The Best Retirement Plan For A Self-employed Person

Self-employment can be defined as a business set up and run by you. It means that you are operating a personal business where you are answerable to no one but yourself. You are independent and do not work under any employer. 

However, having a personal business and operating a retirement plan is always very difficult because most self-employed people felt they have more advantages than their counterparts who are working under an employee. While it is true that being self-employed gives you some freedom, this does not mean that you should ignore having a retirement plan. 

Also, unlike an employee who would have to make retirement contributions through a paycheck, having your own business makes it easier to sort out the money for retirement plans. However unlike the employee who would enjoy the benefit of having an employer open a 401 K account for him or her, being self-employed means you are on your own. In fact, in most cases, an employee makes additional gains from contributions matched by his or her employer. But for the self-employed, you are in charge of deciding whether or not to have a retirement account. The choice of the account to choose also relies heavily on you. The earlier you make the decision and start a retirement plan, the better for you.

Increase In Self-employment

According to a 2018 study by Freshbooks - a software development center for freelance writers - in 2020, more than 42 million Americans would prefer to be their own boss by embracing self-employment. This is roughly one-third of the working-class Americans. While the growing increase of entrepreneurship is commendable, it is quite disheartening that a substantial 40% self-employed Americans operate retirement plans only sporadically. By contrast, it means that only 12% of traditionally employed workers are sporadic savers. Added to this, about 28% of self-employed people felt there is no need for them to operate a retirement account.

• Why Is Having A Retirement Plan Hard For Self-employed People?

When asked why they are not operating any retirement plan, the reasons self-employed people often give bothers on these five

• Lots of debt to pay off

• Lack of steady income

• Health care expenses

• Cost of running the business

• Educational expenses

Also, most self-employed persons refused to have a retirement plan because they would have to do this by themselves. It is not like the employees' case where a handy employer is available to walk you through the processes and steps.

The self-employed do not have the employer's matching advantage, no shares on company stock and no automated paycheck deduction. Hence it is always difficult for a self-employed to start on a fresh page. Because the amount that would be saved in the retirement plan depends on how much your earns, it might be difficult knowing how much you can contribute until the end of the year.

However, even with the challenges, self-employed persons still have some opportunities when it comes to saving. The retirement plan can easily be calculated under business expenses since it is the money spent on establishing the plan. More importantly, a self-employed retirement plan offers a pretax benefit that helps to reduce taxable income. As an employer, there are a few retirement plans that allow you to contribute more money than the IRA.

Retirement plans for self-employed

Generally, there are four types of retirement plans for self, -employed, some of which are single-player 401(k) retirement plans while others are IRAs. The four retirement plans for self-employed include:

• One-Participant 401(k)

• SIMPLE IRA

• SEP IRA

• Keogh Plan

All the above-listed options are generally tax-deductible. This implies that your money grows over the year as tax-free until the time of withdrawal. However, to avoid facing the payment of tax and other penalties, it is advisable that you leave your account alone until you are 59½.

Moreover, the suitability and complexities of the four accounts vary depending on the size and duration of your business. Your income and personnel would also be considered.

One-participant 401(k) retirement plan

This is also known as solo 401(k), uni-k, solo-k, or individual 401(k). One participant 401(k) retirement plan is basically for sole proprietors. This implies that the plan is only for those running a one-man business with no employees except your spouse and children.

However, with one participant 401(k) retirement plan, the business owner can contribute both as an employer and an employee.

How It Works

The one-participant 401(k) operates in a similar way as the 401(k) account opened by large companies. The only difference between the two is that while the 401(k) plans opened by large companies are for their employees, a one-participant 401(k) plan allows you to contribute as the employer and employee at the same time. With one-participant 401(k), participants are given the privilege to pay more than the 401(k) plans operated by companies for their employees. For instance, in the 401(k) plan operated by the employer on behalf of an employee, the employer makes a pretax payroll deduction from his or her paycheck. The employer then matches this contribution up to a specific amount. Both the employer and the employees get a tax-break in their individual contributions.

However, the one-participant 401(k) plan is such that you are both the employer and the employee and you have the option of contributing up to the capacity of each position. Hence you can contribute as an employer ( referred to as an employee nonelective contribution) and as an employee(referred to as an elective deferral).

In 2020, elective deferral can be adjusted to $19,500 or $26,000 depending on the age of the participant. If below the age of 50, the participant can only pay a maximum of $19,500, but from age 50 and above, the participant can contribute a maximum of $26,000. 

Significantly, if you are running the business together with your spouse, he or she can contribute up to the same amount, while you match the contribution. This is why a one-participant 401(k) retirement plan is said to operate the most generous contribution limit.

How To Set Up The Plan

James B. Twining, CFP®, the founder and wealth manager of Financial Plan, Inc., Bellingham, Wash, "401(k)s are complex plans, with significant accounting, administration, and filing requirements.” “However, a solo 401(k) is quite simple. Until the assets exceed $250,000, there is no filing required at all. Yet a solo 401(k) has all the major tax advantages of a multiple-participant 401(k) plan: The before-tax contribution limits and tax treatment are identical.” This shows that for a business owner to be able to operate a solo 401(k) retirement plan, there are some processes that would be required.

