Self-employed retirement plans: Tax tips to know

This article was fact-checked by our editors and Christina Taylor, MBA, senior manager of tax operations for Credit Karma.

Working for yourself can feel like living the American Dream.

But will your dream turn into a nightmare a few decades down the road when it’s time to retire? It could, if you fail to save for retirement.

When you work for someone else, your employer might sponsor a retirement savings plan for employees, like a 401(k). They may even match a portion of your contributions. But when you work for yourself, saving for retirement is entirely up to you.

Roughly a third of small-business owners don’t have a self-employed retirement plan, according to a 2017 survey by online business community Manta. And of those, 21% tapped into retirement funds to help their businesses.

Not making enough money to save was the top reason, at 37%, that respondents said they weren’t saving for retirement. Yet opening a retirement savings plan when you’re self-employed can pay off now, with tax benefits, in addition to providing financial security after you retire.

If you work for yourself, consider these retirement savings tips for self-employed people.

Types of self-employed retirement plans

When you’re self-employed, you have access to some of the same kinds of retirement savings vehicles you would have if you worked for someone else. For example, you can open and contribute to a traditional IRA as long as you received taxable compensation (which can include self-employment income) during the taxable year and were younger than 70½ by year’s end. And, as long as you aren’t covered by an employer-sponsored retirement plan, you may be able to deduct all your contributions.

You also have access to some additional retirement vehicles, including …

• Solo 401(k)
• Simplified Employee Pension (or SEP-IRA)
• Savings Incentive Match Plan for Employees (or SIMPLE IRA Plan)

Let’s look at each type of self-employed retirement plan and how they work.

Solo 401(k)s

Before you started working for yourself, you might have worked for someone else. And that employer may have offered employees the option to participate in an employer-sponsored 401(k) plan. As a self-employed person, you can still have a 401(k).

A solo 401(k), or one-participant 401(k) plan, is a retirement account option for self-employed people (and their spouses) who have no employees other than themselves.

They generally work the same way other 401(k)s work, with an important exception. When you create a solo 401(k) and you’re self-employed, you can make contributions as both the employee and employer.

You can make elective deferrals (the kind an employee would make) of up to 100% of your compensation (your earned income as a self-employed person) but not more than the annual contribution limit, which is $18,500 in 2018. The limit bumps up to $24,500 if you’re 50 or older, because you’re allowed $6,000 extra as a “catch-up” contribution.

You can also make non-elective contributions (the kind an employer could make for you if you worked for someone) of up to 25% of your compensation. As a self-employed person, your compensation is your earned income (net earnings minus half your self-employment tax and the contributions you made for yourself as elective deferrals).

IRS Publication 560 has a rate table and worksheet to help you calculate your contribution limit.

Here’s how it works.

Joe, a freelancer, establishes his business as an S-corp and opens a solo 401(k). Wearing his “employee” hat, Joe can defer up to $18,500 of his income from his business to his 401(k) in 2018. Since Joe is 51, he can also make a $6,000 “catch-up” contribution, for a total of $24,500. If Joe worked for someone else instead of himself, and his employer didn’t make any matching contributions, $24,500 would be the maximum Joe could put into his employer-sponsored 401(k) for 2018.

But Joe is employed by the company he owns, so he can don his “employer” hat and make additional contributions to his solo 401(k). His company can contribute up to 25% of his compensation to his solo 401(k).

The limit for total contributions to 401(k) accounts for 2018 is $55,000, excluding catch-up contributions.

Advantages and deductions

Solo 401(k) plans may allow you to save more than other alternatives, since, as a self-employed individual, you can contribute as both an employer and an employee. That makes a solo 401(k) a retirement option worth considering.

“If you are paying yourself less than $220,000 per year, you might be able to save more in a solo 401(k) than with a SEP,” says Matt Hylland of Hylland Capital Management LLC in North Liberty, Iowa.

Keep in mind that contribution limits for 401(k)s apply per person, not per plan. If you work for another company and contribute to a 401(k), those contributions count toward your total limit.

Additionally, there’s a downside to 401(k)s, says ReKeithen Miller, a certified financial planner and enrolled agent in the Atlanta office of Palisades Hudson Financial Group: “A Solo 401(k) plan can require more administration than an IRA, especially if the plan allows for loans.”

SEP-IRAs

A Simplified Employee Pension Plan, or SEP-IRA, is an IRA that any size business can use, including a sole proprietorship. However, a SEP is different from a solo 401(k) in that all contributions are made by the business. Employees — if you have any — don’t pay into their own SEP accounts.

