Planning for retirement is arguably one of the toughest challenges Americans face.
According to the recently released National Financial Capability Study from the FINRA Investor Education Foundation, 56% of all Americans worry about running out of money during retirement, just 39% of Americans have attempted to figure out their retirement number, and a mere 37% were able to pass a basic financial literacy quiz. The data would suggest that the odds are stacked against Americans retiring comfortably and on their own terms.
If you're self-employed, you should know about these retirement options
But self-employed persons have things even tougher. Because they represent a minority of the labor force -- 10.1% to be exact, or approximately 15 million people in 2015 -- the self-employed are often overlooked when discussing retirement plan options. Today we're going to change that by looking at the four smartest retirement plan options (in no particular order) that the nation's 15 million self-employed people may be able to take advantage of.
Also known as an "individual 401(k)" or a "uni-401(k)," a solo-401(k) plan shares a lot of similarities with a traditional 401(k) plan available through an employer.
Both an employer-sponsored 401(k) and a solo-401(k) had $18,000 contribution limits in 2016 for workers ages 49 and under, and an additional catch-up contribution of $6,000 available to workers aged 50 and over. The combined contribution works out to a max of $24,000. The two plans are also funded with pre-tax dollars, meaning they can reduce your current-year tax liabilities. Finally, a traditional 401(k) and solo-401(k) are both tax-deferred plans, meaning you'll begin paying tax once you start making withdrawals during retirement.
The big difference for self-employed people is that you can also contribute up to 25% of your business' total earnings (or 20% for a sole-proprietor or single-member LLC) on top of your employee contribution to a solo-401(k). The maximum combined contribution in 2016 is therefore $53,000 for workers aged 49 and under and $59,000 for those aged 50 and up.
Furthermore, a solo-401(k) gives you the option of hiring your spouse, which can double your saving potential. Your spouse will be eligible to contribute up to $53,000 in 2016, or up to $59,000 if they are eligible for the catch-up contribution. Whether you're running your business alone or with your spouse, a solo-401(k) can be a smart retirement option.
The Savings Incentive Match Plan for Employees, or SIMPLE IRA plan, is a retirement option that can be particularly attractive for businesses with a lot of (but still fewer than 100) employees.
As of 2016, you can contribute up to $12,500 annually if you're 49 or under, with a catch-up contribution of $3,000 for those aged 50 and up for a grand total of up to $15,500. Like a 401(k), the SIMPLE IRA allows your investments to grow on a tax-deferred based. Furthermore, if you decide to make matching contributions, those contributions are deductible for the employer as a business expense.
On the flipside, keep in mind that if all employees choose to max out their matching contribution of 3%, it could get quite expensive for the self-employed business owner. Even if an employer chooses not to contribute, he or she will still be responsible for a 2% fixed contribution for all eligible employees. Also, you'll note, the $12,500/$15,500 annual limit is substantially lower than what you can contribute to a solo-401(k) or any of the options we're going to explore below. Despite these drawbacks, the SIMPLE IRA can be quite popular for small businesses, and it's really easy to set up.
The Simplified Employee Pension, or SEP IRA as it's known, is similar to the SIMPLE IRA, but it's generally going to benefit businesses that have relatively few employees (we'll get to why in a moment).
As of 2016, SEP IRAs allow a self-employed individual to contribute up to 25% of their self-employment earnings to the plan. Just like a solo-401(k), the maximum contribution caps out at $53,000. What makes a SEP IRA so attractive is that you have full flexibility on how much you contribute annually, with your contribution able to grow in-step with your business' earning power. Just as you'd find with a Traditional IRA, money in a SEP IRA grows on a tax-deferred basis and becomes withdrawable as early as age 59 1/2 or as late as age 70 1/2. Also like a Traditional IRA, you'll pay ordinary income tax on the money once you begin making withdrawals.
The one downside to consider is that if you offer a SEP IRA as a business owner to your employees you have to contribute the same amount to their account as you do to your own. That can be an expensive venture, which is why these plans work best for relatively small businesses.
Finally, the self-employed can contribute to a defined-benefit plan, which is akin to setting up a pension plan. These are particularly attractive options for higher-income self-employed persons with few or no employees.
According to the IRS, maximum annual benefits can be up to $215,000 in 2016, meaning a defined-benefit plan offers the juiciest contribution of them all. Like the other plans discussed above, your investments are considered tax-deferred. Other attractive aspects of defined-benefit plans highlighted by NerdWallet include the ability to reduce your taxable income by writing off the contributions as a business expense, and being able to combine a defined-benefit plan contribution with contributions to other plans, such as a solo-401(k).
The downside is that you have to make contributions on your employees' behalf, which can get expensive if you have a lot of employees. Among the four aforementioned plans, a defined-benefit plan could also be the costliest to run. But if you're a high-income self-employed individual, chances are that a defined-benefit plan could be your best bang for the buck.
Sean Williams has no material interest in any companies mentioned in this article. You can follow him on CAPS under the screen name TMFUltraLong, and check him out on Twitter, where he goes by the handle @TMFUltraLong.
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