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How Do I Save for Retirement if I am Self-Employed?

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Save for Retirement

When you’re self-employed, you have the freedom to create your company vision, define your work hours, design your physical (or virtual) office space, and handpick both your clients and employees. You make all the decisions and assume responsibility… for everything… including saving for your retirement.

The U.S. workforce has seen a dramatic shift from employer-funded pensions to employee-funded retirement plans. Gone are the days of working for a company for 40 years and retiring to a hammock as you collect your monthly pension check.

Today, the onus is on us to contribute to a company-sponsored retirement plan like a 401(k). But what if you run the company?

Anyone who has started his or her own business knows it’s not all rainbows and butterflies. It’s tough to juggle all the responsibilities that come with managing and expanding the business. Revenues ebb and flow, and so does your personal income.

When you’re self-employed, you typically don’t think of opening a retirement account early on. You focus on keeping the doors open and growing revenues. The typical evolution is from survive to prosper.

But somewhere along the journey you need to decide how to save for your future. You may want to kick back and enjoy a traditional retirement one day, or you may simply want the financial freedom to choose how hard you work later in life. Either way, you need to start cultivating the income that will support your life at that time. And the earlier you start, the better off you’ll be.

Business owners should be saving for retirement just like everyone else, but there are additional variables to consider. That means you have options. But with more options comes more complication. Start by focusing on these three areas to determine how you can plan for retirement if you’re self-employed. 

How Much Can You Save?

The first thing to consider is how much money you can actually save. If you’re breaking even in your business, saving for retirement is not an option.

Once you do break into the black, determining how much you can actually save is the first step. If you’re just starting out and saving less than $5,500 (or $6,500 for those over age 50), a traditional IRA is often the easiest (and cheapest) option.

Simply find an investment company like Fidelity or Vanguard that offers a diversified group of low-cost investments (i.e.., mutual funds or exchange traded funds) and open an account in minutes.

Want to save more than that but know you won’t exceed $12,500 ($15,500 for those over age 50)? A SIMPLE IRA may be the best way to go. This is also a relatively simple option with a higher limit than the traditional IRA.

If you’re looking to really sock away some cash, a SEP IRA could be the answer. You can contribute up to 25% of your net income to a maximum of $53,000 in 2015 and 2016 (up to $59,000 for anyone over age 50).

Depending on your business, you may also want to look into a 401(k). You can contribute up to the same amount as you can put away in a SEP IRA. There are a few major differences between these two accounts, and we’ll discuss some of those below.

Do You Have Employees?

Although the contribution limit is important, there are other factors to consider. The IRS regulations for each of the above account types will ultimately determine which one is best for you.

One of those rules has to do with how many employees you have. For the solo practitioner, this is not a problem and you can zero in on an account based on the amount you’d like to save. But if you run a bigger business, the number of employees becomes a major factor in how you can plan for retirement.

Many retirement accounts require the business to contribute directly to employee accounts. With a SEP IRA, the employer must contribute the same percentage of income he or she contributes to a personal account for each employee. This can get expensive with multiple employees. Here’s an example:

Let’s say you want to contribute 15% of your income to a SEP IRA. For each eligible employee, you have to contribute the same 15%. That means if eligible employee #1 makes $50,000, you’re on the hook for contributing $7,500 to that employee’s SEP IRA account. The same goes for all other employees that meet the eligibility requirements. (See these IRS SEP Plan FAQs for employee eligibility requirements.)

A SIMPLE IRA has less of an employer contribution requirement. At the risk of oversimplifying the rules, you can choose to contribute a flat 2% for each employee or offer to match up to 100% of the employee’s contribution up to 3% of salary. If you know that every employee will take advantage of the full match, the 2% option may be your best option. (See the IRS SIMPLE Plan FAQs for employee eligibility requirements.

This is not the case for a 401(k) plan, as an employer contribution is elective with this type of account. The caveat is that 401(k) plans have different funding rules and tend to be more expensive based on IRS administrative requirements.

