Retirement Savings for the Self-Employed

Being self-employed can be incredibly satisfying. You get to be your own boss, keep your own hours, and make your own decisions about how to run your business. However, no matter what type of work you do, being self-employed still requires financial planning, and that means paying expenses, putting enough money aside for taxes, and preparing for retirement.

McKinsey estimates that there are 68 million freelance workers in the United States. Many entrepreneurs are taking advantage of the gig economy, taking contract jobs doing everything from driving for Uber and Lyft to professional consulting work. However, if you are working as a contractor, you are not entitled to benefits such as a company-sponsored 401(k) savings plan. This makes it even more essential to set aside money for income taxes and other expenses.

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Unfortunately, data tells us that entrepreneurs aren’t great at retirement planning. A survey of 1,960 small business owners revealed that 34 percent lack a retirement savings plan. The reasons these entrepreneurs cite for not saving for retirement include lack of income (37 percent), a need to invest their savings to fund their business (21 percent), and planning to sell their business to pay for retirement (18 percent).

The good news is that as a self-employed worker, you have a variety of great retirement options available to you. Here’s how you can make the most of your retirement options.

Plan Ahead for Taxes and Retirement Funds

The biggest mistake that most self-employed people make is not saving enough for annual contributions. Every payment that comes in is seen as profit, especially if you have a low-overhead business such as consulting. You set your own salary and pay yourself from whatever you earn. However, you need to be sure to set aside enough from each payment to account for federal and state income taxes, self-employment taxes, and retirement funds.

When you are self-employed, your income tends to change from year to year, so you have to accurately predict your annual earnings to prevent a shortfall come tax time. Most self-employed workers make quarterly estimated tax payments (1040-ES) to cover federal income taxes. In addition to income tax, you will need to calculate self-employment tax, which includes 12.4 percent for social security and 2.0 percent for Medicare.

Setting aside enough cash for taxes is one thing, but what about financial planning for retirement? You can save a substantial amount on taxes with a tax-deferred retirement account, but the amount you can put into retirement savings is dictated by your earnings, and you usually can’t make an exact determination until tax time.

Your best strategy is to set aside a portion of every payment for taxes and retirement. Depending on your earnings, you may want to plan to set aside anywhere from 25-33 percent.

Options for Self-Employed Retirement Savings

The good news is that if you are self-employed, you have a variety of options for retirement savings:

  • SEP IRA – In addition to a traditional IRA, you also can use a SEP IRA specifically created for the self-employed and owners of very small businesses. A SEP IRA lets you contribute 25 percent of earnings or $56,000 (whichever is less). SEP IRAs are flexible and you don’t have to contribute each year, but it can save you a lot at tax time.
  • Solo 401(k) – Designed for solo workers or couples running a business, the solo 401(k) lets you contribute as you would to an employer-offered plan. You can contribute up to $56,000 or 100 percent of earned income, whichever is less, and contributions are pre-taxed, with taxes paid when distributions are made after age 59½ . If you are 50 or older, you also are eligible for a $6,000 catch-up contribution.
  • SIMPLE IRA – A SIMPLE IRA was created for small companies and allows employees to contribute up to $13,000 (or $16,000 if you 50 or older) of tax-deferred earnings into an IRA account.
  • Roth IRA – If you are just starting out, you can put away up to $6,000 in a Roth IRA, plus an additional $1,000 in catch-up contributions if you are 50 or older. Unlike a traditional IRA, taxes are prepaid with a Roth IRA, so there are no taxes due when funds are distributed.
  • Defined benefit plan – For high-income individuals with no employees, a defined benefit plan is designed to set aside tax-deductible contributions that are taxed when you retire. How much you save is determined by anticipated retirement age and expected return on investments. This is more expensive than most self-employed retirement options with high setup and annual fees, and is usually administered by a brokerage firm.
  • Keogh Plan Keogh Plans predate SEPs and SIMPLE IRAs, but they are still around. A Keogh is a pension plan that you can set up with an annual goal—up to $55,000 or 100 percent of income—and the money is tax-deferred. What makes Keoghs less attractive to self-employed workers and small business owners is the amount of paperwork required.

Financial Planning Is Essential

If you are working for yourself or considering self-employment, develop a financial plan in advance.

Make sure your plan includes doing the following:

  • Establishing a savings account or money market account where you can put aside money for taxes and retirement savings.
  • Making your quarterly tax payments based on projected income.
  • Saving enough to contribute to a tax-deferred retirement plan. If you fail to save enough it could mean a bigger bill come tax time.

Talk to your financial advisor about opening an IRA, SEP IRA, Simple IRA, or other retirement account, and be sure to transfer money into those accounts at least once a year. The more you can contribute to your retirement accounts, the faster your retirement savings will grow, and the more you will save on your taxes.

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