Being self-employed has certain advantages. You can set your own hours. Build a business on your terms. Also, you have many more retirement planning options at your disposal compared to a W-2 employee. The wide variety of option available to a solo, self employed person makes the planning decision making process a little complicated.
So, in this article I’d like to review some of those options. Mainly:
- SEP-IRA’s
- Solo 401(k)’s
- Defined Benefit Pension Plans
Who these work for
Let’s assume you are self-employed. You have no employees besides your spouse. If you have employees other than your spouse, the strategies below will be more complicated
SEP-IRA
Description
SEP stands for “Simplified Employee Pension”, not “Self Employed Pension” as you sometimes hear.
If you do have employees the idea is relatively simple. You and your employees open your own IRA accounts and the employer (i.e., you) makes contributions directly to the IRA’s. Employees do not contribute part of their salary to the SEP, like in a 401(k). Contributions come from the employer.
If you don’t have any employees (other than your spouse), you can still set up a SEP-IRA and just contribute to your own retirement account.
Here’s how it works.
When you initially set up the SEP plan, you select a percentage of your net earnings from self-employment to contribute to your SEP. Self-employed people are capped capped at 20%. You make annual contributions to your SEP and receive a deduction on your taxes each year. The SEP grows tax free and withdrawals are only taxable when you withdraw at age 59 and a 1/2 or older. Similar to the way a traditional IRA is taxed.
Extra points:
- You don’t need to make a contribution every year. So, you could skip a year if the business hits a rough patch and can’t make the payments.
- You can contribute even if you older than 70 and 1/2, which you can’t do with a traditional IRA.
- Might not be able to male a deduction for a traditional IRA contribution in same year as SEP-IRA contribution, but the SEP-IRA has higher limits
The math
The maximum a self-employed person can contribute to their own SEP in a given year is 20% of their net earnings or $61,000 (for 2022). The contribution percentage is multiplied by your net earnings from self employment, including the deduction for 1/2 of your self-employment tax.
Side note: the statute says the max you can actually contribute is 25%, but for self-employed persons the IRS uses a special formula to figure your actual contribution percentage. Here’s an example.
Joe runs a business and shows $100,000 of net profit on his Schedule C. His self-employment tax is $14,130 and he’s allowed a deduction for half of that ($7,065). Joe selects 10% as his contribution percentage. This is the IRS formula to figure his contribution percentage: 10%/(1+10%) = 9.0909%. So, the net of $92,935 ($100,000 – $7,065) is multiplied by 9.0909% to get $8,449, which contributes to his SEP. Since Joe is an independent contractor he would deduct the $8,449 on his Schedule C, reducing his taxes.
Note also that Joe would also invest those annual contributions and they would grow tax free. He can start withdrawing his contributions from the SEP when he turns 59 and 1/2 and would be required to take mandatory distribution at age 72. Those distributions would be fully taxable.
How to set it up
To set up the SEP, there are three steps:
- You must execute a formal written agreement. IRS Form 5305-SEP would suffice.
- You must give each eligible employee certain information about the SEP (if have employees)
- A SEP-IRA must be set up by or for each eligible employee (or just you if you have no employees)
The deadline is the due date (including extensions) for your business’s tax return. So, you could in theory set up a SEP-IRA for 2021 by 9/15/2022 at the latest. Contribution are due by the same extension.
Solo 401(k)
Description
In a typical 401(k), there are two parts:
- elective deferrals and
- employer non-elective contributions.
The elective deferral is the part of your salary you contribute to the plan. The employer non-elective contribution is what your employer adds. Your employer might match part of your contribution or contribute a percentage of the company’s profits (i.e. profit share).
If you are self employed with no employees except for your spouse, you can create a 401(k) for yourself. The set-up is basically the same as a regular 401(k). You can elect to defer your earned income throughout the year the same as you would your salary through an employer’s 401(k). In addition you can make contributions up to the annual max just like your employer would via a match/contribution.
The math
The maximum earned income you can defer throughout the year for 2021 is $19,500 , plus $6,500 if you are 50 years old or older. That goes up to $20,500 for 2022 (plus $6,500 if you are 50 or older.) The maximum you can contribute to the 401(k) in 2021 is $58,000 for 2021 and $61,000 for 2022. That means at the end of 2021, if you’ve maxed out the $19,500 deferral of your earned income, you can add another $38,500 as a non-elective contribution to your 401(k) for a max of $58,000 for the year.
SEP-IRA or Solo 401(k)? Both?
Can you do both a SEP-IRA and a solo 401(k)? Technically yes, you can. However, an SEP-IRA is considered a deferred compensation plan. That means you need to add contributions you make to the SEP with the contributions to the 401(k). You’re still capped at $58,000 (in 2021) for deferred comp plans. So, it’s better to choose.
