Saving for retirement is never simple, but it’s a little less complicated when you work for someone else. Put 10-15% of your salary into your 401(k). If you can’t, contribute at least enough to take advantage of any matching contributions from your employer.
However, self-employed retirement plans gets a little more complex. There’s no HR professional telling you to sign up for benefits and no company 401(k) plan from which to choose investments. If you want to save for retirement, you have to do it without in-house help.
That extra layer of complexity, though, brings more opportunity. When you retire from your employer, you receive your savings. If you're lucky, you also start collecting a pension.
When you retire from the company you own, you get your retirement savings. But you also get to take advantage of the value you’ve built up in your company over the years. If your business did well, you get a sizable cash infusion to supercharge your retirement just as it begins.
Best Retirement Plans for the Self-Employed
Self-employed people have several retirement options. Each plan has different benefits, tax advantages, and contribution limits. These retirement plans aren’t the only ways to save for retirements. You should also consider other financial vehicles like annuities and an investment portfolio.
Solo 401(k)
A Solo 401(k) is a self-employed retirement plan for businesses with no employees. You can contribute both as an employee and an employer. You can choose between a traditional Solo 401(k) (tax-deferred) or a Roth Solo 401(k) (tax-free withdrawals in retirement). This plan works best for high earners who want large tax-advantaged savings.
SEP IRA (Simplified Employee Pension IRA)
A SEP IRA is easy to set up and allows high contributions as a retirement plan for the self-employed. You can contribute up to 25% of your income. Only employers contribute, so if you have employees, you must contribute the same percentage for them. This plan is best for self-employed individuals with no or few employees who want flexibility.
SIMPLE IRA (Savings Incentive Match Plan for Employees)
A SIMPLE IRA is for small business owners with employees. Employers must match up to 3% of employee contributions or contribute 2% of their salary. This plan is easier to manage than a 401(k), but the limits are lower.
Traditional and Roth IRAs
A Traditional IRA allows tax-deductible contributions, but withdrawals in retirement are taxed. A Roth IRA uses after-tax dollars, but withdrawals are tax-free. These accounts are best for self-employed workers who want extra savings outside their main plan.
Defined Benefit Plans
A Defined Benefit Plan is like a pension for self-employed individuals. Contributions depend on age, income, and retirement goals. These retirement plans for the self-employed allow high tax-deductible contributions but require long-term commitments. They are best for high-income earners who want to save a large amount each year.
Start Early
Most people work for a decade or two before they start thinking seriously about retirement. Wise business owners save for retirement early. But many lack a clear strategy. In their 20s and 30s, they focus on buying a home, finding a spouse, and raising a family.
When you work for yourself, you don’t have that luxury. You need to be putting yourself on track for retirement from the first day you open for business. There are a number of avenues to consider as you begin preparing for an event that is decades away.
Tax Efficiency
Many people forget about taxes when planning for retirement, whether they own a business or work for someone else. That can be a huge mistake! If you ignore taxes in retirement planning, you may face big surprises. This can happen at the worst time—right when you stop working.
Owning your own business gives you an advantage others lack: You get to choose your retirement savings vehicle. Most employees contribute to a 401(k) because that’s what their employer offers. As regular readers of my blog know, a 401(k) is a tax-deferred retirement account.
Your employer deducts 401(k) contributions from your paycheck before taxes. This is nice because it you save your full contribution instead of losing part to income tax.
But few things in life are entirely advantageous, and the tax-deferred nature of401(k)s are no exception. The tradeoff for not paying taxes on the money you contribute is that you will pay taxes when you withdraw that money in retirement. The trouble is that, while we know today’s tax rates, we don’t know what they will be in the future; most experts expect them to be higher.
This means you’ll pay taxes on withdrawals at the likely higher ordinary income tax rate. Also, any gains in the 401k get taxed as ordinary income instead of the usually lower capital gains rate. In short, a significant chunk of your 401(k) retirement savings may go to taxes instead of your retirement.
As a self-employed business owner, you have more flexibility. Without a company match, you can skip tax-deferred accounts. Rather, you can open a Roth 401(k) or, if you’re a sole proprietor, a solo Roth 401(k). You’ll pay taxes on contributions when you make them, but gains and withdrawals in retirement are tax free.
