Choosing the Right Self-Employed Retirement Account

Self-Employed Retirement Account

Need to select a self-employed retirement account? The following guide can help you decide which option is right for you.

For many small business owners, preparing for retirement is more of an abstract idea than a concrete plan. Indeed, 34% of business owners don’t have a retirement savings plan, according to the small business resource SCORE. And 40% of those surveyed expressed concern that they won’t have the funds they need to stop working by age 65.

It’s natural for retirement planning to fall to the bottom of the priority list when dealing with the day-to-day challenges of running a business. At the same time, relying on your business alone to fund your retirement can be risky, especially if you don’t have an exit strategy. Fortunately, small business owners have a variety of self-employed retirement account options to choose from.

If you don’t have a retirement savings plan in place, consider the following self-employed retirement account options:

Traditional or Roth IRA

Chances are you already have a traditional and/or Roth IRA. These individual retirement accounts are available to anyone who earns or has earned an income, including self-employed individuals. While there are no income limits for a traditional IRA, certain high earners may not be eligible to contribute to a Roth IRA.

With both types of accounts, you can contribute up to $6,000 annually in 2022 ($7,000 if you’re age 50 or older). If you contribute to a traditional IRA, you may be eligible for a tax deduction in the same year. You’ll then pay taxes on your withdrawals in retirement. On the other hand, you contribute after-tax dollars to a Roth IRA. You can then withdraw your funds tax-free in retirement.

A traditional or Roth IRA is a simple way to begin saving for retirement on a tax-advantaged basis. This is especially true if you don’t plan on making hefty contributions. However, since these accounts have low contribution limits, you may want to consider another option as your income increases.  

Solo 401(k)

A Solo 401(k) can be an attractive self-employed retirement account option for solo business owners. While there are no age or income limits, you can only contribute to a Solo 401(k) if you have no full-time employees.

The IRS allows one exception to the no employee rule. If your spouse earns an income from your business, that could effectively double the amount you can contribute as a family, depending on your income.

A Solo 401(k) may be ideal if you’re a high earner or need to catch up on your retirement savings. In 2022, you can contribute up to $61,000 to a Solo 401(k). And if you’re age 50 or older, you can contribute an additional $6,500.

One of the benefits of a Solo 401(k) is that you can contribute pre-tax dollars, which reduces your taxable income for the year. There is also a Roth option, which, like a Roth IRA, has income limits.

Simplified Employee Pension (SEP) IRA

A SEP IRA is essentially a traditional IRA with the ability to make employer contributions. As a result, the annual contribution limits are significantly higher than with a traditional IRA.

As a solo business owner, your contribution limit is the same as it would be with a Solo 401(k). If you have employees, they can contribute up to the annual 401(k) limit themselves. You can then decide if you want to make additional contributions to your employees’ accounts.

Compared to other employer-sponsored retirement plans, it’s typically easier and less expensive to set up a SEP IRA. Therefore, a SEP IRA can be an attractive self-employed retirement account option if you only have a few employees but want to offer retirement benefits.

SIMPLE IRA

A SIMPLE IRA, which stands for Savings Incentive Match Plan for Employees, is like a SEP IRA in that it operates like a traditional IRA with higher contribution limits. However, you can only open a SIMPLE IRA if you have employees. And unlike a SEP IRA, you must make annual contributions to a SIMPLE IRA on behalf of your employees. Employees can also elect to make their own contributions.

In 2022, employees can contribute up to $14,000 annually, with catch-up contributions of $3,000 for those age 50 and older. As employer, you can choose to make a non-elective contribution of 2% of the employee’s salary. Alternatively, you can match your employees’ contributions dollar for dollar up to 3% of their salary.

Lastly, employers who create a SIMPLE IRA for their employees with automatic enrollment are eligible for a maximum tax credit of $500 per year, per the SECURE Act of 2019. Typically, this self-employed retirement account option is best if you have 100 employees or more.

Defined Benefit Plan

Finally, you can also set up a defined benefit plan (DB or pension plan) for yourself if you’re self-employed. A DB plan can be attractive since it allows you to significantly reduce your taxable income and fund your own retirement. In addition, you can use a DB plan in conjunction with a 401(k) plan to increase your overall tax deduction.

Self-employed DB plans provide an annuity benefit based on a calculation, typically a percentage of compensation. That means your benefit grows as your income increases. Upon the plan’s retirement age—for example, 65—you can elect to receive a lifetime annuity or lump sum payout. Many participants choose the lump sum option and roll it over into an IRA for continued tax deferral.

One advantage of a DB plan is that its contribution limits are often significantly higher than other self-employed retirement account options. Your individual limit depends on your age, income level, and years of service. Moreover, you can potentially double this limit if your spouse earns income from your business. This calculator can help you determine how much you can contribute to a self-employed DB plan.

If you need to catch up on your retirement savings, a DB plan can help you do so. On the other hand, if you have employees, a DB plan can be complicated to set up and administer. If your resources are limited, you may not want the extra responsibility of offering a defined benefit plan.

Which Self-Employed Retirement Account Makes Sense for You?

A common advantage of the above self-employed retirement account options is that you can invest and grow your funds tax-free until you’re ready to withdraw them in retirement. Therefore, the earlier you choose an option and start contributing, the better.

Of course, it’s important to consider your retirement goals and weigh the pros and cons of each option before making your decision. You may want to consult a trusted financial advisor who has experience with these types of accounts.

Oak Capital Advisors specializes in retirement planning for small business owners. If we can help you evaluate your retirement readiness and set you on a path to financial freedom, please start here. We’d love to hear from you.

Did you find this information interesting? If so, please share it!

Free Guide!

A CRNA's Prescription to Comprehensive Financial Wellness

Download Your Free Copy!