An entrepreneur creates a new business, enjoying most of the rewards and bearing most of the risks. One risk is having to plan retirement independently. You are responsible for creating a satisfying quality of life after retirement, and the sooner you act, the better.

 

• For self-employed workers, establishing a retirement plan is a do-it-yourself job.
• Four plans are tailored to self-employment: the one-participant 401(k), SEP IRA, SIMPLE IRA, and Keogh plan.
• Health savings accounts (HSAs) and traditional or Roth IRAs are two other supplemental options.

 

The Independent Third

According to an annual study by Freelancers Union and Upwork , an estimated 57 million Americans freelance, and the overall share remained steady at 35% of the workforce in 2021 [1]. Although that entrepreneurial spirit deserves applause, other research—"Self-Employed: Defying and Redefining Retirement," published by the Transamerica Center in July 2019—shows that 30% of self-employed workers save for retirement only sporadically, while 15% do not save at all [2]. That is a serious problem.

The most common reasons include:

• Business operating costs
• Lack of steady income
• Healthcare expenses
• Education expenses
• Repayment of major debts

Like everything else in entrepreneurship, setting up retirement is a do-it-yourself task. No human resources staff will guide you through a company-sponsored 401(k) application. There are no matching contributions, company shares, or automatic payroll deductions. You must contribute with discipline, and because contribution limits depend on earnings, you will not know how much you can contribute until year-end.

Still, freelancers have unique opportunities as well as challenges. Funding a retirement account can count as a business expense, as can time or money spent establishing and administering the plan. More importantly, retirement accounts allow pretax contributions, reducing taxable income.

 

Retirement Savings Plans for Self-Employed Workers

Self-employed people favor four savings options. Some are one-person 401(k) plans; others are based on individual retirement accounts (IRAs):

• One-participant 401(k)
• SEP IRA
• SIMPLE IRA
• Keogh plan [3]

With all four, contributions are tax-deductible, and growth is not taxed over the years until withdrawal in retirement. Complexity and suitability vary with business size, both staffing and revenue.

  Creating your retirement strategy is critically important as an entrepreneur because nobody else will do it. Your mantra should be to pay yourself first. Many people think retirement money is whatever cash remains at month- or year-end. That amounts to paying yourself only if something is left over, which defeats the purpose of entrepreneurship.

One-Participant 401(k)

The  one-participant 401(k), its official IRS name, is also called a solo 401(k), solo-k, uni-k or individual 401(k). It is reserved for sole proprietors with no employees other than a spouse working in the business [3]. It closely mirrors the 401(k) plans offered by larger companies, including annual contribution amounts. The difference is that you can contribute as both employee and employer, giving you a higher limit than many other tax-advantaged plans [4].

 

Here is a closer look. In a standard corporate 401(k), you invest as an employee through pretax payroll deductions, and the employer may match contributions up to certain amounts.

• You receive a tax break for your contribution, and
• the employer receives one for its contribution. 

With a one-participant 401(k), you can contribute in both capacities: as employee (called an elective deferral) and as business owner (a nonelective employee contribution) [5] [6]  

How Does an Entrepreneur Establish a Solo 401(k)?

Some paperwork is required, but it is not overly burdensome. To set up an individual 401(k), a business owner works with a financial institution—which may impose fees and limits on available investments.

Some plans limit you to a fixed mutual fund list. But searching the U.S. market reveals many established, reputable firms offering flexible, low-cost plans. Do not hesitate to consult our experts at Partners for Life who will gladly guide you.

SEP IRA

Officially known as a simplified employee pension, the SEP IRA is a variation of a traditional IRA. The easiest plan to establish and operate, it is an excellent choice for sole proprietors, although it also allows one or more employees [8].

With a SEP IRA, unlike an individual 401(k), you contribute only as employer. You can contribute up to 25% of net earnings—annual profit minus half your self-employment taxes—up to $58,000 in 2021, increasing to $61,000 in 2022 [8].

The plan lets you vary contributions, make a lump-sum payment at year-end, or skip contributions entirely. There is no annual funding requirement.

• However, pay attention when you hire employees. Although annual contributions are not required, whenever you contribute, you must do so for all eligible employees, up to 25% of compensation, capped at $290,000 in 2021 and $305,000 in 2022.

Although simple, SEP IRAs may not be the most effective retirement savings vehicle for every entrepreneur because contributions are based on a percentage of earnings.

How to Set Up a SEP IRA

It is easier to establish than a solo 401(k) because you can open it online at brokerages such as TD Ameritrade or Fidelity Investments.

