That's called making your dollars work harder than you, so you can enjoy retirement.