Updated March, 2019
In our CEO’s book, What Your Financial Advisor Isn’t Telling You, Liz Davidson writes about understanding the importance of taxes to your investing returns. After all, it’s not just what you earn but what you actually keep. In honor of National Retirement Planning Week, I thought I’d write about one of the best ways to reduce taxes on your investing: qualified retirement plans.
By allowing you to defer taxes on your contributions and earnings until you withdraw the money, these plans benefit you in a couple of ways. First, you’re likely to pay a lower average tax rate on the withdrawals than on the contributions. (Even if you retire in the same tax bracket, a lot of your withdrawals will probably get taxed at lower rates because of how the tax code is structured.) Second, your investments will grow faster since the money that would otherwise be going to taxes is instead being reinvested.
Savings options for self-employed
But what if you or your spouse is self-employed? You can contribute to an IRA but you’re limited to only $6,000 a year or $7,000 if you’re over age 50. (One advantage to not having a retirement plan at work is being able to deduct all of your traditional IRA contributions regardless of your income.) Here are some other options if you’d like to put away a bit more in a tax-advantaged retirement account:
Individual 401(k). Also called a uni-401(k), solo 401(k) or a 401(k) for one, you’re only eligible if you have no partners or employees (other than maybe your spouse). The main advantage is that you can contribute up to $19,000 per year plus 25% of your earned income (there’s a special calculation of this) up to a total annual contribution of $56k plus an additional $6k if you’re over 50. Withdrawals are limited and subject to a 10% early withdrawal penalty but you can also set it up to allow you to borrow from the plan.
SEP-IRA. With a SEP-IRA, you can contribute 25% of your earned income (up to a total annual contribution of $56k plus an additional $6k if you’re over 50) but you have to contribute the same percentage of pay to each of your eligible employees. However, you can vary the percentage each year. Withdrawals are subject to a 10% early withdrawal penalty.
Simple IRA. With a Simple IRA, you generally cannot have more than 100 employees. Employees can contribute up to $13,000 per year (or $16,000 if over age 50) and you must either contribute 2% of income for each eligible employee (up to $5,600 a year) or provide a dollar-for-dollar match (up to $13,000 per year) of employee contributions of at least 3% of their income. The penalty for early withdrawals is increased to 25% in the first two years and then 10% after that.
When I was self-employed, I chose the SEP-IRA since the individual 401(k) was too expensive for my needs (fees have come down a lot since then) and I couldn’t contribute as much to the Simple IRA (also didn’t like that higher penalty on early withdrawals).
If you or your spouse is self-employed, the individual 401(k) will allow you to contribute the highest amount and take a loan if necessary. If you have employees, it all depends on how much you want to contribute for yourself and for them. In any case, being self-employed is no excuse not to save for retirement and reduce your taxes in the process.