It used to be that only fearless entrepreneurs took the leap into self-employment. But more and more Americans are getting the itch to venture into the unknown. In fact, 27 million Americans will leave the traditional workforce by 2020. This warrants the question, how will these Americans create a self-employment retirement plan without a traditional career path?
Without traditional benefits and an employer-sponsored retirement plan, the self-employed must be more strategic than ever about their self-employment retirement options. So, if you’re self-employed or contemplating taking the leap, here are things you need to consider to create the ultimate self-employment retirement plan.
Understand your savings options
Just because you may not be able to participate in an employer-sponsored plan, you still have plenty of options for saving for retirement. It’s important to understand the differences and what each option can offer you. Here are the most common retirement plans for the self-employed:
Traditional and Roth IRA
IRAs are great retirement vehicles for those who are just leaving their job or are just beginning to save for retirement. Traditional IRAs are tax deductible and Roth IRAs are not. However, in retirement all Roth IRA distributions are tax-free. You must be 59 ½ or older in order to take distributions without the 10% penalty.
As of 2019, you can contribute up to $6,000 in your IRA each year. If you are over 50 you can contribute up to $7,000. However, there are additional contribution limits for consumers who earn too much.
If you have a 401(k) prior to leaving your job, you can roll your funds over into this account.
One-participant or solo 401(k)
A solo 401(k) is a good self-employment retirement option for business owners with no employees. These may exclude their spouse if applicable. With this option the account holder plays the dual role of employer and employee. Total contributions to the account cannot exceed $56,000 ($62,000 including catchup contributions for participants over 50).
Additionally, your compensation can be taken into consideration when determining your contribution limit. For 2019, the compensation limitation is $280,000.
Solo 401(k) plans work similarly to 401(k) plans. You can contribute with pre-tax dollars. Then in retirement you will need to pay income tax on all distributions after age 59 ½. You can also decide to open a Roth solo 401(k) which mimics the tax treatment of the Roth IRA.
This account can be beneficial for those who are self-employed and want to save a lot of money throughout their career or only in a few years.
Simplified Employee Pension (SEP) IRA
Small business owners who have few to no employees may want to consider a SEP IRA. This account may be easier to maintain than a solo 401(k) due to the limited administrative burden and no required annual reporting to the IRS.
You can contribute up to $56,000 in 2019 or 25% of your compensation or net self-employment earnings. There is a $280,000 compensation limit used to calculate contributions. There are no Roth SEP IRAs and all distributions will be taxed as income.
You must contribute an equal salary percentage for each one of your employees, including yourself. For example, if you contribute 5% of your salary to the account, you must contribute 5% of your employee’s salary to their account.
Keep in mind that contributing the same percentage amount to your employees’ account may become costly. If your cash flow is not consistent or large enough to maintain these contributions, you may want to entertain another option.
Savings Incentive Match Plan for Employees (SIMPLE) IRA
If you have a larger business with up to 100 employees, a SIMPLE IRA is a viable self-employment retirement option.
In 2019, you may contribute up to $13,000 with a makeup contribution of $3,000 for participants 50 or older. Employers can select to contribute a standard 2% as a non-elective contribution or a 3% match contribution.
All contributions may not exceed $19,000. If you choose the 2% non-elective contribution, your employees do not have to participate in order to receive the contribution. All employee contributions are tax deductible. But, keep in mind, distributions taken in retirement will be taxed based on your tax bracket.
Also, contributions to employee’s accounts are tax deductible for the business owner as a business expense.
Similar to most retirement plans, a 10% penalty applies to any distributions taken before you reach 59 ½. However, if you take a distribution within the first two years of participation in the plan, your penalty will increase to 25%.
If you’re unsure which self-employment retirement plan is right for you, consider partnering with a financial planner who can help you evaluate your financial situation and determine the best plan for your needs.
Plan for your health care needs
According to the Journal of American Medical Association (JAMA), health care spending rose substantially between 1995 and 2015, and comprised 17.8% of the economy in 2015. It’s evident that health care costs will continue to rise. Saving for your health care costs in the future will set you up for a more secure retirement.
A lot of self-employed workers choose high deductible health insurance plans. This gives them the opportunity to contribute to a Health Saving Account or an HSA. These accounts are tax-exempt trusts or custodial accounts used to pay for medical expenses.
Account holders can claim contributions as tax deductions. All distributions are tax-free as long as you use them to pay for a qualifying medical expenses. If you have a single plan you can contribute up to $3,500 and $7,000 for a family plan in 2019.
Budget in percentages
A lot of self-employed individuals have inconsistent income. This makes it challenging to put a dollar amount on all budget categories. Budgeting for variable expenses with percentages may be a better option if your income is unpredictable which allows you to make adjustments when your income fluctuates.
Be diligent when filing your taxes
When you work for an employer, they handle payroll and tax reporting. But when you decide to pursue your dreams toward self-employment, the responsibility falls on you. As a self-employed individual you must pay quarterly tax estimates. These estimates include Social Security, Medicare, and income taxes. You will also have to pay self-employment tax, which is a combination of Social Security and Medicare tax.
Budgeting for your tax bill now and into retirement is an important piece to your self-employment retirement plan. It’s easy to overspend. Hiring a tax professional can help you prevent potential tax mistakes.
Tax professionals help minimize the complexity of tax preparation and can help you create a tax strategy heading into retirement. Remember every dollar counts. Don’t waste your money on poor accounting methods.
Be sure to check out our 2019 Tax Guide for a quick tax overview.
Keep improving your credit score
A credit score plays an important role in everyone’s financial well-being. However, for the self-employed your credit score can help you save money on interest and business financing. Not monitoring your credit can end up costing you a significant amount of money or even worse, minimize your ability to contribute to your self-employment retirement plan.
A lot of business lines of credit require a personal guarantee. This puts all the liability in your hands if something happens and makes you responsible for the debts. This could potentially over extend your finances, leading to continued financial struggle.
Make sure to cautiously consider all loans you take out for your business. You can review your credit report at AnnualCreditReport.com.
Partner with a trusted financial advisor
Venturing into the self-employment world complicates your retirement planning. Hiring an expert to assist you in establishing a self-employment retirement plan may eliminate some of the stress that comes along with wealth management.
Partnering with a financial planner can help you develop a roadmap for your financial journey. By working with a financial planner, they will encourage and direct the tough conversations to help you be prepared when the unthinkable happens.
Many retirement questions will come up when developing a self-employment retirement plan. You want someone by your side who can explain all your options and help ease all your concerns.
The bottom line
Planning for retirement can be confusing no matter what career path you choose to take. Partnering with a financial planner can help you strategize all the pieces of your retirement puzzle and set you on a path to financial freedom. If you’re ready to take control of your financial future and create a plan to increase your odds of success, please contact our team today.