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Being self-employed comes with freedom and flexibility. It also comes with responsibility. You are responsible for your own healthcare insurance. If you have employees, you have to consider what benefits you’ll offer them. Without an employer’s benefit package, planning for a secure financial future is different for self-employed people. You have to save for retirement on your own. Here are six familiar retirement plans for the self-employed.

1.    Traditional IRA

The traditional IRA is a straightforward savings plan. You contribute to it and the investments you make grow free from tax as long as they remain in the account. The money you contribute is tax deductible, with some restrictions, based on how much money you make.

When you withdraw funds from your IRA they are taxed at your marginal rate at that time. That typically means during retirement, when your marginal tax rate is generally lower than in your working years.

The catch is that you must be age 59 ½ or older when you start making those withdrawals. Otherwise you are subject to a 10 percent penalty (in addition to taxes).

A traditional IRA is the most uncomplicated retirement plan nearly anyone can establish. So, it’s great for self-employed people.

2.    Roth IRA

A Roth IRA functions somewhat inversely to a traditional IRA. Roth IRA contributions are made with after-tax dollars. Unlike a traditional IRA, withdrawals are not taxed. But your contributions are not deductible either. Roth IRAs have income restrictions, so you should always check with your tax adviser before choosing which IRA is best for you. Otherwise, Roth and traditional IRAs are similar retirement vehicles.

Both are subject to contribution limits. Both allow people over 50 to make larger “Catch-Up” contributions above the standard limits. And both are available to anyone. Roth IRAs and traditional IRAs are also very easy to set up (no special costs) and to use.

3.    SEP IRA

This is also the case for Simplified Employee Pension (SEP) plans. SEP plans allow the self-employed to make contributions to individual IRA accounts for themselves and their employees.

SEP plans are available to all businesses and are popular because of their high contribution rates. You can contribute much more to a SEP IRA than either a traditional or Roth IRA. SEP plans are slightly more complicated and subject to more regulation than Roth and traditional IRAs.

A plan document must be filed to establish a SEP plan. Fortunately, the document is a straightforward, three-page template provided by the IRS.

Having a SEP means you can't have another retirement plan that isn't also an SEP. But you can roll over most previous retirement accounts into a SEP.

Only the employer may make contributions to a SEP plan. Employees are not allowed to contribute. They own their individual accounts and make their own investment decisions. They just can’t contribute to them like they could in a 401(k) plan.

Contribution amounts are flexible and can vary from year to year. This allows you to modify contributions based on business conditions. But contributions need to be uniform for all employees. For example, if one employee gets 5 percent, then so does everyone else.

4.    Simple IRA

A Savings Incentive Match Plan for Employees (SIMPLE) IRA is similar to a SEP IRA. SIMPLEs are easy to set up and require a plan document.

Self-employed individuals who establish a SIMPLE IRA act as both employer and employee. As the employee, your contribution must be matched by you as the employer. The requirement is either a set percentage of your annual net income or the amount you contributed as the employee, up to a set percentage of your salary.

The mandated employer contributions can make it difficult to manage a SIMPLE IRA plan. However, like a traditional IRA, you won’t pay taxes on your contributions until you make withdrawals.

But be careful. Early withdraws from a SIMPLE IRA can come with a very steep penalty. You will also incur income taxes on any withdrawals.

5.    Solo 401(k)

A solo 401(k) functions the same way as a traditional 401(k) plan. The main difference is that the plan covers either a business owner with no employees or a business owner and his or her spouse.

Subject to the same rules and requirements as other 401(k)s, Solo plans define the business owner as both employer and employee. This means that you can make contributions to the plan in both roles. The owner can make two kinds of contributions:

  • Elective Deferrals of as much as 100 percent of compensation (“earned income” for a self-employed individual).
  • Nonelective Contributions up to 25 percent of compensation (lower limits might apply to pass nondiscrimination tests).

You make Elective Deferrals as an employee. There are annual limits. And the higher Catch-Up contribution is available. Nonelective Contributions are made by the employer. They are not deducted from your salary.

The Solo 401(k) is a bit more complicated than the other plans reviewed above. So, it comes with more regulation. A third-party plan administrator must manage a Solo 401(k). This makes it more expensive than other plans. Still a Solo 401(k) can be a good choice for people who want to save more than an IRA permits.

6.    Defined Benefit Plan

Defined benefit plans are traditional employee pensions. They create a specific annual benefit. You know exactly how much will be available to you at retirement: like having a salary.

Defined benefit plans create a retirement timetable that is certain. You define your yearly benefit and create a contribution schedule to meet that obligation. As a result, contribution limits are the highest among the six types of plans discussed here.

Participants are not restricted from contributing to other types of plans. And contributions are deductible business expenses.

The complexity of defined benefit plans makes them costly. An independent actuary must authenticate your contributions schedule. There are annual filing requirements. And contributions are a company liability that must be satisfied regardless of other financial commitments.

Everyone Needs to Save

It is imperative that people save for retirement. For the self-employed this can be challenging, whether you are a freelancer, self-employed contractor, or small business owner. The best practice is to start saving early and to save continually and consistently.

Consult with a personal Financial Advisor or Retirement Plan Advisor (depending on the size of your workforce) for guidance regarding the appropriate design and structure of your business’s retirement plan.

Information provided for educational purposes only, does not constitute investment, legal or tax advice, and should not be construed as an offer to buy or sell any security or investment product.  

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