When you create a SEP-IRA, you set up a traditional IRA for each eligible employee. If you’re a sole proprietor, you would establish a traditional IRA only for yourself.

Your contribution limits would be the same as if you were any other employee of the company. So you could contribute up to $55,000 in 2018, but not more than 25% of your compensation. You’ll have to do a special calculation to come up with your compensation as designated by the plan.

If you have eligible employees, you must contribute the same percentage of compensation to their plans as you do to your own. Employees are eligible for the plan if they’re 21 or over, worked for your company in at least three of the previous five years, and received at least $600 in compensation during the tax year. However, your plan can have less-stringent participation requirements as long as the same requirements apply to everyone, including you.

SEP-IRAs are simple to set up and have some other advantages compared with other retirement accounts for the self-employed.

“A SEP-IRA contributions count toward the tax year as long as the account is set up by the tax filing deadline for that year; whereas, a solo 401(k) plan must be set up by the last day of the taxable year,” says Adam Bergman, president of the IRA Financial Trust and IRA Financial Group in Miami Beach, Florida, and New York, New York.

Simple IRAs

A Savings Incentive Match Plan for Employees, or SIMPLE IRA, is an option for sole proprietors and small businesses. You can create a SIMPLE IRA if you have a small business (typically 100 or fewer employees) and you don’t offer any other retirement plan.

If you create a SIMPLE IRA, you must contribute every year by either of the following:

• Matching contributions for employees, up to 3% of employee compensation, not subject to any compensation limits
• Making non-elective contributions of 2% of employee compensation, on up to the annual compensation limit for each eligible employee ($275,000 for 2018), regardless of whether the employee contributes to the IRA or not

When you create a SIMPLE IRA, all eligible employees — including you — open an IRA account. Employees can choose to make contributions to the account from their salaries, up to a maximum of $12,500 in 2018. Employees 50 or older can make catch-up contributions up to $3,000. If you’re self-employed, you’ll make these contributions for yourself from your net earnings, and the same dollar limits will apply — $12,500, plus $3,000 catch-up contribution if you’re 50 or older.

“The SIMPLE IRA is perhaps more suited for the business owner that has employees and wants to reward their staff for their work,” says Jeffrey Quatrone, an enrolled agent in Phoenix, Arizona.

If you’re self-employed and choose to make matching contributions instead of non-elective ones, the contribution limits mean you could invest up to $12,500 in self-employment income as the employee, and then match some or all of that investment as an employer, with the maximum match set at 3% of compensation. Again, you’ll need to calculate your compensation as a self-employed individual.

The contributions that employees make are elective deferrals, which count toward the limit for contributing to all SIMPLE IRAs and 401(k)s. If you contribute $12,500 to a SIMPLE IRA, the maximum you could contribute to a 401(k) would be $6,000 in 2018.

Deducting contributions

If you work for someone else, one of the attractive aspects of saving for retirement is the tax deduction you can generally take for contributions to qualifying plans. You can reap the same benefit as a self-employed individual.

Generally, you can deduct contributions you make to a qualified plan — with some limitations that depend on the type of plan you have. And because you’re self-employed and making contributions for yourself, you’ll need to calculate the maximum deduction you can take for your own contributions. IRS Publication 560 has a Rate Table and Rate Worksheet to help with this calculation, but if you’re unsure, talk to your tax professional about how to take this deduction.

Bottom line

When you work for a company that sponsors a retirement plan, you’ll probably hear a lot about it, since companies tend to promote these benefits to their employees. Some even automatically enroll employees in their retirement plan, and workers who don’t want to participate have to opt out.

But when you work for yourself, no one is going to automatically enroll you in a retirement account. Saving for your retirement is entirely on you.

Solo 401(k)s, SEP-IRAs and SIMPLE IRAs are all self-employed retirement plans that can make it possible to invest money for the future while getting a tax break now. But different accounts are right for different people.

You’ll need to decide which retirement savings plan for self-employed people will best meet your needs.

Christina Taylor is senior manager of tax operations for Credit Karma. She has more than a dozen years of experience in tax, accounting and business operations. Christina founded her own accounting consultancy and managed it for more than six years. She co-developed an online DIY tax-preparation product, serving as chief operating officer for seven years. She is the current treasurer of the National Association of Computerized Tax Processors and holds a bachelor’s in business administration/accounting from Baker College and an MBA from Meredith College. You can find her on LinkedIn.