Your Portfolio Includes Your Business
Perhaps the most difficult part of retirement planning when you’re self-employed is making yourself replaceable. You must see your business as part of your retirement portfolio.
Your business needs to be a viable enterprise without you at the helm. It must be able to continue operating profitably with you completely out of the picture. Why? Because if it’s not, no one will want to buy it from you when you’re ready to retire!
This is hard. Letting your business run without you hurts your ego. It’s even harder when you see it as your "baby." You can’t imagine ever wanting to give it up!
For many business owners, planning their exit feels terrifying. But it makes the business more valuable and easier to sell for retirement funds.
This is not just something I tell business owners to do; it’s something I do myself as a business owner. Every day, I step back and ensure the operations of Asset Preservation Wealth & Tax can continue without me. Personally, I do this mainly out of a sense of responsibility for our clients.
Bluntly, if a bus hits me tomorrow, my clients’ finances shouldn’t suffer as a result. Ensuring the firm thrives without me matters most. But it also strengthens my retirement finances and influences my decisions.
I learned the importance of this the hard way. My mother ran a very successful day spa in California when I was younger. Her business soared in the 90s. But after the dotcom bubble burst, her therapists left, seeking greener pastures far away from anything resembling Silicon Valley.
By the end, she was running the business by herself. She was still making a great income but had nothing left to pass on to a new owner. It was a good way for her to earn a living, but she had no business to sell to help fund her retirement.
Don't just grow your business and save blindly. Think about what you’ll actually need in retirement. Especially as you approach retirement, consider your cash flow needs.
I’ve said it before, but it bears repeating. Guessing a retirement number without a cash flow analysis is a big mistake for your self-employed retirement plan.
Many articles claim you need $1 million or another big number. But your actual needs depend on your goals and situation. Some can retire with far less than $1 million in savings. Others retiring on $1 million would run out of money in just a few years.
Consult with your financial advisor to determine your desired retirement lifestyle and the cash flow level you’ll need. This gives you a clearer idea of your retirement needs and helps prevent financial failure. It's easier to delay retirement than to return to work after running out of money.
What Is the $1,000 a Month Rule for Retirement?
The $1,000 a month rule estimates how much savings you need to generate $1,000 in monthly retirement income. A common approach is using the 4% rule, which suggests withdrawing 4% of savings each year.
To get $1,000 a month ($12,000 a year), you need around $300,000 in retirement savings. This is a rough estimate and depends on investment returns, inflation, and spending needs. Again, this one-size-fits-all approach doesn’t work for everyone. You still should consult with a financial advisor to get a more precise self-employed retirement plan.
What Is the Golden Rule for Retirement?
The golden rule for retirement is to save early, invest wisely, and live within your means. Some recommend saving 15-20% of your income and diversifying investments. The goal is to build enough wealth to sustain your lifestyle without running out of money. However, you still need a cash flow analysis to know what your real goal should be.
Stewart Willis is the founder and president of Asset Preservation Wealth & Tax, a financial planning firm in Phoenix, Arizona. Investment advisory services offered through Foundations Investment Advisors, LLC, an SEC registered investment adviser.
The commentary on this blog reflects the personal opinions, viewpoints and analyses of the author, Stewart Willis, providing such comments, and should not be regarded as a description of advisory services provided by Foundations Investment Advisors, LLC (“Foundations”), an SEC registered investment adviser or performance returns of any Foundations client. The views reflected in the commentary are subject to change at any time without notice. Nothing on this website constitutes investment, legal or tax advice, performance data or any recommendation that any particular security, portfolio of securities, transaction or investment strategy is suitable for any specific person. Personal investment advice can only be rendered after the engagement of Foundations for services, execution of required documentation, including receipt of required disclosures. Any mention of a particular security and related performance data is not a recommendation to buy or sell that security. Foundations manages its clients’ accounts using a variety of investment techniques and strategies, which are not necessarily discussed in the commentary. Any statistical data or information obtained from or prepared by third party sources that Foundations deems reliable but in no way does Foundations guarantee the accuracy or completeness. Investments in securities involve the risk of loss. Any past performance is no guarantee of future results. Advisory services are only offered to clients or prospective clients where Foundations and its advisors are properly licensed or exempted. For more information, please go to https://adviserinfo.sec.gov and search by our firm name or by our CRD # 175083.
