The best retirement plan for an independent contractor depends largely on how many, if any, employees work for them. If you work as a solo independent contractor, retirement plans are generally simpler and less costly than if you have employees. Once you hire employees, you may be obliged to contribute to their retirement plans as well as to your own, placing additional burden on your company financials.
It is standard practice at large corporations to provide 401(k) plans to full-time employees, but as a small business owner, the cost of providing retirement plan benefits may be a large portion of revenues or profits. Before selecting one plan over another, think carefully about the ongoing financial commitments to contribute to a retirement plan or plans of many employees and what the financial liability will mean not just for your personal finances, but for your company’s finances too.
Table of Contents
- Solo 401(k) Retirement Plan
- Opening a Solo 401(k) Account
- How To Finance Your Business From Your Solo 401(k) Plan
- SEP-IRA Retirement Plan
- SIMPLE IRA Retirement Plan
- Traditional IRA & Roth IRA Retirement Plans
Solo 401(k) Retirement Plan
Owning a business or working as a freelancer can make it difficult to find retirement plans that accumulate value.
Many employees can take advantage of an employer-matched 401(k) plan. When the employee makes a contribution, the employer matches a percentage of the contribution.
That option doesn’t exist for self-employed people. Solo 401(k) plans give individuals an opportunity to invest in their retirement funds. While no one matches their contribution funds, they can still benefit by investing in a solo 401(k).
Are You Eligible for a Solo 401(k)?
The IRS only allows business owners without employees to open solo 401(k) plans. Freelance workers without employees also fall into this category.
If you have any employees, then you cannot contribute to a solo 401(k) plan. Business owners with employees should consider retirement investment options such as regular 401(k) plans, SIMPLE IRAs, and SEP IRAs.
Benefits of Contributing to a Solo 401(k)
Although you don’t get matching contributions from a solo 401(k), starting an account does give you several benefits that makes retirement planning easier.
Most people start solo 401(k) plans because they want to take advantage of tax benefits. The government lets you deduct your solo 401(k) contributions from your annual income, which means you don’t pay any taxes on your contributions. Instead, you pay taxes when you remove money from the account.
Alternatively, you can choose to get taxed on your 401(k) contributions and avoid taxes when you withdraw money after retirement.
Regardless of the option you choose, you can give your spouse access to your solo 401(k). Even if your spouse participates in your business, effectively acting as an employee, you can still open and contribute to a solo 401(k).
How can you decide which option works better for you?
If you expect your income to decline after you retire, then you will get more benefits by avoiding taxes on your contributions.
If you think that your income will increase or stay the same after you retire, then paying taxes on your contributions could benefit you because it lets you avoid higher taxes in the future.
Solo 401(k) Contribution Limits
The Treasury Department sets solo 401(k) contribution limits just like it sets limits for regular 401(k) plans. For 2019, you can contribute up to $56,000 to your solo 401(k). The amount that you can contribute, however, depends on how much money you earn in 2019.
No matter how much money you make, you can automatically contribute up to $19,000 to your solo 401(k). People 50 and older can contribute an extra $6,000.
The rest of your contribution cannot exceed $37,000 or 25% of your net self-employment income, whichever is lower. If you earn $280,000 in 2019, then 25% of your income will max out your $37,000 contribution.
Opening a Solo 401(k) Account
Most brokers will let you start a solo 401(k) account with them. Before you can open a plan, though, you will need an Employer Identification Number. You also need an Employer Identification Number to file your taxes.
Your 401(k) account lets you invest in a variety of vehicles, including index funds, mutual funds, stocks, and bonds. For the most part, you’re only limited by what services your broker offers.
Many self-employed people find retirement saving a challenge. With a solo 401(k), you get a straightforward way to accumulate interest and avoid taxes so you can afford to retire.
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Pro Tip: Other names for the same plan include solo-k, uni-k, and one-participant k plans.
Solo 401(k) Example
As the business owner, in addition to contributing as much as $19,000 (or $25,000 if over age 50), you are also entitled to choose employer non-elective contributions of up to 25% of your earned income.
To highlight how this works, consider a business owner with $100,000 of earned income. The business owner can defer the first $19,000 (or $25,000 if over the age of 50) directly into the solo 401(k) retirement plan. And the business owner can contribute up to an additional 25% of salary ($25,000) for a total contribution of $44,000.
For a business owner over the age of 50 who is earning $50,000 in W-2 wages, it is possible to defer the first $25,000 and an additional 25% of salary ($12,500) for a total contribution of $37,500.
The maximum contribution permitted annually for a solo 401(k) plan is $56,000 for those under the age of 50 and $59,000 for those over the age of 50. What makes the solo 401(k) so attractive is that you don’t need to earn as much as other plans, such as the SEP IRA, to contribute the same amount to your retirement plan.
While the solo 401(k) is attractive in allowing you to contribute a large amount in a short period to your retirement nest-egg, it is more administratively burdensome than other retirement plans. Once you accumulate $250,000, you will be obligated to file annual report Form 5500-SF with the Internal Revenue Service to declare assets in the plan.
