Retirement Planning Basics: Options for the Self-Employed and Small Business Owners

Providing wealth management services to folks in Austin and Hill Country means that we work with a lot of entrepreneurs and small business owners. While it may be hard as an entrepreneur to think about life beyond your professional endeavors, it’s still important to plan for retirement early so that when the time comes, you’re able to step away from your business and enjoy the profits of your life’s work. 

We’ve talked about Roth and traditional IRAs and 401(k)s, but these retirement planning options are not always well-suited for the unique needs of the entrepreneurial individual. So, on behalf of Austin’s entrepreneurs and business owners, we thought we’d look at the retirement accounts that were created with you in mind. 

SEP IRA

One of the distinguishing factors between IRAs and 401(k)s is that IRAs are not affiliated with an employer. This is not the case for SEP and SIMPLE IRAs, which are offered by employers to their employees and differ from 401(k) accounts in other ways, such as their contribution limits. SEP and SIMPLE IRAs are great retirement account options for self-employed people (under sole proprietorships) and small business owners with few employees. 

The primary benefit of SEP IRA is for the employer (who can be a self-employed individual). These accounts have fewer administrative nuances than 401(k) plans, lower start-up costs, and are easy to set up through a broker. They also offer flexibility for eligibility requirements and contribution amounts. 

Like a traditional IRA, contributions are tax-deductible and grow tax-deferred until the distributions are made in retirement, at which point the money withdrawn is taxed as income. The contributions are made by the employer, which means that this tax break is for the business, and the employee will pay taxes when they withdraw the funds in retirement. There is no “Roth” option for the SEP IRA, so tax-deductible contributions with taxed withdrawals is the only option for this account. Withdrawing money early will incur penalty fees, like most other retirement accounts. 

The main benefits of an SEP IRA are found in the contribution details. Contributions are adjustable, so employers have the flexibility to adjust their contributions according to how business is doing. Depending on your circumstances, contribution limits may also be higher than other accounts allow: the limits for 2022 are 25% of compensation or $61,000 annually (whichever is less). This is much higher than a traditional IRA or a Roth IRA’s contribution limits. These accounts also require small business owners to make proportional contributions for their eligible employees if they contribute for themselves. 

SIMPLE IRA 

The SIMPLE in SIMPLE IRA stands for Savings Incentive Match Plan for Employees. Did you get all that? Despite the clunky acronym, this plan is easy to set up and run, making it another option for small business owners and self-employed individuals. 

Contributions are tax-deferred, meaning that employees defer a portion of their salaries into these plans and then pay taxes when they make distributions. Like a 401(k), employees are able to have their contributions deducted from their paycheck.

This IRA requires employers to match contributions, making a match of either 3% of an employee’s annual contribution or, if the employee does not contribute, a nonelective 2% contribution of each employee’s salary. Unlike other matching scenarios with other retirement accounts, this money belongs to the employee immediately and will go with them if they leave the company, regardless of how long they have worked there. 

SIMPLE IRA account contribution limits for 2022 are $14,000 per year for those younger than 50, and $17,000 for 50 and older who want to make “catch-up contributions”. These amounts are higher than a traditional or Roth IRA. Depending on the details of the plan and gross income for employees, there are other tax credits available to individuals and employers utilizing SIMPLE IRA accounts. 

Distributions are similar to a traditional IRA, in that money is taxed only when it is withdrawn. There are penalties and fees if the money is withdrawn before the account owner reaches retirement age of 59 and a half, and minimum distributions are required to start at age 72. 

Solo 401(k)s

Another option for self-employed people who want to enjoy the benefits of a 401(k) are solo 401(k) plans. 

These plans are also called a one-participant 401(k) or a solo K. There are no age or income restrictions, but account holders must be business owners with no employees. Sole proprietors, freelancers, and independent contractors whose business generates income typically fit this description. The spouse of the self-employed individual may also participate in their solo 401(k) plan. 

As for the tax advantages, you get to choose the model that you prefer. You can set up a solo 401(k) like a traditional or Roth 401(k) – either contributing pre-tax money to get a break on taxes the same year that you make the contribution, or making after-tax contributions and withdrawing the money tax–free in retirement. 

Typically solo 401ks allow for more contributions than an SEP, SIMPLE, traditional, or Roth IRA, although their contributions will not help them to avoid the self-employment tax. The total solo 401(k) contribution limit for 2022 is $61,000, with a catch-up contribution of $6,500 permitted for individuals 50 or older. Typically withdrawals must be made in retirement, but with a solo 401(k) you can take out loans from the plan prior to retiring, so there is a little bit more flexibility with this plan in that regard. 

Because the individual with a solo 401(k) is both the employee and the employer, these contributions have limits associated with each role. As the employee, you can contribute up to $20,500 in 2022, or 100% of compensation, whichever is less. As the employer, you can make an additional contribution from your net self-employment income. If your self-employed venture is your side gig and you have a 401(k) plan from another job, your employee contribution limit must be within the maximum for the year, but the employer contribution is not limited. 

You can open a solo 401k at most online brokers provided that you have an Employer Identification Number. Like traditional and Roth 401ks, you will have options to many investments through the broker, including mutual funds, index funds, exchange-traded funds, individual stocks, and bonds. There is more paperwork involved in setting up and maintaining a solo 401(k) compared to an SEP or SIMPLE IRA, but the benefits in flexibility and contribution limits afforded by this plan  may outweigh this time investment. 

You’ve Got Options

Self-employed individuals and small business owners deserve a happy retirement just like everyone else, and there are many options for entrepreneurial individuals to set themselves up for this security. Preparing for retirement often also involves combining IRA or 401(k) plans with an investment management strategy that will help sustain you throughout your retirement. 

Connect with NEST’s resident Mentor Gloria (who is also a small business owner herself!) and learn how a robust financial plan can help you prepare for retirement. Email Gloria at info@nestfinancial.net for a no-obligation consultation!

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DISCLAIMER: We are legally obligated to remind you that the information and opinions shared in this article are for educational purposes only and are not financial planning or investment advice. For guidance about your unique goals, drop us a line at info@nestfinancial.net