Retirement Savings and Contributions for Self-Employed

If you are self-employed, you are on your own for more than just your income. There is no employer, HR or accounting department at your back keeping track of your insurance and retirement needs for you. Not only are you fully in charge of earning your own income from your business, but you also are fully responsible for creating and funding a healthy retirement income. Invest “Early and Often” are the magic words – and knowing what options are available for self-employed persons can facilitate that for you.

With freelancing and self-employment on the rise, more people every year need to know about how to manage their self-employment income. A study done by Upwork showed that 36%, or more than one-third, of the US workforce had done some form of freelancing in 2021. Whether your self-employment income is your primary means of support or a second income, you should know how to make your money work for you in the later years of your life.

Different Options for Retirement Plans

Saving for retirement can be more difficult as a self-employed person, for a variety of different reasons. Inconsistent income, debt payoff, business expenses, and healthcare premiums can all be reasons why long-term investing gets overlooked in favor of the present expenses and stressors. A little education in the available retirement options for self-employed people, and sound financial advice about the miracle of compound interest, can be enough of a push in the right direction to get you started on your retirement investing journey today.

The options for self-employed retirement plans look a little different than the conventional employer-sponsored investment vehicles. Employer group plans are out, and most people don’t know enough about the ins and outs of investment plans to confidently make their own individual retirement plans. Consulting with a financial advisor about your unique financial situation is a good place to start.

One-participant 401(k)

The one-participant, or individual, 401(k) plan is very similar to the conventional employer-sponsored 401(k) with a key distinction – you are allowed to contribute to the plan as both employer and employee, leading to a higher yearly contribution limit than an employee contributing up to an employer match. Both “sides” of your contribution are tax-deductible. The “employer” side of your contribution is treated as an employer non-elective contribution, and the “employee” side is treated as an elective deferral.

Elective deferrals for 2022 cannot exceed $20,500, or 27,000 if the individual is over 50. Total plan contributions for 2022, not including “catch-up” contributions for those over 50, have a limit of $61,000. This generous plan is reserved for sole proprietors with no employees, except for a spouse working for the business.¹

401(k) plans have more paperwork than other retirement accounts to establish but working with a financial institution or financial advisor will streamline the process.

SEP IRA

The SEP, or Simplified Employee Pension, plan is a way for employers to fund a pension for their employees. Since as a self-employed person you are both employer and employee, you would contribute to a SEP plan solely from your status as “employer”. As the employer, you are eligible to contribute up to 25% of your net income from your business, capped at $61,000, to a SEP plan. While this seems like a generous amount, you must ensure that your business’ net income is large enough and steady enough to support this contribution structure.

For instance, if you make only $35,000 in self-employment income in a given year, you would be able to contribute only $8,750 to a SEP plan that year, whereas if you had a 401(k) you would theoretically have been able to contribute a great deal more. However, if you are lucky enough to earn $250,000 in a year from your business, you would be able to contribute the full $61,000 limit to your SEP account. The $61,000 matches the amount that you would be able to contribute through a 401(k) plan, but a SEP plan is much simpler to establish and maintain than a 401(k) plan.

SIMPLE IRA

The Savings Incentive Match Plan for Employees or SIMPLE, differs from the SEP plan in two critical ways: there is no set percentage limit for contributions, and there is a much lower overall contribution yearly cap. You can contribute 100% of your freelancing or self-employment income, up to $14,000 in 2022, to a SIMPLE IRA.

Establishing a SIMPLE IRA is, as the name implies, simple. You must fill out IRS Form 5305 – Form 5305-SIMPLE, Savings Incentive Match Plan for Employees of Small Employers (SIMPLE) – for Use With a Designated Financial Institution, and open a SIMPLE IRA account with a bank or other qualified financial institution.

Qualified or profit-sharing plans

Profit-sharing and money-purchase plans are other, less common, retirement investing vehicles. They both involve employer contributions with a yearly limit of $61,000 for 2022, and they both require yearly federal filings at tax time. The difference is that under a profit-sharing plan, there is no set amount or percentage of income that must be allocated to the plan in a given year, whereas under a money-purchase plan, the contribution must be a fixed percentage.

You may have heard these, or any self-employment retirement plans referred to as Keogh plans. This name refers to the originator of the legislation that first allowed non-corporate entities to sponsor retirement plans. Since the law no longer discriminates between corporate and non-corporate entities’ retirement plans, the term is no longer generally used.

Traditional and Roth IRAs

Any individual may make a traditional or Roth IRA in addition to, or instead of, an employer-sponsored retirement plan. If none of the above options fit your specific needs, you can always open an IRA account. Traditional IRAs allow you to contribute pre-tax dollars, while Roth IRA’s receive after-tax dollars. The maximum annual contribution for 2022 for either version of an IRA is the lesser of $6,000 or your total earned income for the year.

Health Savings Accounts (HSA)

While an HSA is primarily exactly what it sounds like, it can be used as a retirement account if you do not need the money for immediate healthcare needs. Since an HSA is pretax money, can be invested to earn interest within the HSA, and is non-taxable if used for healthcare purchases, it can be a nice way to set aside a nest egg for a time in your life when you might have higher healthcare costs. Additionally, the money can be withdrawn for any reason once you reach 65.

In order to open an HSA, you must have a qualifying high deductible insurance plan that includes an HSA. The maximum yearly contribution to an HSA is $3,650 for individuals and $7,300 for couples and families. This can be a nice addition to your other retirement funds.

Pay Yourself First

Investing as a freelancer can be tricky. It can feel like your money is being pulled in so many directions. You may feel like the immediate needs of taxes, business expenses, reinvestment for business expansion, debt payoff, and your cost of living must take priority, and whatever is left over can be sent to retirement. This is paying yourself last and will set you up for a smaller nest egg in the future. Budgeting a set amount or percentage every month for retirement, and prioritizing that allocation, will allow you to pay yourself first. You are worth it.

Speaking with a financial advisor or tax planner can help you to choose the right retirement plan for your individual needs. For additional questions, please contact Kislay Shah CPA at kislay@shahcpaus.com or call 646-328-1326.