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How To Finance Your Business From Your Solo 401(k) Plan
A business owner looking to grow their business can finance expansion by borrowing the lesser of $50,000 or 50% of contributions from their solo 401(k) plan.
An added benefit of the solo 401(k) plan is the opportunity to borrow from plan contributions to finance your business. The most you are permitted to borrow is $50,000 or 50% of your contributions, whichever amount is lower.
For solopreneurs who need money to grow their business, this is an attractive financing choice because interest rates are reasonable. The fly in the ointment is that you must repay borrowed funds within 5 years, so make sure to crunch the numbers for the business before electing this financing option.
SEP-IRA Retirement Plan
A SEP-IRA has a high contribution limit, no requirement to make annual contributions, and all contributions are made with pre-tax dollars. Business owners are required to contribute the same percentage of pay to employee SEP-IRA plans as they contribute to their own SEP-IRA plan.
Similar to a solo 401(k), a SEP-IRA has a high contribution limit. The limit is $54,000 in 2017 ($53,000 for 2016). However, the most that can be contributed annually is the lesser of 25% of annual compensation or $54,000. So if the business owner earns $100,000 annually, then no more than $25,000 may be paid into his or her SEP-IRA retirement plan.
Another attractive feature of the SEP-IRA is that contributions do not have to be made every year, so if your business encounters cash flow issues you are not required to continue making contributions. A further advantage of the SEP-IRA is that all contributions are made with pre-tax dollars, so you benefit from the inherent tax advantages.
Where the SEP IRA has drawbacks for the small business owner without abundant cash flow is employees must receive the same percentage of pay into their SEP-IRA plans as the percentage the business owner contributes to their own plan.
Consider a small business owner earning $100,000 annually who has three employees and wishes to direct 10% of earnings ($10,000) to a SEP-IRA plan. If each of the three employees earns $50,000, the business owner must contribute 10% of $50,000 ($5,000) to each employee SEP-IRA plan, for a total of $15,000.
For a business owner with employees, you can see that choosing a SEP-IRA can quickly becomes costly. If the business is growing and plans are in place to hire more employees, careful evaluation of projected costs should be made before electing the SEP-IRA.
SIMPLE IRA Retirement Plan
A SIMPLE (Savings Incentive Match Plan for Employees) IRA allows independent contractors to contribute more to a retirement plan than is possible through a traditional IRA. For business owners with employees, the SIMPLE IRA gets more complicated: an employer must select the amount of contribution matching, notify employees of periods when contribution levels may be changed and keep election periods open for at least 60 days.
Independent contractors without employees will find the SIMPLE IRA to be an attractive retirement plan option. While contributions to a traditional IRA are restricted to $5,500 annually (or $6,500 over the age of 50), contributions to a SIMPLE IRA of up to $12,500 annually (and $15,500 for those over age 50) are permitted.
For business owners with employees, the IRS mandates that the employer must select one of the contribution methods below and inform employees which one is chosen for the following year.
- 2% non-elective contribution: contribute 2% of each employee’s compensation to the employee’s plan, irrespective of whether the employee contributes; or
- 3% matching contribution: match each employee’s contribution on a dollar-for-dollar basis up to 3% of the employee’s total compensation.
It is permitted to reduce the 3% figure to a lower amount provided it is above 1%. Over a 5 year period, a selection amount below 3% is permitted in only two calendar years.
The SIMPLE IRA is more administratively burdensome than some other plans because employees must be notified when they can change their contribution amounts during the plan’s election period, which must be at least 60 days long. The IRS stipulates that at least one election period between November 2 and December 31 is made available to employees, though the employer can open up additional election periods if they wish.
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Traditional IRA & Roth IRA Retirement Plans
Traditional and Roth IRA retirement plans have lower annual contribution limits than other retirement plan options but are a good choice for those early in their careers or unable to contribute more than the threshold limits each year. The Roth IRA is generally the better choice if you believe your tax rate will increase over time. Plus, the Roth IRA has greater flexibility because contributions (not earnings) may be withdrawn tax-free and penalty-free.
In a traditional IRA, pre-tax dollars are contributed while in a Roth IRA after-tax dollars are contributed. In both cases, contributions are limited to $5,500 annually ($6,500 over the age of 50). Although the cap is lower compared to other plans, traditional IRA and Roth IRA plans are good starter options for independent contractors who don’t have the means to set aside a larger amount for retirement.
The Roth IRA has the edge over the traditional IRA in two ways:
- If you expect your tax rate to increase over time, the Roth IRA is the better choice because you pay lower taxes upfront than you would otherwise in retirement years with a traditional IRA.
- You can withdraw your contributions without paying taxes or penalties at any time – because after-tax contributions were made, the IRS has already received tax payments. However, investment gains are subject to Roth IRA withdrawal rules, including a minimum five year period that the account must be held.
No matter which retirement plan you choose, the power of compounding gains over long time periods can significantly increase the size of your retirement nest-egg, so find the best IRA provider to meet your needs and get started.