For a few reasons, the 401(k) might be a better choice. Here are some you may consider:
- the SEP-IRA is taxed like a traditional IRA. It CAN NOT be a Roth.
- You can elect for the solo 401(k) to be a Roth (no deduction up-front, but distributions aren’t taxed when you withdrawal later)
- If you are age 50 or older, you can add another $6,500 to a solo 401(k). SEP-IRA’s don’t have catch up contributions.
- SEP-IRA contribution are capped at 20% for self-employed people. You can potentially put more into solo 401(k)’s.
Solo Roth 401(k)’s
In a Solo 401(k), you can elect for your salary deferrals to be treated as a Roth IRA. You wouldn’t get a deduction, but they would be tax-free when distributed later. Even in a Solo 401(k), the employer contributions are always pre-tax, like a traditional IRA.
However, it maybe possible to make an after-tax, employer contribution to your own Solo 401(k) in addition to your employee deferral to your Roth 401(k). If you “rolled” these contributions out to a Roth IRA, it is often called a “Mega Back Door Roth IRA”. (As of this writing, Congress is poised to eliminate this option).
Solo 401(k)’s compared to SEP-IRA’s
Here’s an example of why contributing to Solo 401(k) might be preferable to a SEP-IRA.
Joe is self-employed and has $200,000 net earnings from self-employment. His deduction for 1/2 of his self employment tax is $11,531. His maximum SEP-IRA contribution of 20% would be $37,693 ($200,000 – 11,531 = 188,469*20%). With a solo 401(k), Joe could defer $19,500 of his net earnings, and then add $38,500 as a non-elective contribution. His total contribution to the 401(k) would be the $58,000 max for 2021 compared to $37,693 to the SEP.
Multiple 401(k)’s
A Solo 401(k) also comes handy if you are employed, and you participate in your employer’s 401(k) AND you have a side gig.
Here’s an example of this directly from the IRS website:
In 2020, Greg, 46, is employed by an employer with a 401(k) plan, and he also works as an independent contractor for an unrelated business and sets up a solo 401(k). Greg contributes the maximum amount to his employer’s 401(k) plan for 2020, $19,500. He would also like to contribute the maximum amount to his solo 401(k) plan. He is not able to make further elective deferrals to his solo 401(k) plan because he has already contributed his personal maximum, $19,500. He would also like to contribute the maximum amount to his solo 401(k) plan.
Greg is not able to make further elective salary deferrals to his solo 401(k) plan because he has already contributed his personal maximum, $19,500, to his employer’s plan. However, he has enough earned income from his business to contribute the overall maximum for the year, $57,000. Greg can make a nonelective contribution of $57,000 to his solo 401(k) plan. This $57,000 limit is not reduced by the elective deferrals Greg made under his employer’s plan because the limit on annual additions applies to each plan separately.
Greg’s total annual contribution would be:
- $19,500 salary deferral to his first 401(k)
- $57,000 contribution to his side gig 401(k)
- Total annual contribution: $76,500.
And that doesn’t even cover his employer’s match (if any) from his first 401(k). So, it could be even more. If Joe is 50 or older, he can add $6,500 to that as well.
How to set it up
The deadline for setting up a Solo 401(k) is the end of the year, December 31st (for calendar year taxpayers). The deadline for making contributions is the due date for the corporate/employer’s return (including extensions).
Defined Benefit Pension Plans
A defined benefit pension plan is like a super-sized retirement option. You can stash away more to a DB pension plan than to a defined contribution plan like a SEP-IRA or 401(k).
The math
Unlike a 401(k) or SEP-IRA, a DB plan isn’t limited to how much you can put INTO it. It’s limited to your annual benefit when you retire. Specifically, a DB plan is limited to an annual benefit of the lesser of (1) 100% of your compensation for your highest 3 consecutive years, OR (2) $245,000.
Figuring out how much you can add to a DB plan requires an actuary to perform calculation each year. How much you can contribute depends on your age, your net earnings, and how long you have been in business. However, it may be possible to contribute at least $100,000 a year to a defined benefit plan. That amount is pre-tax, meaning you get a tax deduction for it. You can generally withdrawal from a DB plan starting at age 62 or 65, but could be earlier depending the plan.
So, you might be able to add $58,000 (for 2021) to a solo 401(k) and another $100,000 (or more) to a defined benefit pension plan. You’d get deduction for each and reduce your current taxes.
How to set it up
You must set up a defined benefit plan before the end of the calendar year. Contribution must generally be made 15 days after the end of each quarter. These plans are complicated and require professional assistance to set up and maintain.