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Self-Employed? How to Save Quickly for Retirement When Your Single-Person Business Takes Off

By Catherine Brock – Nov 1, 2019 at 3:10PM

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Your business is thriving, and it’s time to set up a retirement plan. Here’s what you need to know.

You'd love to blame the HR department for your lack of retirement planning -- but that's not very gratifying when you are the HR department. Running a single-person business has its advantages, but depth in human capital isn't one of them. Now that your business is doing well, it's time to put on your HR hat and address your retirement benefits. 

According to the Bureau of Labor Statistics, roughly 16 million people in the U.S. are self-employed. But many of these self-made bosses aren't doing enough to save for the future. The Pew Charitable Trusts found that only 13% of self-employed people running single-person firms are participating in any kind of retirement plan. And those who are contributing save less than traditional workers. 

A woman working at a store who is self-employed

Image Source: Getty Images

You can step outside those statistics, however, by establishing and contributing to a retirement plan with high contribution limits.

Two options available to you as a self-employed person running a single-person business are the Solo 401(k) and the SEP IRA. Both have substantially higher contribution limits than a traditional or Roth IRA -- which cap your contributions at $6,000, or $7,000 if you're 50 or older.

To maximize contributions after 50 

If you are aged 50 or older, the Solo 401(k) has higher total contribution limits than the SEP IRA. Designed specifically for single or married entrepreneurs who have no employees, the Solo 401(k) allows you to contribute both as an employee and as an employer. Each of these two roles has its own rules for contributions, and you can use those rules to your advantage. 

Employee contributions to a Solo 401(k) are in the form of pre-tax salary deferrals. In 2019, you can contribute up to $19,000, as long as your contributions don't exceed your total salary. But here's where the Solo 401(k) differs from the SEP IRA. Once you're 50 or older, you can also contribute an additional $6,000 in what's called "catch up" contributions to your Solo 401(k). How's that for a senior discount?

Employer contributions to this plan are capped at 25% of your compensation. These contributions work like an employer match contribution in a traditional 401(k). You account for the contribution as a pre-tax expense and deposit the funds in the Solo 401(k) from your business account.

Combined, your employee and employer annual contributions cannot exceed $62,000, or $56,000 if you're not eligible for the $6,000 in catch-up contributions.

So how does this play out in real life? Assuming you are older than 50, you could hit that maximum contribution limit of $62,000 with W-2 wages of $148,000. You would max out your employee contribution at $25,000, including the $6,000 of catch-up contributions. And the employer portion could be as high as $37,000, or 25% of your wages. 

Contributing without W-2 wages 

Even if you don't pay yourself a salary and treat your business profits as pass-through or Schedule C income, you can still contribute handsomely to your Solo 401(k). In this scenario, your compensation is calculated by deducting contributions and one-half of your self-employment tax from your net earnings. Contributions are still subject to the 25% cap on compensation, up to $62,000 or $56,000 if you're younger than 50.

For company contributions only

The SEP-IRA is different from the Solo 401(k) in that all contributions come from the employer. As a self-employed person, this distinction might seem irrelevant -- you operate as both employer and employee, after all. But there are two scenarios where employer-funded contributions might not work for you. 

First, there's no provision for catch-up contributions in a SEP-IRA, since these are always employee-funded. You can still contribute up to $56,000 annually in your SEP IRA for 2019, but that limit applies whether you're 25 or 65. In other words, you don't get the $6,000 of extra contributions when you hit 50.

Second, employer-funded contributions to a SEP-IRA cannot discriminate -- meaning you have to pay the same percentage contribution to every employee in the plan. That isn't ideal if you intend to hire employees in the future, particularly if you want to maximize your own contributions. If you are uncertain about your future hiring plans, the Solo 401(k) might suit you better.

If you do go with the SEP-IRA today and change your mind, it's not the end of the world -- you can always convert the SEP-IRA to a Solo 401(k) later. 

Which account is right for you? 

Both the Solo 401(k) and the SEP IRA have annual contribution limits in excess of $55,000. But if you're over 50 and value flexibility in your retirement plan, the Solo 401(k) is likely the better choice. But don't hang up your HR hat just yet -- now you're ready to get your account set up

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