The first condition to set up a solo-401(k) retirement plan is that the business owner would have to work with a financial institution that might impose some charges on the participant. The financial institution also decides on the investment plans to operate. However, a little bit of shopping will spur the interest of many reputable and trustworthy firms that offer low-cost flexible plans.

SEP IRA

This is officially known as a simplified employment pension. As implied by the name, a SEP IRA is a variation on a traditional IRA, hence part of its pattern of operation is like the traditional IRA. Unlike the one, -participant 401(k) retirement plan, the SEP IRA is relatively easy to operate and is advisable for sole proprietors who do not want to go through the strenuous process of the 401(k). In fact, it gives room for one or more employees outside your spouse.

How It Works

The SEP IRA strictly operates a one-man contribution. This implies that unlike 401(k) that allows the business owner to contribute both as the boss and the worker, in SEP IRA, you can only contribute as an employer. However, you can contribute up to 25% of your net earnings which is defined as your annual profit less half of your self-employment taxes. The maximum contribution for the SEP IRA is $57,000. There is no annual funding retirement but the plan offers flexibility to vary contributions.

Also, the flexibility and simplicity of the plan made it a go-to for a one-person business. Although SEP IRA only allows you to contribute just as an employer alone, there is a big catch if you have people working for you. Unlike other plans that operates consistent annual contribution, in SEP, you can choose not to contribute to the plan every year, but when you do, you would have to do the same for all your eligible employers. Your contributions on behalf of your employees are 25% of their net compensation, a maximum of $280,000 per year.

Despite the simplicity of the plan, it is not the most effective type of retirement plans for retirement.  “You can contribute more to a SEP IRA than a solo 401(k), excluding the profit-sharing, but you must make enough money since it’s based on the percentage of profits,” says Joseph Anderson, CFP®, president of Pure Financial Advisors, Inc., based in San Diego, Calif.

How to set up the SEP IRA retirement account

SEP IRA can be easily opened online, at brokerages such as Fidelity Investment or TD Ameritrade.

SIMPLE IRA

This is officially referred to as Saving Incentive Plan match for employees. This type of retirement plan is a bridge between the SEP IRA and the 401(k) plan. It can be used by both sole-proprietors and small business owners with 0-100 employees 

How It Works

SIMPLE IRA follows the SEP IRA pattern of operation. The distributions rule is the same except that SIMPLE IRA reduces the contribution threshold. In 2020, the maximum value of net earning that can be saved in the account is $13,500 with an additional $3000 for participants who are 50 or above.

Both employer and employees can contribute the same amount but as an employer, you would be required to choose between contributing additional 2% to every eligible employee’s income, whether or not he or she contributed or contribute dollar for dollar up to 3% of each participating employee’s income to the plan each year.

Also, like the 401(k) plan, the SIMPLE IRA operates a tax-deductible contribution for employers and pretax contributions for employees. In a way, this reduces the obligation of the employer, but there is still a mandated matching. Also, the amount an employer can contribute to the account is subjected to the same limit of contributions by the employee. Like the 401(k), withdrawal is after retirement age which is 59½. Early withdrawal is subjected to a more severe penalty of 25% within the first two years.

How To Set Up The SIMPLE IRA

The mode of setting this retirement account is similar to one-participant 401(k). It means that interested participants would have to go to a financial institution to open the account. The institution would be the one to choose the investment opportunities you can operate. Also, you would be charged, especially for participation and administration fees.

Keogh or HR 10 retirement Plan

This is commonly referred to as a qualified or profit-sharing plan. It is rated at the most complex type of plan for sole-proprietors but has options that permit more saving 

• How It Works

Keogh operates a fixed contribution plan par every pay period. In 2018, the total contribution was $70,000 while in 2019, the maximum annual benefit was $225,000 or 100% of the employee’s compensation, depending on the one which is lower than the other.

To use the Keogh retirement plan, the business must be unincorporated and set up as a sole proprietorship, limited liability company (LLC). Contributions to Keogh's plan are generally pretax however, there can be vesting.

Keogh retirement plan is very beneficiary for high earners 

• How To Set Up A Keogh Retirement Plan

Keogh retirement plan entails a federal filing requirement hence you would need the help of an investment advisor, accountant or financial institution. Also, the option for the custodian is limited as a result you might need a brick-and-mortar institution rather than an online-only service.

Traditional or Roth IRA 

If none of the four retirement plans is suitable for you, you can open a traditional or Roth IRA. Traditional IRA allows you to contribute pretax dollar while Roth allows you to contribute after, -tax dollar. In 2020  the maximum annual contribution is $6,000 and $7,000 depending on your age. If you are age 50 or older, you can contribute up to $7000 but if you are below, you can contribute $6000. 

Summary

Many self-employed persons and even those working under an employer used to think that retirement contribution is the money you pay last when you must have sorted out the vital expenses. However, this is like paying yourself last. According to David Blaylock, CFP, director of financial planning at Kindur, Dallas/Fort Worth, Texas. “Paying yourself first means saving before you do anything else. Try and set aside a certain portion of your income the day you get paid before you spend any discretionary money.”

Therefore it is advisable that you start your retirement savings as soon as possible. Keep in mind that the sooner you start, the more money you would be able to cash out.