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Understanding Your Retirement Plan Options as a Self-Employed Individual Thumbnail

Understanding Your Retirement Plan Options as a Self-Employed Individual

As a self-employed individual, you’ve worked hard and made many sacrifices to create the freedom of time and money for yourself, but what about your future retirement? You’re probably wondering how best to set yourself up for success there as well, but choosing the best retirement plan option for yourself can be a daunting task with all the different options out there. For self-employed individuals, there are effectively five main retirement plan options that you can choose from, but not all are created equal. These options include an IRA (traditional or Roth), a Solo 401(k), a SEP IRA, a SIMPLE IRA, or a defined benefit plan. In this article, we’ll cover the basics of each plan type and why they may or may not make sense for you, depending on your current needs and financial situation.

Traditional or Roth IRA

Traditional or Roth IRA’s are not specific to self-employed individuals, as anybody, self-employed or not, can contribute to one providing they fit the criteria for such. But first, it helps to understand the primary differences between the two types of IRAs, which is how they are treated for tax purposes.

In general, a Traditional IRA allows for tax-deductible contributions, meaning that your contributions reduce your taxable income dollar-for-dollar in the year they are made. Those contributions then grow tax-deferred with no taxes paid on any gains realized in the account until they are taken out in retirement. Once you reach retirement age and start taking distributions from your Traditional IRA, your distributions are treated as ordinary income and taxed as such.

Traditional IRAs are also subject to the required minimum distribution (RMD) rules once you reach age 72. RMD’s follow a specific life expectancy table that is dictated by the IRS. We won’t go into the details of this table, but if you are already at RMD age, you can use this IRS worksheet to help you easily calculate what your RMD amount needs to be.

With Roth IRAs, on the other hand, contributions are made using after-tax dollars, meaning there is no tax break when you make contributions and your taxable income is not reduced as a result. Your Roth IRA contributions then grow tax-free and are taken out tax-free in retirement. 

Additionally, Roth IRAs are NOT subject to the RMD rules. They are subject, however, to the 5-year rule, which effectively allows you to take withdrawals of earnings in your Roth IRA without paying taxes as long as your first Roth IRA contribution was at least 5 years ago. 

With both types of IRAs, you can take withdrawals at any time penalty-free after you reach age 59 ½, with distributions either taxed (Traditional IRA) or not taxed (Roth IRA). Roth IRAs, specifically, will also let you withdraw contributions-only (not earnings) at any time penalty-free and tax-free outside of the 5-year rule mentioned above. 

However, all other “premature” distributions taken from your IRAs may be subject to a 10% penalty in addition to any ordinary income taxes you might have to pay, depending on the type of IRA. As with most rules, though, there are also exceptions, such as for unreimbursed medical expenses and paying health insurance premiums while unemployed, among others.

Lastly, there’s the matter of contribution limits for both types of IRAs, and income limits imposed surrounding those contributions. 

For 2022, the contribution limits for both Traditional and Roth IRAs are as follows:

  • $6,000 if you’re under age 50
  • $7,000 if you’re over age 50

While you may contribute to both a Traditional and Roth IRA in any given year, your total limit between the two is capped at the limits above. In other words, you can’t contribute $6,000 (under age 50) to a Traditional IRA and then contribute an additional $6,000 to a Roth IRA, you can only contribute a total of $6,000 between the two (e.g., $4,000 Roth IRA/$2,000 Traditional IRA).

As for the income limits surrounding contributions, Traditional IRAs and Roth IRAs are treated differently. Traditional IRAs currently allow for contributions regardless of your income level, but your ability to take a tax deduction for those contributions is based on your adjusted gross income (AGI) and your filing status as shown below:

For Roth IRAs, since there is no tax deduction for contributions, income limits are imposed according to your AGI and filing status on your ability to make contributions to your Roth. These income limits are as follows:

If you are over the income limits for making tax-deductible contributions to your Traditional IRA, you can still make contributions, they’ll just be with after-tax dollars and won't be tax-deductible. You also would have to pay taxes again on those funds again when you take them out in retirement and would be better suited making a Roth IRA contribution providing you are still under the Roth IRA income limits. 