For example, with 401(k) plans with a total balance of $250,000 or more, the business owner is required to file a Form 5500 with the IRS. (See United States Department of Labor for more details on small business 401(k) plans.)

Do You Want to Defer Income for Tax Purposes?

A third factor to consider as you choose a retirement plan for self-employed individuals is taxes. If you are a business owner, saving money on taxes probably sounds great, and the right retirement plan can help.

All of the above-mentioned plans offer a tax deferral benefit. In other words, you do not have to pay personal income taxes on money deposited in one of these accounts. Unfortunately, you still have to pay the federal self-employment tax of 15.3% (2015) on any contributions to your retirement plan.

Depending on your tax bracket, this may or may not benefit you in the long run. If you’re in a higher tax bracket now than you will be in retirement, it may be wise to defer those taxes until later.

But if you’re in a lower tax bracket now than you expect to be later (which is usually the case for most early-stage business owners), then you might consider a Roth account, where you contribute after-tax money.

This money then grows tax-deferred and comes out tax-free in retirement if all guidelines are followed. The Roth option is not available for SIMPLE and SEP plans.

If you’re self-employed, you have plenty of options when it comes to planning for retirement. These choices bring with them many questions that you must ask yourself before you can decide which retirement plan is right for you.

Not only must you consider how things look today, but you also need to consider how you expect your business to grow tomorrow. The good news is that most choices are not irreversible. This means that if you open one type of retirement account now, you do have the ability to stop contributing to it and choose another one in the future.

The most important thing is to start saving. When you start making money in your business, use one of these options to help you plan for retirement. Even business owners who love their job need to plan for a day when they may not be making money.

Advertiser Disclosure: The products that appear on this site may be from companies from which MagnifyMoney receives compensation. This compensation may impact how and where products appear on this site (including, for example, the order in which they appear). MagnifyMoney does not include all financial institutions or all products offered available in the marketplace.

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Life Events

Contribute to an IRA and Save on Taxes Now

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Many people invest in traditional individual retirement accounts (IRAs) because they’re told these accounts offer a good way to save for retirement. And it’s true!

One of the biggest reasons why? You get to invest money in an account that can grow tax deferred until retirement. In other words, you can save money now and take advantage of the fact that you won’t be on the hook to pay taxes on investment returns (interest, dividends and capital gains) until you take the money out later in life.

What is it about tax deferral that’s so great when it comes to saving for your financial future? Essentially, this is a legitimate, legal way to avoid paying taxes if you use your traditional IRA in the right way.

Here are the specific types of tax deferral you can take advantage of when you save for retirement in an IRA – along with why they make a powerful impact on your nest egg.

Should You Save for Retirement or Pay Down Your Mortgage?

Example 1: No Taxes on Investment Returns

As mentioned above, the money you invest in your IRA can grow and you don’t have to pay taxes on interest, dividends, and capital gains that you earn by investing in stocks, bonds, mutual funds and exchange-traded funds.

That means you can buy and sell investments and not worry about the tax consequences as long as you keep that money in the IRA account.

Not having to pay taxes right away benefits you because it may boost your ability to save. If you have to account for taxes on your investment returns, which may cut into the amount you can actually contribute to your account. But since taxes are deferred, you can take advantage and save more right now – and allow compound interest more time to go to work for you and your investments.

Example 2: No Taxes on Current Income

An even better benefit comes in the form of income tax deferral. In certain situations, you may be able to avoid paying taxes on a portion of the income you earn in any given year by contributing to an IRA.

Here’s an example: Let’s assume you’re eligible for tax deferral and you’re in the 25% marginal tax bracket. (Without getting into too much detail, this means you make between $37,450 and $90,750 if you’re single and between $74,900 and $151,200 if you’re married and choose to file taxes jointly with your spouse.)

If you contribute $5,500 into your IRA this year, you’ll receive a deduction on your tax return in the amount of $1,375. Put another way, it feels like you only invested $4,125, which your wallet will appreciate. This is because you don’t actually pay ANY income taxes on the $5,500 until later (typically in retirement).

