Self-Employed Retirement Savings Opportunities

September 28, 2016 9:41 am

Daniel R. Legault, CFP®

Senior Financial Advisor

If you are self-employed, you have the potential to save a lot more in retirement plans compared to traditional salaried employees. On the other hand, you could have non-traditional financial pressures which may make it difficult to save consistently. It is vitally important that you pay yourself as you prepare for retirement. I highlight two retirement options below, one of which will allow you to save far more than a traditional retirement account.

It is important to note that this advice is intended for the self-employed individual that does not have any employees (with the only potential exception being a spouse employee).

You Have Options
Some retirement savings options include the Traditional IRA, SIMPLE IRA and Roth IRA. These can be good savings vehicles, but typically have lower contribution limits. This article will focus on two other options, the SEP IRA (a well-known option), and the Solo (Individual) 401k (lessor known but in many ways more powerful)

The best choice for you will depend on your self-employed income, potential savings amount, and whether or not you have other employment. Options include:

  1. SEP IRA: This retirement account is probably the most familiar retirement account to self-employed individuals. It’s fairly straightforward, with contributions tax deductible and earnings accumulate tax deferred. Basically you can add 25% of your compensation with a maximum limit in 2016 of $53,000.
  1. Solo or Individual 401k: I view this as a super-charged SEP, and here is why. Your contributions are similar to a regular 401k, in that for 2016 you can contribute $18,000 as an employee contribution, plus an additional $6,000 if you are age 50, and finally there can be a third component which is referred to as a non-elective employer contribution of up to 25% of net business income. The maximum combined amount for someone under age 50 in 2016 is $53,000, and $59,000 for those over age 50.

 

Important Note: The maximum amount for the SEP and Solo 401k includes all qualified plans. So if you have another job in which you have a traditional 401k, you are still limited to a combined $53,000 or $59,000.

 

Examples Work Best
(Assumes individual corporate entity with w-2 wages)

Let’s look at a couple of examples to illustrate the difference of these two options: These are simplified examples intended to illustrate the variation in the savings amounts.

Example 1: Mary is 55 years old and has net business income in 2016 of $50,000 as a self-employed writer. 

  1. SEP IRA: Contributions to plan include 25% of net income, or $12,500

 

  1. Solo 401k: Contributions to the plan include (1) $18,000 employee contribution, (2) $6000 catch-up contribution for being over age 50, and (3) up to 25% of net business income of $12,500, for a total of $36,500

 

Example 2: John is 60 years old and has net business income of $140,000 as a self-employed architect. 

  1. SEP IRA: Contributions to plan include 25% of net income, or $35,000

 

  1. Solo 401k: Contributions to the plan include (1) $18,000 employee contribution, (2) $6000 catch-up contribution for being over age 50, and (3) up to 25% of net business income of $35,000, for a total of $59,000 (maximum limit)

 

Final Thoughts
As you can see, the Solo 401k can dramatically increase the amount of savings each year. In both cases, if your spouse is employed, there are further potential savings options.

A Solo 401k needs to be open in the year in which you plan on making a contribution. For example, if you want to make a 2016 contribution, you will need to have the account opened by the end of 2016. This differs from the SEP IRA which can be established by the tax filing time.

IMPORTANT DISCLAIMER: I strongly suggest you work very closely with your CPA or Financial Advisor in determining the specific amount you can contribute to each of these plans you will see below. There are some important rules which fall outside the scope of this post.

 

Dan Legault, CFP® serves as Senior Financial Advisor at StrategicPoint Investment Advisors in Providence and East Greenwich. You can e-mail him at dlegault@strategicpoint.com.

 

The information contained in this post is not intended as investment, tax or legal advice. StrategicPoint Investment Advisors assumes no responsibility for any action or inaction resulting from the contents herein. Dan’s opinions and comments expressed on this site are his own and may not accurately reflect those of the firm. Third party content does not reflect the view of the firm and is not reviewed for completeness or accuracy. It is provided for ease of reference.