Hence, if you are over the income limits for both Traditional IRA and a Roth IRA, and to also avoid the conundrum of paying taxes again on nondeductible contributions in a Traditional IRA, you can utilize a current tax loophole with the backdoor Roth IRA conversion strategy. The backdoor Roth IRA conversion works as such:

  1. Make a nondeductible contribution to your Traditional IRA
  2. Immediately convert that contribution to your Roth IRA

As a self-employed individual, you are allowed to make Traditional and/or Roth IRA contributions in addition to utilizing the other retirement plan options we cover below. The only restrictions on doing so boil down to the rules described above.

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Solo 401(k)

A Solo 401(k), also known as an Individual 401(k), works the same as a traditional 401(k) plan you’d find working at a company with W-2 employees but is only available to single-member business owners with no full-time W-2 employees. You can have a Solo 401(k) and have W-2 employees, but only if they work less than 1,000 hours per year. 

However, the SECURE Act passed in December 2019 has changed this rule slightly. Now, any part-time employees who work at least 500 hours per year (but less than 999 hours) for 3 consecutive years in a row, starting January 1st, 2021, must be offered the option to participate in the 401(k) plan. Years prior to 2021 may be excluded, so part-time employees who meet the above requirements between January 1st, 2021 and January 1st, 2024, must be offered the ability to participate starting in 2024.

Once you are no longer eligible to have a Solo 401(k), whether you hire full-time employees, or you have part-time employees who are eligible to participate, you will need to either convert your Solo 401(k) to a Traditional 401(k) plan or pick one of the other options we cover in this article. The one exception to this rule is your spouse, providing they work in your business with you, in which case they can fully participate in the plan the same way you do.

As a participant in your Solo 401(k)’s, you wear two hats as far as contributions are concerned: as the employee, and as the employer. These are broken down as such:

  • Elective deferrals (employee; either Pre-Tax or Roth)
  • Profit-Sharing contributions (employer)
  • After-Tax contributions (employee if the plan allows; NOT the same as Roth)

Your elective deferrals are the same as Traditional 401(k) plans and capped at 100% of your income up to $20,500 for 2022 if you are under the age of 50, or $27,000 if you are over the age of 50. If your business is taxed as an S Corporation, these contributions are deducted directly from the W-2 wages you pay yourself throughout the year. There are no income limits on contributions made to your Solo 401(k).

Your elective deferral contributions can be made to either your pre-tax account (Traditional) or your Roth account (after-tax) within the plan. Pre-tax contributions reduce your taxable income for the year, grow tax-deferred, and are taxed as ordinary income when you distribute them in retirement. Roth contributions, on the other hand, are made with after-tax dollars, do NOT reduce your taxable income for the year, but grow tax-free, and are taken out tax-free in retirement.

Additionally, as the “employer” in your business, you can make profit-sharing contributions to your Solo 401(k) plan. Your profit-sharing contributions can only go in your pre-tax account (and are treated as such as a result), and are subject to the following limits, depending on how your business is taxed:

  • 25% of your annual W-2 wage (if taxed as an S Corporation).
  • 20% of your net adjusted business income (for sole proprietors and single-member LLCs NOT taxed as an S Corporation). Net adjusted business income is calculated by taking your net business income for the year and subtracting one-half of your self-employment tax.

Lastly, if your Solo 401(k) plan allows for it, you can also make after-tax contributions to the plan as an employee. These are NOT the same as Roth contributions and are made to an account that is separate from your pre-tax and Roth accounts. All 401(k) plans, including Solo 401(k)’s, allow for a maximum of $61,000 in total contributions to the plan if you are under age 50, or $67,500 if over age 50. 

