Retirement plans for self-employed

While self-employment has its own unique benefits, retirement perks are definitely not among them. However there are a number of plans out there that can help the save employed save and prepare for retirement, ranging from SEPs to Solo 401Ks and other programs. Freelancers, gig workers and independent contractors are pretty much on their own in terms of planning and saving for their future, and the resources below can help them prepare.

The retirement plans can even be used if you freelance or do “gig-economy work” on a part time basis, which millions of people do. For most workers, a 401(k) is the centerpiece of their retirement plan. It’s a particularly great deal when it’s set up through an employer with a dollar-for-dollar matching plan, along with perhaps some medical coverage or even a pension.

It’s true that independent workers tend to be at something of a disadvantage when it comes to retirement planning, but that doesn’t mean it isn’t possible to retire comfortably. There are plenty of options. The earlier someone opens up a 401K or Simplified Employee Pension (SEP), or saves, the better. It takes a little more self-discipline and advance planning for freelancers as well as gig workers, but those are qualities that are usually required to make it in self-employment to begin with!

Find several popular plans that independent or gig-economy workers can use to set enough money aside for their golden years. Or locate additional resources for gig workers. Saving for retirement is a critical financial literacy skill to have.

Retirement programs for gig workers, freelancers, and the self-employed

A number of people have multiple jobs. Maybe they work for a business and then also do part time gig type or freelance jobs on the side. The self-employment retirement plans listed below can also be used in these cases too. As an example, lets say you earn an extra $2,000 per year, that $2,000 can be applied to these self-employment retirement options below.

1) Self-Employed / Solo 401(k)

You’ve no doubt heard of the 401(k) plan. Most companies offer it to their employees. It’s a special fund that you contribute payments to for retirement, which enjoys special tax privileges. However there is a self-employed 401K plan as well for those who work for themselves.

The 401(k) has largely replaced the pension as the central funding source for retirement. The deal is that you can contribute a certain amount per year either without having to pay taxes on it, or paying a smaller amount of tax than you normally would for income. As long as you wait until you are near or at retirement age to withdraw, you end up in a favorable tax situation in terms of collecting on the interest that the account has accrued over the years.

401(k) plans usually go through an employer, but there are special independent plans for independent workers and those running small businesses. You might hear it called the “solo,” “individual,” “self-employed” or “one-participant” 401(k), but it’s all the same thing. That last name is important, because this 401(k) type is only for those who are solo workers and don’t have employees. Business owners with employees won’t be allowed to contribute to it. Contribution limits can change by the year, but as of 2020 you can set aside up to $57,000 per year with this plan.

As far as taxes go, there are “traditional” and “Roth” options (which you’ll see with many types of retirement plans). The traditional option lets you defer taxes until you withdraw the money, but at that time you’ll be taxed on the interest. With a Roth plan you are taxed up front but can eventually withdraw without paying anything extra if you meet the qualifying conditions: the Roth account is at least five years old, you’re at least age 59 and a half, or if you’re younger than that but have a qualifying permanent disability. If you withdraw from a Roth early, you pay income tax on the money and may also be hit with a 10% early withdrawal fee to boot. Roth IRAs are also income-limited; you have to make less than $124,000 per year to make the full annual contribution.

The self-employed can open a solo 401(k) through an investment broker such as Vanguard, Fidelity, E Trade or TD Ameritrade. They can also provide general retirement, investment, as well as financial literacy advice – not just retirement planning. Additional financial help is always beneficial to anyone, maybe more so those who work for themselves such as a freelancer.

Most of those brokers will then have you choose from one of their mutual fund or ETF options, which is a diversified portfolio of stocks that the broker manages and that is designed to minimize risk and provide fairly stable and predictable growth over the long term.

There are solo 401(k) plans out there that are totally fee-free, but they usually offer limited options; for example, you might be forced to select a traditional plan (no Roth without fees) and not be given the ability to take out loans against your 401(k). Depending on the provider, there may be a one-time setup fee or an annual maintenance fee (but usually not both); these can range from $20 to $1000, but fee waivers are also a possibility once you have enough assets invested with the broker. If those fees seem high for a gig worker, then look into more retirement planning programs below.

