I have received phone calls in the past from clients who were already retired, but had decided to come back and offer consulting services. The conversation included a look at the various approaches that could be taken to defer income recognition, and how these funds can be invested in an efficient tax manner. We will review and discuss the advantages and disadvantages of some of the common strategies that a person who is self-employed can use to save for retirement.
Traditional IRA
Traditional IRAs are a way to plan for your retirement while enjoying tax advantages. The contributions made to a Traditional IRA can be deducted depending on a number of factors, including the age and earnings level of the client. The earnings and gains that are held in a Traditional IRA do not become taxable until they are distributed. The contribution limit for 2023 is $6,500, unless the contributor is 50 years old or older.
Traditional IRAs offer tax-sheltered gains and (potentially deductible) contributions.
The traditional IRA has some disadvantages, including Required Minimum Distributions and early withdrawal penalties. RMDs are required to be taken from an IRA when you turn 72 years old (73 if your 72nd birthday falls before December 31st, 2022). You will be penalized 25% of the RMD amount if you forget or choose to not take it. This can reduce to 10% of the RMD amount if you correct the mistake quickly. In addition to the tax, you will also be charged a 10% penalty for withdrawing your money early. This early withdrawal penalty is not applicable to your first home purchase, educational expenses or certain medical costs.
Roth IRA
The Roth IRA shares many similarities with a traditional IRA, but there are some important differences. A Roth IRA and a Traditional IRA differ in how you receive a tax deduction and when. Tax advantages of a Roth IRA are that withdrawals are not taxed in retirement. You are also not obliged to make a RMD if you have a Roth IRA.
The Roth IRA has a downside: it’s subject to income limits. With a Roth IRA, you can’t contribute if your income exceeds the limits. In 2023, the full phase-out begins when your modified adjusted gross (Single) or MFJ (Married Filing Jointly) income is greater than $153,000.
Solo 401(k)
The 401(k), sponsored by the employer, is a benefit to not be self-employed or working for an employee. The one-participant plan offers these benefits for self-employed people. The one-participant plan, also known as a solo retirement account (401k), covers business owners who do not have employees and their spouses. The rules and regulations of these plans are the same as those for employer-sponsored 401(k), but you can contribute as an employee and as a business owner.
Contributions made by “employees” (also known as elective deductions) are limited to 100% (or earned income), up to a maximum of $22,500. (Under the law for 2023). Age 50 and older individuals may contribute an extra $7,500 (under the 2023 law). This allows them to make a maximum elective deferral of $30,000. The maximum amounts are updated every year to reflect inflation. You can contribute 25% as an “employer”. Your combined contributions are capped at $66k in 2023. Contributions made as an “employer”, as well as contributions made as an “employee”, are both tax-deductible.
Solo 401(k), on the other hand, offers many of the same features that are available in self-employed retirement plans, such as SEP IRAs. However, unlike SEP IRAs, a 401k allows for “employee elective deferrals” and catch-up contribution. Owners of a Solo 401(k), if they have the same level of income, may be able contribute more to their account than they would in a SEP IRA. Some individual 401(k), plans also allow for a loan to be taken against your account.
It is difficult to get a solo-401(k). To set up a solo 401(k), you will need to file paperwork with the IRS in order to obtain an employer number. You will also be unable to participate in the plan if you hire any employees.
SEP IRA
SEP IRAs can be established by employees or independent contractors. The SEP IRA allows business owners to make contributions toward the retirement of their employees and their own savings. This plan may be a good option for businesses that have both a positive and negative year. The annual contributions can be changed from year to year. SEP IRA accounts are very similar to traditional IRAs and follow the same rules for investment, distribution and rollover as traditional IRAs.
An SEP IRA has the advantage of being available to all businesses, regardless of size. It is also not restricted to companies with a specific number employees. SEPs are also free of startup or operational costs and do not require employers to file paperwork. This makes them a cost-effective option. The annual contribution is flexible as stated earlier, and this is helpful if your cash flow is a problem.
SEP IRAs have the disadvantage that catch-up and elective deferral of salary are not permitted, as they are in traditional IRAs or solo 401(k). Employers must make proportional contributions for each employee who is sponsored by your plan. Employers are only allowed to contribute to SEP IRAs, and can do so up to a limit of $66,000 or 25% of an employee’s salary (as per the law of 2023). You, as a self-employed person, would be the employer for your own account and would make the contributions in the same way that a business would.
SIMPLE IRA
SIMPLE IRAs are IRAs that cater to companies of 100 or less employees. SIMPLE IRAs are very simple to set up compared with other retirement saving vehicles. SIMPLE IRAs do not require any start-up costs or ongoing operating expenses.
The SIMPLE IRA offers a number of benefits, including a higher contribution cap than a traditional IRA. It is also easier to maintain and allows for a rollover. Employee contribution will be $15,500 under the law of 2023. However, employees older than 50 can include an additional $3,500. The SIMPLE IRA’s exclusivity to small companies is another pro. Saving for retirement is easy with this vehicle. This plan is a great option for employees, as your employer will match up to a certain percentage of what you contribute each year. Contributions are optional, but you can (and should!) make them. You can also make tax-free transfers from SIMPLE IRAs into other types of IRAs after two years (as long as it’s not a Roth IRA).
The downsides of a SIMPLE IRA are lower contribution caps than those of other retirement vehicles offered by companies, and a higher early withdrawal penalty (25%) if you withdraw within two years.
Defined Benefit Plan
Self-employment pension plans are defined benefit plans. The fixed benefit is based upon your earnings and length of service. The actuarial method is used to determine the contributions and distributions of a defined-benefit plan. To determine your retirement benefit, you would have to consult an enrolled actuary. The actuary can then calculate the maximum contribution you are allowed to make based on your income, age and expected returns on investments.
It can be expensive and difficult to set up and maintain defined benefit plans. To avoid taxes and fines, you must make sure that your contributions are at the required minimum each year. A defined benefit plan has another downside: you must offer the same benefits to all employees, whether there are two or fifty. It can get very expensive if you have to fund each employee the same way.
If you are able to afford them, these plans can be a great asset in planning your retirement. According to the law of 2023, defined benefit plans are only limited by a maximum retirement benefit that cannot be more than $265,000 per year. Defined benefit plans also offer a wide range of options for saving money in retirement. Contributions are tax deductible for business expenses and grow tax deferred until they’re received at retirement. You can also have other retirement plans if you are a member of a defined-benefit plan. This will allow you to increase your savings. A defined benefit plan is a good option if you’re a self-employed person with a high salary who wants to maximize their retirement income.
The conclusion of the article is:
You can see that there are a number of ways for self-employed individuals to plan for their retirement. There are also many things to take into consideration when choosing the best method for you. Please contact your Wealthspire adviser if you need more information, or want to explore any of these options in detail.