After you have made your employee elective deferrals and profit-sharing contributions to the plan, any amount remaining up to the maximum contribution limits listed above can be made to your after-tax account in the plan. 

For example, let’s say you are under age 50, and a sole proprietor with $100,000 in net business income for the year, your contributions, including your after-tax contributions, could look like this:

  • $20,500 elective deferral contributions (pre-tax or Roth)
  • $18,470 profit-sharing contribution (pre-tax only; $100,000 x 15.3% SE tax = $15,300 SE Tax x 50% = $7,650; $100,000 - $7,650 = $92,350 net adjusted business income x 20% profit-sharing contribution limit = $18,470)
  • $22,030 after-tax contributions ($61,000 maximum contribution limit - $20,500 elective deferrals - $18,470 profit-sharing contribution = $22,030)

After-tax contributions are essentially a hybrid between pre-tax and Roth contributions. They are made with after-tax dollars, but they grow tax-deferred and are taxed again when taken out in retirement. In order to avoid this “double taxation”, the IRS still currently allows for mega backdoor Roth conversions, where the after-tax contributions are made and then immediately converted in-plan to your Roth account (or out-of-plan to a Roth IRA). You can read more about the ins and outs of how this works in our article A Simple Guide to After-Tax 401(k) Contributions

For most self-employed individuals, a Solo 401(k) is going to provide the maximum benefits as far as retirement plan options are concerned primarily due to their high contribution limits and ability to leverage both Roth and after-tax contributions for their tax advantages. 

The only downsides are that a Solo 401(k) often has administrative fees associated with the plan (depending on the plan provider), and they’re required to make annual tax filings with the IRS once they have $250,000 or more in assets within the plan. Additionally, there is a 10% penalty on premature distributions (taken before age 59 ½) that don’t meet the exceptions. However, you can take up to 50% of your Solo 401(k) balance up to $50,000 in the form of a loan both tax-free and penalty-free providing your plan allows. 

SEP IRA

A simplified employee pension individual retirement account (SEP IRA) can be used by businesses of any size, whether you have employees or not. SEP IRAs function like a hybrid between a 401(k) and a Traditional IRA. 

Like Traditional IRAs, SEP IRA contributions are made with pre-tax dollars (from the business), which grow tax-deferred, and are taxed as ordinary income when taken out in retirement. You also generally must be at least 59 ½ years of age to take withdrawals from the account without paying a 10% penalty, and you have to take required minimum distributions (RMDs) once you turn age 72. 

SEP IRA contributions can only be made by the employer (you), so if you have employees, whatever percentage amount you contribute for yourself, you must also contribute for each eligible employee. Employees must meet the following criteria to be eligible to participate in your SEP IRA:

  • Be at least 21 years of age
  • Have worked for the business for three of the past five years
  • Have earned at least $650 from the job in 2022 (includes part-time employees and 1099 contractors)

SEP IRAs have similar contribution limits to 401(k)’s with the maximum limit being $61,000 for 2022. However, unlike 401(k)’s, SEP IRAs do not have an additional catch-up contribution for those over age 50, and the contribution limit is capped at 25% of you and your employees’ compensation up to the $61,000 listed above, whichever is less.

For example, let’s say you make $150,000 per year and you have two employees making $100,000 per year each, and you choose to contribute 25% of compensation to the SEP IRA. Your contribution amounts would be as follows:

  • $37,500 to your SEP IRA
  • $25,00 to each of your employee’s SEP IRAs

While SEP IRAs have high contribution limits, the fact that they are capped at 25% of compensation may not translate to being a superior option over a Solo 401(k)/Traditional 401(k) plans, unless you have net business income above $244,000 to max out the plan ($244,000*25% = $61,000). 

However, SEP IRAs typically have no administrative fees associated with the account and no IRS reporting requirements. You can also contribute to a SEP IRA in addition to a Solo 401(k)/Traditional 401(k), so a SEP IRA can be a great option if you have a full-time job with an employer 401(k) you are participating in along with a self-employed gig on the side. 