2) Simplified Employee Pension (SEP) IRA

Individual retirement accounts (IRAs) are very similar to 401(k) plans, and the SEP IRA is very comparable to a traditional 401(k). The main difference is in the terms as well as set-up fees. The annual allowed contribution to the IRA is usually much lower than a 401(k), but the SEP IRA is a special type that matches the current 401(k) cap of $57,000 per year. You can only save up to 25% of your net income as well to that maximum.

Many freelancers as well as gig workers use a Simplified Employee Pension, with Fidelity indicated this is the most popular retirement product for the self-employed. Most brokers will allow a freelancer or self-employed worker to set up a SEP account for free.

What else is different? IRAs are a little more flexible in terms of investment options than 401(k) plans are. This means that with a SEP IRA there are many more ways to save for retirement; you can invest in stocks, bonds, ETFs, commodities, mutual funds and so much more. Regulations make it such that brokers have to offer more specific packages in terms of 401(k) plans; you’ll often find hundreds of added options when selecting what to invest in with an IRA.

There are some limitations to the SEP IRA, however. These are not “deal-breakers” for the self-employed though. One of the big ones is that there is no Roth option. Another is that there are no “catch-up contribution” amounts added once you get closer to retirement age. This is why, as financial literacy teaches us, it is always better to save and invest earlier. As gig workers or the self-employed can’t pour more money into a retirement plan later to “catch up”.

3) The Backdoor Roth

Higher-income earners who are self-employed sometimes create what is called a “backdoor Roth” to reduce their overall tax burden and get around the Roth income restrictions. The process is to create a traditional IRA, wait at least a few weeks so that the contributions register as separate transactions, and then convert that contribution to the Roth IRA.

You still eventually have to pay tax on the initial contribution to the traditional IRA, but you avoid being taxed on the back end by waiting until at least age 59.5 to cash out the Roth. Depending on the circumstances this can be a favorable tax scenario for workers (whether self-employed or not), and it is important to minimize taxes as part of a financial literacy program.

The main problem with this strategy is that it only really works if you don’t already have an existing traditional IRA of some sort that you want to leave alone. If you do have an IRA, any new IRAs you create are viewed as one entity by the IRS in terms of taxes. That would mean that if you have an existing IRA you are trying to maintain and you then create a new traditional IRA to roll over to a Roth, the bulk of the funds in the existing IRA would then become taxable.

4) “DIY” Pension With a Defined Benefits Plan

Freelancers and independent contractors don’t qualify for pensions, but if you make enough money it’s possible to set one up for yourself with something called a “defined benefits plan.” This used to be a popular employer-sponsored pension structure, though it is not offered much anymore. With a high enough income you can recreate this type of plan for yourself, however. Some well-off freelancers and consultants do create one as they tend to have more money for retirement planning.

This is a complex strategy that is best suited to someone with a legally established small business structure, and will definitely require the involvement of a both a qualified accountant and insurance actuaries. This means a DIY pension may not be the best retirement plan for a gig worker who maybe does the job on a part time basis.

The general gist of it is to use insurance contracts through the business to lower your personal tax rate; an article at Pacifica Wealth goes into much greater detail and suggests that it’s best for middle-aged small business owners who make six figures in personal income per year, which probably excludes most gig economy workers.

Tips and Tricks for the Self-Employed

Keep in mind that 401(k) plans and the regular non-SEP IRAs allow you to make added “catch-up contributions” of an extra $6,000 per year once you hit age 50.

There are always different circumstances, but in general the best approach for the regular self-employed working person is to prioritize maxing out a Roth IRA and Roth 401(k) as this will likely provide the most money in the long run.

If you’re expecting to need to pay for your own health care during retirement (like many freelancers or self-employed workers need to do), it may be a good idea to also start contributing to a health savings account (HSA). This account allows you to set aside, grow and eventually use your expected health care expenses all without paying any taxes on them. This does depend on the state you plan to settle in, however, as several opt to charge state income tax on them.

Also keep in mind that the retirement plans described above are meant for the solo worker, whether or not you structure your operations as a business entity. If you’re running a business that has regular employees on a payroll, some of these options (such as the SEP IRA and Individual 401(k) for employees) might work for you but there is an expanded range of options to explore such as the SIMPLE IRA.

By Jon McNamara