Retirement Plans for Sole Proprietors

Being self-employed or a sole proprietor can be challenging, rewarding and expensive. Sole proprietors have a plethora of items to worry about…the self-employment tax, business insurance, computers, office expenses, health insurance premiums, and so on. Retirement planning may seem like another item on the list of chores, and if you plan to be self-employed for the rest of your career, retirement planning is absolutely essential for you.

Luckily the IRS offers several options for the self-employed, which include:

Traditional IRAs and Roth IRAs

The Traditional IRA and Roth IRA options are of course available to self-employed individuals and is one of your most flexible options. Each has its own tax implications, and they are not as difficult to understand and implement as SEP IRAs and one-participant 401(k) plans. For example: with a traditional IRA, your contributions are generally tax-deductible (so if you make $50,000 in income and contribute $5,000 to your IRA, you’ll only be taxed on $45,000 of your income this year).

With a Roth IRA, you don’t get a tax break in the current year, but your money grows tax-deferred, and assuming you leave it alone for at least 5 years and until you reach age 59 ½, it can be withdrawn tax-free. So, you would be taxed on your full income now, but when you contribution grows massively, you will not be taxed on the earnings at retirement. Since tax rates may be higher in the future, the Roth IRA is always a solid choice.

If you’ve never explored these retirement vehicles, you can get more information here. We are available to help you understand the IRS language.

Consider an IRA if: You are just getting started saving for retirement and want to do something easy. An IRA is also good for “unintentional” freelancers who hope to work a traditional job again soon. 

Simplified Employee Pension Plan (SEP)

If you’ve ever worked for another company as an employee, you may already be familiar with this concept. SEP plans can provide a significant source of income at retirement by allowing employers, including self-employed individuals (sole proprietorship’s or partnerships) to set aside money in retirement accounts for themselves and their employees. The SEP is an IRA-based plan and are bound by the same rules for investment, distribution and rollover as traditional IRAs.

Many small employers favor SEP plans because of eligibility requirements for contributors, including minimum age of 21, at least three years of employment and a $500 compensation minimum. In addition, the SEP IRA allows employers to skip contributions during years when business is down. Contributions made by employers cannot exceed more than 25% of an employee’s compensation, or $53,000 maximum. As with the Traditional IRA, withdrawals from SEP IRAs in retirement are taxed as ordinary income, however, at age 70.5, withdrawal requirements apply.

The calculations required for SEPs can be challenging sometimes. We can help you with these.

Consider a SEP if: You want to save more than $5,500 per year, which is a good idea if your budget can handle it. In particular, financial experts recommend having enough saved for retirement to cover at least 60% of your pre-retirement income.

401(k) plan

Yes, as a sole proprietor you can set up one of these up even if you are not a full-time employee. They are sometimes referred to as “one-participant 401(k) plans” (though your spouse can also participate) and can let self-employed people get around some SEP IRA rules. With a SEP, you can choose to contribute a flat dollar amount, but if you make a relatively small self-employment income, the I.R.S. limits your contributions to 25% of that income. With a solo 401(k), you can contribute up to the annual $18,000 limit, just like a regular 401(k), and since you are both the employer and the employee, you are allowed to make contributions as both.

These solo plans work similarly to employer-provided 401(k) plans; they have comparable rules and requirements and have some specific reporting. For example, you can make elective deferrals of up to 100 percent of your earned income until you hit the annual deferral contribution limit of $18,000 in 2016 (or $24,000 if you’re age 50 or older). Additionally, the business can provide a matching employer contribution to your deferral to increase the amount of money put into the 401(k) plan annually. Both contribution types are flexible and you can change them at any time. Through these two contribution sources, the maximum contribution amount per person per year ($53,000 for 2016) can be reached with proper planning and reporting.

Warning: “Earned income” as the IRS defines it for self-employment is a complex concept that requires some advanced calculations. If you want to explore this option, please let us work with you on it from the beginning. You want to be sure that you do not exceed the maximum contributions as both employer and employee.

Consider a 401(k) if: You want to make larger contributions than with a regular IRA, and want more flexibility than in a SEP IRA. A solo 401(k) is a good option if you would like to have a Roth account with a greater contribution limit than a Roth IRA.

Consequences

Some sole proprietors say that they just plan to work forever so they don’t need to have a sizable nest egg ready for retirement. As accountants, this line of thinking always throws up red flags for us. Depending on your vocation, your physical health, and your overall attitude, this may work for you.

We have seen clients who feel this way hit age 65, only to discover one of a variety of realities:

• They don’t have the energy they expected, and business is suffering.
• Their friends are all retiring, and they feel like a failure because they are unable to.
• They feel bad because they haven’t amassed an estate that they will be able to leave for their children or grandchildren.
• The fast-paced, ever changer world we live in has passed them by, and there is little need for their product or service anymore.

Retirement plans are simpler if you’re a full-time employee, but that doesn’t mean that you can’t contribute to a retirement plan while being self-employed. We understand the every-day complexities of being a sole proprietor, and retirement could be the last thing on your mind.

No matter which plan you choose, remember that while it is crucial to save for retirement, it is even more important to make sure you have a stable foundation now since self-employed individuals lead a more unstable lifestyle without guaranteed income. Before putting everything away towards retirement, make sure you save up to create a plump emergency fund, which is extra important for the self-employed.

We want every sole proprietor to have the option to retire at a reasonable age and to do so comfortably. If you expect to still be flying solo at the typical retirement age, we would really like to help you create a workable plan to do so. There are several ways to structure a retirement plan that meets your needs being self-employed. We can help you to examine the best fit for your situation and make a plan to start saving for retirement.