SIMPLE IRA

Officially called the Savings Incentive Match Plan for Employees, a SIMPLE IRA combines an IRA and a 401(k) plan. Although available to sole proprietors, it works best for small businesses with 100 or fewer employees for whom other plans would be too expensive [9]. It follows the same investment, rollover, and distribution rules as a traditional IRA or SEP, except for lower contribution thresholds. You can put all net earnings from self-employment into the plan, up to $13,500 in 2021 or $14,000 in 2022, plus an additional $3,000 if you are 50 or older.

Employees contribute alongside employers in matching annual amounts. As employer, you must either match dollar for dollar up to 3% of each participating employee's income every year or make a fixed contribution of 2% of every eligible employee's income, whether or not they contribute [9]. Like a 401(k), it is funded through employer contributions that are tax-deductible and employee contributions made pretax. In a sense, the employer's obligation is smaller because employees contribute, despite the required match. The amount you can contribute for yourself as employer is subject to the same limit as employees.

• Pay attention: early-withdrawal penalties are substantial—25% within the plan's first two years.

How to Set Up a SIMPLE IRA

• As with other IRAs, open the plan through a financial institution with rules about which investments may be purchased.
• The institution may also charge participation and administration fees. The process resembles a SEP IRA, with more paperwork.

Keogh Plan

The Keogh plan , also called an HR 10 or qualifiedprofit-sharing plan , may be the most complex option for the self-employed. It also offers the greatest retirement savings potential. It generally can take the form of a defined-contribution plan, with a fixed amount or percentage contributed each pay period.

To use these plans, the business must be unincorporated and established as a sole proprietorship, limited liability company (LLC), or partnership. Although all contributions are pretax, vesting requirements may apply. These plans benefit high earners, especially the defined-benefit version, which allows larger contributions than any other plan.

How Do You Establish a Keogh Plan?

Keogh plans have federal filing requirements—in other words, extensive paperwork. Entrepreneurs commonly seek help from an accountant, investment advisor, or financial institution. Custodian choices may be more limited than with other retirement plans, so you will probably need a physical institution rather than an online-only service.

A Keogh plan generally best suits businesses with one or two high-earning principals and several lower-paid employees.  

Health Savings Account (HSA)

As an entrepreneur, you will need to pay for health insurance. Individual medical plans tend to have high deductibles. If that describes your situation, consider opening a health savings account (an HSA). Although designed for medical expenses rather than retirement, it can function as a de facto retirement account [10]. It is funded with pretax dollars, and money grows tax-deferred, as in an IRA or a 401(k). Although intended for out-of-pocket medical expenses, you need not withdraw the money, so it can accumulate year after year. At age 65, you can withdraw for any reason. Medical withdrawals—whether for current expenses or reimbursement of earlier costs—remain tax-free. If it is a nonmedical expense, your current tax rate applies.

• To open an HSA, you must be covered by a high-deductible health plan (HDHP).

Traditional or Roth IRA

If none of these plans seems suitable, you can start your own individual IRA. Both Roth and traditional individual retirement accounts are available to anyone with earned income, including freelancers. Roth IRAs accept after-tax contributions; traditional IRAs accept pretax contributions.

Most self-employed people work for someone else before starting out on their own. If you had a retirement plan such as a 401(k), 403(b) or 457(b) with a previous employer, the best way to manage accumulated savings is often to transfer them to a rollover IRA or a one-participant 401(k).

A rollover lets you choose how to invest instead of being restricted to an employer plan's options. The transferred sum can also jump-start savings in your new entrepreneurial career.

Plan and Manage Your Retirement Funds

Start saving for retirement as soon as you earn income, even if you cannot save much initially. The earlier you begin, the more you accumulate through the power of compounding.

As savings increase, consider a financial advisor's help in determining the best allocation. Some companies even offer free or low-cost retirement planning advice.

   

Links for Further Information:

• [1] https://www.upwork.com/research/freelance-forward-2021
• [2] https://transamericacenter.org/docs/default-source/retirement-survey-of-workers/tcrs2019_sr_self-employed-retirement.pdf
• [3] https://www.irs.gov/retirement-plans/retirement-plans-for-self-employed-people
• [4] https://www.irs.gov/retirement-plans/one-participant-401k-plans
• [5] https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-tax-on-early-distributions
• [6] https://www.irs.gov/retirement-plans/plan-sponsor/401k-plan-overview
• [7] https://www.irs.gov/retirement-plans/plan-sponsor/simplified-employee-pension-plan-sep
• [8] https://www.irs.gov/retirement-plans/how-much-can-i-contribute-to-my-self-employed-sep-plan-if-i-participate-in-my-employers-simple-ira-plan
• [9] https://www.irs.gov/retirement-plans/plan-sponsor/simple-ira-plan
• [10] https://www.irs.gov/publications/p969