A Guide to Self Employment Retirement Plans

Retirement planning is often easier for employees who work for companies that provide them with 401(k)s, which take pre-tax dollars directly from their paychecks and grow the money through investments and compounding interest. Some employers offer 401(k) matching, which increases each contribution amount and, therefore, the account's growth capacity.

Setting up a plan is less straightforward for self-employed professionals, such as freelancers, independent contractors, and small business owners, who may not be aware of their plan options. If you're self-employed, understanding how to get started with a self-employed retirement plan can make a tremendous impact in realizing your savings goals.

3 types of self-employment retirement plans for individuals without employees

Broadly speaking, self-employed individuals without employees (other than a spouse) have three types of retirement plans to choose from. Each one offers a unique set of advantages and disadvantages. Discuss them with a financial adviser before you commit to any course of action. That way, you can be sure that your decisions today align with your retirement goals.

Individual retirement account

An IRA is both similar to and different from a 401(k). Like a 401(k), it's a retirement scheme that allows the account holder to invest their contributions in stocks, bonds, funds, and other financial products. The money grows tax-deferred, and the account holder can withdraw from it to live out their retirement. The principal quality that distinguishes an IRA from a 401(k) is that it's not employer-sponsored. You must work through a financial entity such as a bank, credit union, or broker to open one yourself.

When people think of IRAs, what they normally have in mind are traditional IRAs versus Roth IRAs. The defining difference is that you can contribute pre-tax dollars to a traditional IRA but after-tax dollars to a Roth IRA. When you begin making withdrawals, you'll generally owe taxes on each withdrawal from the former but not from the latter. A secondary distinguishing feature is that traditional IRAs lower your present tax burden by reducing your adjusted gross income, so it provides you with an immediate tax advantage as well.

Traditional IRAs may be better suited to those who want to save on taxes now, as well as those who expect to be in the same or a lower tax bracket after they retire. Roth IRAs may be preferable to those who expect to be in a higher bracket.

Both traditional and Roth IRAs impose the same annual limit on how much you can contribute, which fluctuates to account for inflation. The limit in 2024 is $7,000 for most account holders. Those who are older than 50 can contribute $8,000 per year to accelerate them toward their retirement goals.

Solo 401(k)

A solo 401(k) is exclusively for business owners without employees other than a spouse. According to IRS rules, you can't contribute to a solo 401(k) if you have any full-time employees. Another rule is that you can make two types of contributions: one as an employer and another as an employee, as every small-business owner technically qualifies as both.

Other than that, a solo 401(k) works exactly like an employer-sponsored 401(k) in that it grows pre-tax dollars through selected financial products. You can also opt to fund your account with after-tax dollars instead, in which case you have a Roth solo 401(k). As with an IRA, the Roth version may be better for those who expect to be in a higher tax bracket in retirement.

A specific annual limit applies to each tax entity you embody. As an employee of your small business, you can contribute up to a specified inflation-adjusted amount ($23,000 in 2024, but $30,500 for those 50 or older) or 100% of your pre-tax earned income — whichever is less. Then, as the employer, you can make a profit-sharing contribution up to 25% of your net self-employment income, which equals your net profit minus self-employment tax and the amount you've contributed as an employee. In 2024, the total contribution amount can't exceed $69,000 ($76,500 for those 50 or older).

If you're eligible for a solo 401(k), you can open one through a broker. You'll need to provide an employer identification number to do so, which you can obtain through the IRS. You must also provide personal identification and bank account information, as well as identify the person you want to inherit your funds in the event of your death.

Defined-benefit plan

A defined-benefit plan is a pension for self-employed people. The word defined refers to the fixed and pre-established benefit calculated for the individual based on a formula that accounts for factors such as age, income, and years in business.

The contribution limit is also calculated based on such factors. If you're 55 years old now, earn $275,000 per year from your business, and have operated your business for 10 years, you might expect a contribution limit of almost $260,000 per year. The high contribution limit allows you to grow your money more quickly compared with other retirement plans, so you can reach your retirement goals in a shorter amount of time. Like a traditional 401(k) or IRA, the contributions come from pre-tax dollars, so you can also minimize your present tax burden.

There are some disadvantages, however:

• Cost: Defined-benefit plans involve high setup fees, as well as annual fees. The cost may go up if you have employees, as you must offer the plan to them, contribute funds on their behalf, and potentially pay more fees.
• Commitment: You must commit to paying a certain amount in contributions every year or run the risk of paying more fees.
• Setup and administration: You must work with an actuary to determine the defined benefit and contribution limit. Defined-benefit plans are also the "most administratively complex plan," in the words of the IRS, not only because of the necessary actuarial projections but also due to the required insurance for benefit guarantees.

Given the above complexities, defined-benefit plans may be best suited to self-employed individuals with high incomes and no employees.

2 self-employment retirement plans for business owners with employees

Here are two self-employment retirement plans to consider if you're a business owner who has employees (other than a spouse), although they are also available to you if you have no employees at all:

Simplified employee pension IRA

The SEP IRA is a type of traditional IRA, so it follows the same investment and distribution rules. It does feature higher contribution limits, however, and business owners can use it to support their employees' retirement goals as well as their own.

Funding for SEP IRAs comes exclusively from employer contributions. The only employee who contributes to their own SEP IRA account is the business owner. In 2024, the contribution limit is $69,000 or up to 25% of compensation or net self-employment income — whichever is less, and with a $345,000 limit on compensation. There's no higher limit for people aged 50 or older.

The main advantage of a SEP IRA is flexibility. You can contribute more money in highly profitable years but less (or none at all) in times of financial difficulty. No additional documentation is necessary to account for these fluctuations. An important caveat to note is that if you contribute to your own account in a particular tax year, you must contribute the same percentage of salary to each of your eligible employees.

Savings incentive match plan for employees

You can think of a SIMPLE IRA as a SEP IRA that allows contributions from both the employer and employees. For the employer, there are two possible contribution arrangements for a SIMPLE IRA:

• 2% fixed non-elective contribution: Each eligible employee receives a contribution from the employer equal to 2% of the employee's compensation.
• 3% match: The employer matches the employee's contribution, dollar-for-dollar, up to 3%.

In terms of annual contribution limits, a SIMPLE IRA occupies a middle ground between a traditional IRA and a SEP IRA. The 2024 limit is $16,000 ($19,500 for those aged 50 or older), which is more than double that for an IRA and less than a quarter of that for a SEP IRA. The contributions are deductible, and those you make as an employer to your employees' accounts are considered business expenses, so you may be able to significantly reduce your tax burden through SIMPLE IRAs.

The importance of adding supplemental income sources

Retirement accounts are just one part of a healthily diversified retirement portfolio. Another and equally important part is supplemental income sources that can help ensure you don't outlive your savings. Investments such as dividend stocks and real estate can offer valuable financial protection in your golden years, as can a fixed annuity — an insurance contract into which you pay a specified amount, which grows tax-deferred and supplies you with steady monthly cash flow once you convert it to distributions in retirement.

We can help you plan for your retirement

If you're interested in securing a steady income to supplement your retirement plan, the annuity consultants at Blueprint Income are happy to help. We're deeply knowledgeable about annuities and can provide you with the information you need to empower your financial decision-making. We also offer various tools to help you through the annuity-buying process and related areas of knowledge. Reach out to us at support@blueprintincome.com or 888-867-7620 to learn more.

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