The Retirement Plan Menu of the Self-Employed…and those that work for them.

August 19, 2022
By: Director, Philip H. Clinkscales, III, CPA, CFA, CAIA, CGMA, CFP®, PFS

When a typical employee starts a job, they are usually offered a pre-set menu of retirement funding options that has been set by their employer. The choices usually involve whether to participate, which to participate in, and how much to participate. This limited choice can, in turn, limit the tax benefits available to those employees as well.

The self-employed, on the other hand, get to set their own menu. This means the options are greater for them and their employees. For those that are self-employed and solo practitioners, the menu can almost be without limits.

The number of self-employed (and their employees) makes up almost 1/3 of total employees(1) and this number has been growing since COVID-19. Below we will explore the options for this growing percentage of the labor force, the self-employed:

1. Traditional and/or ROTH Individual Retirement Accounts (IRAs)

For many just starting a business from scratch, the initial plan choice is likely an IRA. This is a very simple “plan” to establish, contribute to, and maintain. There is very little, if any, administration of the plan and very little to no overhead costs as well.

Coincidentally, this type of account (especially the Traditional version) is likely to be the final destination for most, if not all, of your other retirement plans once you are done working.

Plan Type: Individual – No ties to the employer.
Setup: Easy
Administration: Little to None
Cost to Setup & Maintain: Little to None
Annual Contribution Limit: $6,000 ($7,000 with catchup in the year you turn 50 and later)
Tax Benefits: Beneficial to make an annual decision on which type to utilize in each year.

ROTH IRA Benefit: tax free growth if distributed after age 59 ½. Here the contribution itself has income limitations and is non-deductible. All other factors equal, the ROTH IRA should be utilized in lower income years.
Traditional IRA Benefit: maximum annual tax deduction equal to the annual contribution limit but the deduction is subject to income limits. All other factors equal, the Traditional IRA should be utilized in higher income years relative to the ROTH IRA.

2. Solo 401(k)

If you still have no employees and the company income has outgrown the IRA options relative to the tax benefits provided by them, a Solo 401(k) may be worth considering. You are unable to utilize this option if you hire any employee other than your spouse (think Solo 401(k) is available to all employees on a solo joint personal tax return).

Plan Type: Employer
Setup: Easy
Administration: Little – for accounts under $250,000. Additional regulatory filings for those above that amount.
Cost to Setup & Maintain: Little to None
Annual Contribution Limit: $61,000 ($67,500 with catchup in the year you turn 50 and later) or 100% of earned income, whichever is less.

Employee Portion (Employee Deferral): $20,500 ($27,000 with catchup after age 50)
Employer Portion: 25% of compensation (or 25% of net self-employment income for single member LLCs or sole proprietors). Compensation up to $305,000 is applicable for consideration.

Tax Benefits: Current deduction for contributions and tax-deferred growth. Taxed at time of distributions beginning after age 59 ½. Much like an IRA, there is a ROTH option available.

3. Simplified Employee Pension (SEP IRA)

The Simplified Employee Pension is necessary to consider once you, as a self-employed individual, begin to hire an employee or employees (other than your spouse). Sometimes you may need more help (other than your spouse), and sometimes working with your spouse may not work out.

Plan Type: Employer but with Individual Participant IRAs
Setup: Easy
Administration: Simplified
Costs to Setup & Maintain: Little to None
Annual Contribution Limit: Contributions as a percentage of salary MUST be the same for ALL employees (owner/ employee included).

Employee Portion (Employee Deferral): None
Employer Portion: $61,000 or 25% of compensation (25% of net self-employment income for single member LLCs or sole proprietors), whichever is less. Compensation up to $305,000 is applicable for consideration.

Tax Benefits: Current deduction on contributions for the employer and tax-deferred growth. For the individual, taxed at time of distributions beginning after age 59 ½. No ROTH option available.

4. A Savings Incentive Match Plan for Employees (SIMPLE IRA)

As you grow in the number of employees and/ or the payroll dollar amounts, another option may prove useful. This option is available to employers with less than 100 employees.

Plan Type: Employer, but with Individual Participant IRAs

Setup: Easy to More Involved
Administration: Easy to More Involved
Costs to Setup & Maintain: Little
Annual Contribution Limit:

Employee Portion (Employee Deferral): $14,000 ($17,000 with catchup in the year you turn 50 and later) subject to a total of $20,500 ($27,000 with catchup after age 50) for ALL employer plans.
Employer Portion: Matching of employee contributions up to 3% of compensation OR a fixed 2% for all eligible employees. Compensation up to $305,000 is applicable for consideration.

Tax Benefits: Current deduction for contributions and tax-deferred growth. Taxed at time of distributions beginning after age 59 ½. No ROTH option available.

5. 401(k)

This is the plan most W-2 employees interact with at non-self-employed employers and can be an option for those with a great number of employees.

Plan Type: Employer
Setup: Involved
Administration: Involved
Costs to Setup & Maintain: Relatively Expensive
Annual Contribution Limit: $61,000 ($67,500 with catchup in the year you turn 50 and later)

Employee Portion (Employee Deferral): $20,500 ($27,000 with catchup in the year you turn 50 and later)

Employer Portion: It can vary in forms and amounts – Matching, Qualified Matching, Profit-Sharing, Qualified Nonelective, Money Purchase.

Tax Benefits: Current deduction for contributions and tax-deferred growth. Taxed at time of distributions beginning after age 59 ½. Much like an IRA, there is a ROTH option available.

6. Defined Benefit Plan

For those self-employed individuals (especially solo practitioners employing zero to very few) with higher incomes, the below options may be particularly appealing. These can be great tools for those that would like to store away an amount of money greater than that offered by Defined Contribution plans. Unlike the above which are considered Defined Contribution plans due to the fact that the amount contributed is the known variable, the below options are considered Defined Benefit Plans. These can also be used as standalone plans or in conjunction with one of the above plans to really supercharge your retirement funding and the current tax benefits of doing so. Employees generally must be offered to participate in the plan and the employer will need to make contributions on their behalf. Often, these plan types will require the services of a separate administration firm commonly referred to as a Third-Party Administrator (TPA).

  1. Defined Benefit Pension Plan
    These are referred to as pension plans because the “known” guaranteed amount is a monthly benefit starting at retirement. This is based on a formula involving compensation and length of service.
  2. Cash Balance Plans
    These plans are much the same as pension plans but rather than a “known” monthly benefit amount, the “known” guaranteed amount is a maximum lump sum payment amount at retirement.

Plan Type: Employer
Setup: Very Involved
Administration: Very Involved
Costs to Setup & Maintain: Expensive Setup and Annual Expenses
Annual Contribution Limit: Calculated by an actuary usually with minimum, maximum, and recommended values that can be quite large.
Tax Benefits: Current deduction on contributions for the employer. The maximum deduction must be calculated by an actuary.

Conclusion

Having a retirement plan as a self-employed individual, whether solo or with employees, is important as part of your overall financial plan. By knowing all your options, you will be able to choose a plan that fits best with your situation to maximize the benefits available.

(1) Kochhar, Rakesh (2021, November 3) The self-employed are back at work in pre-COVID-19 numbers, but their businesses have smaller payrolls. Pew Research Center. https://www.pewresearch.org/fact-tank/2021/11/03/the-self-employed-are-back-at-work-in-pre-covid-19-numbers-but-their-businesses-have-smaller-payrolls/

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