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

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Updated on Tuesday, April 12, 2016

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.

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