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SIMPLE IRA

SIMPLE IRAs are available to business owners of all sizes up to 100 employees. In general, they are a great option for those who want to reward employees, but may not be ready for a Solo or Traditional 401(k) plan as SIMPLE IRAs are generally easy to administer, have minimal (if any) administrative fees, have no IRS reporting requirements, and have “simple” rules. 

SIMPLE IRA contributions are split between the employer and the employee participant(s). On the employer side, the employer is required to make contributions to plan participants either one of two ways:

  • A mandatory match of up to 3% of participants’ compensation; OR
  • A non-elective match up of 2% of participants’ compensation.

With the 3% matching option, you as the employer only have to match dollar-for-dollar up to 3% if the participant is also contributing. For example, if a participant is only contributing 1% of their compensation to the plan, you would only match 1%. With the 2% non-elective option, on the other hand, you have to contribute a flat 2% to all eligible participants’ accounts, whether they contribute or not.

On the employee side, SIMPLE IRAs allow participants to contribute up to $14,000 for 2022 if they are under age 50, or $17,500 if they are over age 50. All contributions are pre-tax, grow tax-deferred, and are taxed as ordinary income when distributed in retirement. For employees to be eligible to participate in the SIMPLE IRA plan, they must have earned at least $5,000 from you, the employer, in any 2 preceding years, and also be expected to earn at least $5,000 in the current year.

For premature distributions taken before age 59 ½ that don’t meet the exceptions, there’s a 10% early withdrawal penalty (like Traditional IRAs, SEP IRAs, and Solo/Traditional 401(k)’s). If an early withdrawal is taken in the first 2 years of plan participation, that penalty is raised to 25% on the amount withdrawn. Required minimum distributions must also be taken starting at age 72 as well.

Defined-Benefit Plan

A defined-benefit plan, also known as a pension plan, is available to businesses of any size with any number of employees (including no employees). This type of plan is called a “defined benefit” plan because employees receive a fixed monthly benefit in retirement that is calculated using a formula that typically takes into account the length of employment and salary history. 

The other big difference here over the other types of plans we’ve covered in this article is that employees do not have control over the investments in the plan, and are generally not required to make employee contributions to the plan. Rather, the employer is responsible for making contributions and managing the plan’s investments and risk. As a result, employers will usually hire an outside investment manager to manage the plan for them. 

Contribution amounts are also predetermined based on what is needed to provide definitely determinable benefits to the plan’s participants, which requires actuarial assumptions and computations. If at any point, the plan’s assets and investment returns are not sufficient to cover employee benefits, the employer is responsible for coming up with the additional cash needed to pay out benefits. All contributions made to the plan are tax-deductible for the employer. 

In general, the annual benefit for a participant under a defined benefit plan cannot exceed the lesser of:

  1. 100% of the participant’s average compensation for their highest 3 consecutive calendar years, OR
  2. $245,000 for 2022 (may be subject to cost-of-living adjustments in future years).

Seeing that defined-benefit plans are difficult and expensive to administer and put the entire responsibility on the shoulders of the employer, these types of retirement plans have lost popularity over the years and are generally not a preferable option for self-employed individuals/small business owners as a result.

The Bottom Line

The retirement plan space is rife with different options that provide a variety of different contribution limits, tax advantages, administrative and reporting requirements, and levels of complexity. Finding the best option for you means taking into account your current financial situation, comfort level in administering the plan, and ability to maximize your contributions and tax advantages. If you’re not sure which option is best for you, we recommend consulting your current financial advisor and licensed tax professional, or scheduling a free consultation with one of our expert advisors to discuss your current situation and needs, and help you make a decision that’s best for you.

Securities and investment advisory services offered through Calton & Associates, Inc. member FINRA and SIPC, a Registered Investment Adviser. Forefront Wealth Partners is not owned or controlled by Calton & Associates, Inc.