If you’re self-employed or a small business owner, you know that saving for retirement is just one of the many things you have to figure out on your own. 

Saving for retirement when you’re self-employed is a challenge. Not only do you have to research and employ the strategy that best suits you, but you also have to commit to it. The commitment to saving is one of the biggest challenges we see when working with clients, because income is rarely straightforward for the self-employed. Income isn’t always steady or predictable; and there may be business debts and estimated taxes to pay. It’s no wonder that a retirement research study conducted by Transamerica found that only 55% of self-employed people save consistently for retirement. 

Creating structure, automating as much as possible and remaining disciplined are the keys to success for self-employed retirement savings. It takes will power, but if you use savings strategies that specifically benefit self-employed people, you can sock away a lot more money than you otherwise could working for someone else. 

Before doing anything, you want to determine how much you actually need to save for retirement—that way, you understand your “why” for saving and put intention behind the dollars you earn. A simple retirement calculator, like Nerdwallet’s, can give you a rough idea of how much to save, but it’s definitely worth a more in-depth discussion with a financial planner. Once you have a sense of how much you need to meet your goals, the next step is to choose a retirement plan. 

Read More: Why Should You Save Money?

For the self-employed and small business owners, five main options exist to save for retirement: a Traditional or Roth IRA, SEP-IRA, SIMPLE IRA, Solo 401(k), or a defined benefit plan. 

Traditional or Roth IRA

While anyone can contribute to an IRA, including those who aren’t self-employed, it’s a good starting place for self-employed people who can only save a modest amount each year. The 2021 maximum annual contribution is $6,000, and it’s $7,000 if you’re age 50 or older. 

IRAs are easy to open and they can be funded in addition to one of the other four retirement savings options listed in this post. Anyone with employment income can use a Roth or traditional IRA. 

Roth IRAs let you contribute after-tax dollars and withdraw the funds tax-free in retirement. Traditional IRAs let you contribute pre-tax dollars and tax you on withdrawals in retirement. The choice of which option to go with depends on whether you think you’ll be in a higher tax bracket at retirement. The tax advantage of contributing to a traditional IRA is that you get to deduct that amount from your gross income, thus lowering your tax bill for the year. If your income is high enough, you may exceed the limits for contributing to a Roth IRA. The income limits only apply to Traditional IRAs if someone in the household has access to a retirement plan, like a 401(k) through work. 

Remember that with the IRAs and all of these plans, the key to their success is investing the funds for long-term growth. If you’re not sure how, having this conversation with a financial planner is a good idea. 

SEP-IRA (Simplified Employee Pension Plan)

The SEP-IRA is the most popular strategy we use with our self-employed clients. It’s best for individuals or small business owners with few to no employees. A SEP-IRA is just as easy to open as a traditional or Roth IRA, but with this option, you can potentially save a lot more money. The trick here is working with your CPA to make sure you know how much you can actually contribute.  

With a SEP-IRA, you can save up to 25% of your compensation or net self-employment earnings, up to a limit of $58,000 in 2021. The contributions you make to a SEP-IRA are tax-deductible, so you can significantly reduce your taxable income while stashing away retirement savings. Employers with SEP-IRAs have to contribute an equal percentage of salary for each eligible employee, and you also count as an employee. After a certain length of time, which you write into the documents when setting up the SEP-IRA, employees become eligible for matched contributions. This means that once they’re eligible, you’ll have to contribute 25% of your employees’ compensation to their SEP-IRAs. 

SIMPLE IRA

A SIMPLE IRA may be a good option if you own a small business and want to offer a retirement savings plan to your employees without taking on too much administrative burden. The “SIMPLE” stands for “Savings Incentive Match Plan for Employees,” and the IRA stands for “Individual Retirement Account.” 

For 2021, the maximum contribution to a SIMPLE IRA is $13,500, plus an additional $3,000 if you’re age 50 or older. This is less than what you can contribute to a SEP-IRA or Solo 401(k), and you also have requirements for contributing to employee accounts. As the employer, you either have to match dollar for dollar what your employees contribute to their plan, up to 3% of their income, or you can contribute a fixed 2% of each employee’s income whether they contribute or not. The contributions you make to employees’ SIMPLE IRAs are deductible as a business expense. 

Solo 401(k)

The Solo 401(k) is an option that’s only available to business owners (and their spouses if the spouse is also employed in the business). Therefore, you are unable to contribute to one if you have any employees other than your spouse. The Solo 401(k) offers the chance to save a sizable amount of money towards retirement. The contribution limit for 2021 is $58,000, plus an additional $6,500 for those aged 50 and older. 

Unlike the SEP-IRA, which limits your contributions to 25% of income, the Solo 401(k) allows you to contribute as both the employee (elective deferrals) and the employer (employer contribution, also known as “profit sharing”).

For the elective deferral (employee) portion, you can contribute up to $19,500. For the employer contribution, there are two ways you can do it. If your business is a corporation, you can contribute up to 25% of the employee W-2 gross income. If your business is a sole proprietor/partnership, you can contribute up to 20% of net income. Combined, the elective deferral and employer contributions cannot exceed the limit of $58,000 (plus the $6,500 amount, if you’re 50 or older). 

We’ve used this option for people who want to and can put away a lot of money for retirement, or for people who want to increase their saving in the years when the business is doing well. You can also set up the plan as a Roth 401(k) so that the employee contributions are made after paying taxes and are withdrawn in retirement tax-free (you can only use the Roth strategy for the employee contributions). 

Defined Benefit Plan

Defined benefit plans are rare due to the high administrative costs and the level of certainty that’s required around income. This option is best for people with very high incomes who want to save a lot of money. It only starts to make sense for people who are able to put upwards from $100,000 of pre-tax dollars into retirement savings and have predictable enough cash flow to commit to that on an ongoing basis.  

Defined benefit plans are more expensive and difficult to set up, requiring an actuary to determine your deduction limit. You’ll figure out how much you contribute to the plan based on the benefit you plan to receive at retirement. The benefit is determined by your age and expected investment returns. 

Maintaining this kind of plan is complex, requiring guidance from both a CPA and financial planner. If you have employees, the fee to maintain the plan will go up. You will likely need to make contributions for them too. For this reason, the defined benefit plan strategy is more effectively used for businesses where the spouses and family members are employees so that a lot of money can be diverted from the business into retirement savings. You also are committed to funding the plan with a certain amount of money each year. That means you need to have stable business income. Otherwise, you’ll have to pay additional fees if you need to change the amount. 

The Big Picture

We find that the key ingredients of success in any self-employed retirement savings strategy are simplicity, automation, and commitment. First, we need to understand the savings goal. Then we come up with a system that either automatically transfers savings into your chosen account or holds you accountable for doing so on a regular basis. Lastly, we check in as frequently as necessary so that we can update the plan as things change with work and life. This is why we often use the SEP-IRA and Traditional or Roth IRAs as savings strategies. These types of plans are straightforward, effective, and help us support clients in their retirement savings goals. 

Self-employment income is often volatile, so it makes sense to change your level of savings as things ebb and flow. We partner closely with our self-employed clients and check in on a quarterly, or even monthly, basis to see where things stand. By being flexible and dedicated, self-employed individuals have the opportunity to maximize retirement savings in ways that non-self-employed people can’t.

Interested in receiving this content in our monthly newsletter? Sign up here!