Since you don’t pay taxes on that money, that means you get to invest the full $5,500 – rather than just $4,125. That’s the amount you would have had to invest in a normal brokerage account if you actually had to pay $1,375 in taxes to the IRS. Thanks to the deduction, you don’t have to.

Over time, this can add up to a significant amount of investment growth in your IRA making tax deferral a very powerful factor. Just think about the amount you can save in taxes over your working years if you continue to invest $5,500 into your IRA every year. (That’s the maximum amount you can contribute to an IRA in 2015 if you’re under 50. The amount rises to – $6,500 for anyone over age 50.).

Make Sure You Take Advantage of Tax Deferrals

So, how do you take advantage of tax deferral inside an IRA? Well, to receive the benefit of the example number one above, you simply have to earn an income. If you do, then you can open an IRA and begin investing up to $5,500 every year that you earn a wage.

Once you hit 50 years old, you can then contribute another $1,000 per year. (These limits will continue to increase with cost of living adjustments.)

Example number two is a little tougher to qualify for. In order to deduct the amount of money you contribute to your IRA, you must not have access to another retirement plan elsewhere, typically through work. If, for example, your company offers a 401(k), then you have access to another plan. And if you do have that access, you cannot deduct your IRA contributions (there is an exception noted below).

The key phrase here is “have access to” because it doesn’t matter if you actually contribute to the employer plan or not. You are still not eligible for a tax deduction on IRA contributions because you could have contributed to that 401(k). Before you get too bummed out, know that, you do get the same tax benefit explained in example two by contributing to your employer’s retirement plan so you’re still in good shape. Plus, you may even get a matching contribution from your employer, which is something you won’t get in an IRA.

There is one exception to this rule. If you make less than $61,000 in any one year, you can deduct your IRA contributions even if you have access to another retirement plan at work ($98,000 if married filing jointly and $10,000 if married filing separately). You may also be eligible for a partial deduction depending onyou modified adjusted gross income. Find the IRS chart here.

How to Have a Million Dollars in Retirement with a $50k Annual Salary

One More Tax Advantage to Use in Your Favor

If you’re not excited about the opportunities to take advantage of saving on your taxes now while simultaneously saving for your financial future, here’s a bonus for you: if you haven’t contributed the maximum amount to an IRA for the 2015 tax year (or even opened up an IRA yet), you have until you file your taxes or the April 15 deadline to contribute for last year!

Why would you do this? Well, the more money you get into your IRA, the more money you have working for you for retirement on a tax-deferred basis. If you have the funds available, it’s a great opportunity to increase your retirement nest egg.

Plus, if you just realized that you owe taxes for 2015 and you are eligible to receive a tax deduction by contributing (see rules above), you can reduce a percentage of the taxes owed so you don’t have to pay as much.

It’s yet another win-win situation offered by contributing to your IRA!

Advertiser Disclosure: The products that appear on this site may be from companies from which MagnifyMoney receives compensation. This compensation may impact how and where products appear on this site (including, for example, the order in which they appear). MagnifyMoney does not include all financial institutions or all products offered available in the marketplace.

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Pay Down My Debt

Should You Invest or Pay Off Credit Card Debt?

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Maximizing Special Benefits for Teachers

Wondering whether you should pay off your credit card debt or invest your money in the stock market? This question is one of the most common questions I receive as a financial planner, so let’s put this issue into perspective and finally get some answers.

Anyone can answer this question once framed appropriately. First, you need to understand the impact that stock market returns (both negative and positive) and interest rates (on your debt) have on your money. Once you do this, the information you really need comes largely from the variables involved with the debt. This includes things like the type of debt you have, the interest rate on what you owe, and the current balance.

These variables are more important in understanding whether you should pay off something like high-interest credit card debt or invest than any factors related to the stock market in any given year.

Understanding the Impacts of Long-Term Investing

Many people fear the stock market – and for good reason. We’ve had some pretty serious market crashes over the past 15 years. But the way I see it, we’re lucky to have experienced such downturns. Many people now approach investments with caution, and that’s a good thing.

