Congratulations! You’ve taken the massive step to become self-employed! Whether it’s a side hustle or full-time job, self-employment will change how you save for retirement (mostly because there’s no benefits package on your first day showing where to enroll in the company 401(k) account). Saving to your retirement plan as an entrepreneur takes more initiative, but you also have more flexibility with the types of accounts you can contribute to and how much you can save annually.
For simplicity, I will assume you’re a one-person shop at this point. Having employees adds layers of complexity and for that scenario we recommend bringing in a financial advisor or a third-party administrator.
Why Should I Save for Retirement at this Pivotal Moment of Launching My Business?
Though it may be tempting to add every last dollar back into the business, we highly encourage you to start the habit of adding to a retirement account from the outset of your business venture.
Each dollar that goes into a retirement account will lower your taxable income (so you’ll pay less taxes) and get invested to grow tax-free to support your future! You may like working now, but at some point you might want the option to slow down or end work altogether. Adding to retirement may not feel like it’s investing in your business, but it is investing in the future you.
How Do Retirement Contributions Work Now that I’m Managing them on My Own?
As a small business owner, your 401(k) deduction won’t be taken from your paycheck every two weeks, so how do you create a saving system for retirement?
When starting your own business, you need to establish business bank accounts that are separate from your personal bank accounts. From there, there are few ways to organize your business finances. We recommend working with an accountant to decide what you should be saving (monthly or quarterly) into a business savings account for taxes and retirement. This is a step you don’t want to miss! A surprise tax bill or missed opportunity can be avoided if you save while you earn.
Additionally, most entrepreneurs add to their retirement accounts in one lump sum at the end of the year (or during tax time), so saving throughout the year to a business savings account will prepare you for that contribution.
There are Many Retirement Account Options. Which One Makes Sense for Me?
Yes, there are multiple retirement plans available to you as an entrepreneur. I’ve listed the most common accounts below.
Individual Retirement Accounts – IRAs (Traditional or Roth IRA):
Regardless if you’re self-employed or not, as long as you have earned income, you can contribute to either a Roth or Traditional IRA to the limit of $6,000/year ($7,000/year if you’re over 50 years old. Note that the IRS does update these contribution figures every few years).
For example, if your business netted $10,000 (gross revenue minus expenses), you can add the full $6,000 to an IRA. If your business netted $3,000 (gross revenue minus expenses), you can only add up to your income earned: $3,000. The IRS defines earned income as wages, salary, taxable income, or net income from a self-employed venture which means to add to an IRA, your business must be earning income and not be in the ‘negative’.
Choosing to contribute to a Roth IRA or Traditional IRA means deciding whether you want a tax deduction now (Traditional IRA contribution) or a tax-free withdrawal in the future (Roth IRA). Your accountant or financial advisor can help you here!
IRAs are not company retirement plans, they are personal retirement plans. They are simple to open and can be opened and funded up to the tax filing deadline, typically on April 15th (April 18th, 2022 for the 2021 tax filing year). An important detail to remember is IRAs must be funded by the tax filing deadline even if you file for a tax extension!
If you or your spouse are not covered by a workplace retirement plan, there are no income limits when contributing to a Traditional IRA. Meaning, you can earn as much money as possible and still add to an IRA (although you would most likely move on to other options at that point). However, there are phase-outs you should be aware of. Let’s say you’re still under your company 401(k) and doing self-employed work on the side. In that case, if you earn above a certain amount, you are not eligible to add to an IRA. Find out more information by visiting the IRS website.
Simplified Employee Pension Plan – SEP IRAs:
SEP IRAs are retirement accounts for self-employed individuals. They are extremely simple to open and can be opened and funded until the tax filing extension. Meaning, you can add to last year’s retirement account all the way up until you file taxes. Your business entity will determine what date you can file your taxes until. S Corporations and Partnerships can extend until September 15, and LLCs, C Corporations, and Sole Proprietors can extend until October 15.
SEP IRAs are funded by the employer only. It may be confusing because you are both the employee and employer; with a SEP, you – the employer – are contributing on behalf of you, the employee.
How much you can add to a SEP IRA depends on how much income you earn and how your business is taxed. The IRS allows you to add approximately 18% of your self-employment income if you are taxed as a Sole-Proprietorship, Partnership, and Single LLC. If you are taxed as an S-Corp, C-Corp or Corp LLCs, you may add 25% of your wages. The 2022 SEP IRA contribution limit is $61,000 ($58,000 for 2021 and $57,000 for 2020)
You can use this interactive calculator to help calculate your maximum annual retirement contribution based on your income.
The $61,000 maximum is only available if your income exceeds $244,000 (25% of $244,000 = $61,000), so even though a SEP IRA is extremely easy to set up and maintain, you will be limited by your salary/net income.
However, if your goal is to maximize retirement savings, we recommend an Individual 401(k).
We love individual 401(k)s (also called Solo 401(k)s)! Why? Because you can contribute to them as the employee and the employer. You can also make catch-up contributions, which means you can save even more into your retirement account! Note that Individual 401(k)s are only for self-employed Individuals or partners in a business with zero employees.
With an Individual 401(k), you can make a contribution as an employee in the amount of $20,500 ($27,000 if you’re over 50). This is not a percentage of your income. For example, if your wage was $21,000, you can still add $20,500. That’s great!
From there, your employer (you) can add a profit-sharing contribution to your account up to 25% of salary or approximately 18% of self-employment income from Schedule C (the same formula as the SEP IRA). The total contribution limit between employee and employer contributions is $61,000 ($67,500 for those over 50 and taking advantage of the $6,500 catch-up).
It’s important to establish your Individual 401(k) by December 31st so that your year-end payroll reflects any employee contributions (up to $20,500 under age 50, $27,000 over age 50). You can then add the employer contributions (limit is $40,500) up until your tax filing deadline. Again, your business entity will determine what date you can file your taxes until. S Corps and partnerships can extend until September 15, and LLCs, C corps, and Sole Proprietors can extend until October 15.
What Entrepreneurs Should Remember
As an entrepreneur, adding $20,500 into an Individual 401(k) account (or even $6,000 into an IRA) might seem incredibly intimidating. You may not even be earning a profit in your first year! That’s okay. A little bit at a time makes a big difference.
We often find entrepreneurs start with an IRA and then switch to a SEP the next year when they can add more. Sometimes we skip the SEP and go directly to the Individual 401(k). What’s important is that you create a rhythm in saving for future you from day-one of your business.
As advisors, we genuinely love having the conversation about self-employed retirement options, and when it comes to annual savings, we serve as both accountability and coordinator for our self-employed clients. Schedule a call with an Abacus advisor today and learn more about your retirement options!