Choosing a Retirement Plan when you are Self-Employed

So you’ve started a business or maybe you’ve had one for a long time, or perhaps you are working as an independent consultant….

Congratulations, you can now set up a retirement plan!

Unfortunately, the process is more complicated when you are an owner. When you’re an employee your employer makes the decisions about what type of plan to offer and what the terms of the plans are. When you’re the boss, you get to decide.

Why set up a retirement plan?

The primary reasons to set-up a retirement plans are as follows:

• Reduce your income taxes, now or in the future.
• Build a nest egg for your retirement.
• Provide a benefit to your employees so you can attract (and retain) talent.

For today’s discussion we will focus on planning considerations when you are self-employed with no employees, and your priority is to reduce your taxes. We will publish a separate article to discuss retirement plan considerations for small businesses with employees.

The most basic type of retirement plan is an IRA, of which there are two types:

• Traditional IRA – These are funded with pre-tax dollars, reducing your current taxes. The funds will be taxable when you take the funds out later.
• Roth IRA – These are funded with after-tax dollars. The assets grow tax free, for your lifetime, and up to 10 years thereafter (or longer, under certain circumstances).

The contribution limits for IRAs are relatively low ($6,500 if you are under 50 and $7,500 if you are at least 50). Your ability to contribute to them is also limited by your income and whether your spouse is covered by a retirement plan at work.

If you are not satisfied with these limits and would like to defer more of your taxes, you may want to consider more advanced options like a SEP IRA, SIMPLE IRA, Individual 401k, or even a Defined Benefit plan. These plans have the advantage of allowing employer side contributions, and in many cases higher employee contributions as well. It may seem strange to think of yourself that way, but in the mind of the IRS, as a self-employed person you are both the employer and the employee. Therefore, you can contribute to your retirement plan separately in each role.

Depending on your situation, you may want to consider the following options:

• Simplified Employee Pension (SEP IRA) – This is a very easy option if you have a high income and don’t expect to have employees. The contribution is limited by a formula which is approximately 20% of your net income and is capped at $66,000 for 2023. You don’t need to contribute the same amount each year, but if you have employees at some point, you will be required to fund SEP-IRAs for each of them based on a uniform percent of pay for each employee. You can set up a SEP plan for a year as late as the due date (including extensions) of your business’s income tax return for that year.
• SIMPLE IRA – This option is a little more complex to set up than the SEP IRA. It is a good fit if a SEP-IRA does not permit large contributions due to the income limits. Contributions are split between employee deferrals and employer match. The maximum you can defer as an employee is $15,500 plus a $3,500 catch up for those 50 and older. You can then match these deferrals in your role as employer. The employer contribution is either 2% for every eligible employee or a match up to 3%, with immediate vesting. You can set up a SIMPLE IRA plan effective on any date from January 1 through October 1 of a year, provided you did not previously maintain a SIMPLE-IRA plan.
• Individual/Solo 401k – This is attractive if you want to make larger employee deferrals and want to combine these with substantial employer contributions. The maximum employee deferral for 2023 is $22,500 plus $7,500 if you are at least 50. The maximum combined employer and employee contributions is $66,000, plus the $7,500 catch up contribution if you are 50 or over. Employer contributions can’t exceed approximately 20% of your net income. Compliance testing is waived so long as your only employees are yourself and your spouse. Also, annual IRS filings are waived until the plan reaches $250,000. Self-employed employers can establish a solo 401k as late as their business tax filing deadline, including extensions.
• Defined Benefit “Cash Balance” Plans – This can be very attractive if your income is high and predictable. These are more complicated and require engaging a benefits consultant / actuary to calculate the required contributions each year. This also makes them more expensive to administer. In exchange for this complexity, these plans allow you to contribute considerably more each year than other plans we have discussed. These contributions, which you make as the employer, are based on the design of the plan, employee income, age of your employees and certain return assumptions. Depending on your circumstances, contributions could be well over $300,000 per year, in addition to contributions made to the other plans we have discussed. One downside is that once in place, plan contributions are mandatory, regardless of your income. You also may be required to fund larger contributions than planned if the underlying investment portfolio does not perform as expected. You can set up a Cash Balance plan for a year as late as the due date (including extensions) of your business’s income tax return for that year.

It’s exciting and can be quite lucrative to be self-employed. Fortunately, the government has provided a wide range of options to help you save for retirement in a tax efficient way. If you are interested in exploring these options further, or know someone who might, please reach out to your JMG financial advisor for more information.

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