Let’s dig into the numbers a little bit, though, to see how these positive and negative investment returns actually impact our money. For the purposes of this article, we’ll assume that the “stock market” is the S&P 500 Index, as it’s one of the most common indices used in the US. All investment returns used here will be historical returns from the S&P 500.

Let’s look at the time period that caused most of this fear in recent years: 2008. If you invested $5,000 in the stock market on January 1, 2008, you would have had $3,172 on December 31, 2008 – or a loss of 36.55%. Not a great result.

Now let’s take a broader look and see what would have happened if you invested that same $5,000 in the market five years earlier on January 1, 2004. On December 31, 2008, you would have had $4,890 – or a loss of 2.19%. It’s still a loss, but one that’s much more manageable in the grand scheme of things.

But if you invested that same $5,000 on January 1, 1994, you would have had $5,323 on December 31, 2008. That’s a gain of 6.46%. As you can see, the longer you were invested, the better your chances of coming out with a gain.

Of course, not all 15-year periods will produce the same results. The point here is that our investments do have the ability to withstand even the most poorly performing markets if we invest for a longer periods of time. That said, there’s no guarantee that we will experience positive investment returns in any specific timeframe.

Understanding the Impact of Paying Interest on Your Credit Card Debt

Unlike stock market returns, which are not guaranteed, paying down debt is as close to a guaranteed return on your money as you can get. This is true because for every dollar of debt you pay off, the less interest you pay the loan company.

In other words, the faster you pay down the debt, the more money you have to use elsewhere. Let’s look at an example.

Let’s say you have a credit card balance of $5,000 with a 17.5% interest rate. If you pay $125 per month (without making any additional purchases on the card), it will take you about 5 years (or 61 months) to pay off this card.

During that time, you will have paid $2,557 in total interest. To be clear, you will have paid the $5,000 debt balance plus interest of $2,557, for a total repayment of $7,557.

[Use our Credit Card Payoff Calculator to see how long it will take you.]

Choosing Between Investing and Credit Card Debt Repayment

Combining the two examples above can provide us with a solution to our question. Put yourself in this position for a minute. Say the date is January 1, 1994 and you have $5,000 sitting in your bank account and another $5,000 in credit card debt. You’re wondering what you should do with that money. Do you invest it or pay down your credit card debt?

And for the sake of this conversation, let’s assume you’re already taking advantage of saving money in a 401(k) plan if one is available and your employer offers a matching contribution. A good rule of thumb is to make that form of investing your top priority: contribute enough to get the match.

As mentioned above, if you invested that $5,000 in the stock market on January 1, 1994, you would have had $5,323 in 15 years. That’s a 6.46% compound return on your money. Not bad.

If you were also paying off your credit card debt using a minimum monthly payment of $125, you would be debt free in 5 years – but would have also paid the aforementioned $2,557 in interest to the credit card company.

What if you took that $5,000 and paid off your debt in one lump sum payment on January 1, 1994? By doing so, you immediately guaranteed yourself a savings of $2,557, because there would be no need to pay interest on your loan. You also wouldn’t have to pay $125 each month for the next 5 years.

What to Do Once You’ve Paid Off Your Credit Card Debt

So what do you do with that additional $125 each month? Now that you aren’t forced to repay that credit card debt, you can do whatever you want with that money.

The smart investor might set up an automatic contribution into an investment account of $125 per month. But you could just as easily split it in half and put $62.50 into the investment account and save the other $62.50 for a trip in a few years. In 33 months, you’d have $2,000 for a nice trip down to a tropical paradise – and you would be steadily adding to your investments at the same time.

There is no one-size-fits-all answer to this situation, and that’s why it gets confusing. The right choice for you will depend on the variables for your debt and your long-term goals.

I do know one thing for sure. The answer comes in the form of taking action. Take some time to understand your financial situation and choose a path that makes sense for you.


Advertiser Disclosure: The products that appear on this site may be from companies from which MagnifyMoney receives compensation. This compensation may impact how and where products appear on this site (including, for example, the order in which they appear). MagnifyMoney does not include all financial institutions or all products offered available in the marketplace.

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