SAVING FOR RETIREMENT WHEN YOU'RE SELF-EMPLOYED
SUMMARY
Whether you work as an independent contractor, run your own business by yourself, or do gig work on the side, you have self-employment retirement plan options that extend beyond standard IRAs.
SOLO SAVING FOR THE FUTURE
In the age of widespread freelancing and side hustles, the question of saving for retirement is a timely and pertinent one. Maybe you drive for Uber part-time. Maybe you sell handmade goods on Etsy. Maybe your primary source of income is 1099 consulting work. For some people, their self-employment income is supplementary to their full-time job wages. For others, it comprises the entirety of their business endeavors.
Contributing to an IRA, either traditional or Roth, is common wisdom. The maximum annual contribution, however, is only $6,000 ($7,000 if over age 50), which can severely constrain those with the ability and desire to put more money towards retirement. There is always the option of investing money in a taxable account, but you don’t get the tax advantages offered by retirement accounts. What more can you do? Enter the SEP IRA and the Solo 401(k).
SEP IRA
The Simplified Employee Pension individual retirement account (SEP IRA) is funded entirely by employer contributions. All contributions are tax-deductible, and gains within the account, like a traditional IRA, are tax deferred. Individuals who file as sole proprietors, LLCs, and corporations can open a SEP IRA, even while fully funding a traditional or Roth IRA or a 401(k) at a different employer.
SEP IRA contribution limits are much higher than traditional and Roth IRAs. The allowable maximum contribution is 25% of your net self-employed income, up to $58,000 in 2021. SEP IRAs are relatively easy to open, and because they comprise employer-only contributions, they can be established and funded as late as your business’s tax return due date.
The calculation for the contribution limit can be complicated for self-employed income, as you first have to determine your net earned income, or self-employment compensation. The IRS defines this as your self-employment net earnings after deducting one-half of your self-employment tax and the contributions you make for yourself. A variety of online calculators are available to help you determine your maximum contribution, but confirm the number with your tax advisor.
Net Earned Income = New Profit - 1/2 of Self-employment Tax - Contributions
One advantage of the SEP IRA is that if you end up bringing on more employees, you are not disqualified from using it. Hired employees can participate (and must be included if eligible). For those operating alone, however, there may yet be a better option.
SOLO 401(K)
The Solo 401(k), also known as an Individual 401(k), has a number of advantages for the self-employed individual that a SEP IRA doesn’t.
Unlike the SEP IRA, the Solo 401(k) can be funded by both employee and employer contributions. As an employee, you can defer up to $19,500 (2021; it will increase to $20,500 in 2022) with a $6,500 catch-up contribution if you’re over age 50. As an employer, you can contribute up to 25% of your net earned income, for a maximum annual contribution limit (including employee contributions) of $58,000 (2021; $61,000 in 2022), not counting the catch-up contribution. This provides two advantages over the SEP IRA. First, the Solo 401(k) catch-up contribution brings the contribution limit up to $64,500 (2021) in total for those over age 50, a full $6,500 more than in the SEP IRA. Second, you are not restricted only to employer contributions, which means you can contribute as much as $26,000 more in a solo 401(k) without being restricted by the percent of net earnings limitation.
Another great advantage some Solo 401(k)s have over SEP IRAs is the ability to make after-tax Roth contributions. If you take advantage of the Roth option in your plan, you won’t receive a deduction for your contributions. Instead, as with a Roth IRA, once you meet certain parameters, you can take tax-free distributions from the account. This includes only contributions you make as an employee; employer contributions are placed in a traditional 401(k) plan and will be taxable upon withdrawal.
A third potential benefit of a Solo 401(k) over a SEP IRA is the ability (at this time) of doing a mega backdoor Roth (MBDR) conversion. MBDRs are similar to backdoor Roth conversions, in which those whose income disqualifies them from contributing to a Roth contribute instead to a traditional IRA, and then convert it into a Roth contribution. The MBDR allows 401(k) contributions, up to $38,500 annually, to be recharacterized as Roth contributions, either into a Roth option within the plan or to an outside Roth IRA. At the time of this writing, however, Biden’s infrastructure bill currently being negotiated in the Senate includes language that would disallow MBDRs starting in 2022.
Some Solo 401(k) providers allow loans from the plan, which adds another possible form of flexibility.
As with SEP IRAs, the employer contribution to a Solo 401(k) is calculated based on the IRS’s definition of net earned income (Net earned income = net profit – ½ self-employment tax – contributions).
The downside of the Solo 401(k), if applicable, is that the employee contribution limit includes all 401(k)s to which an individual contributes. For example, in 2021, if John Smith contributes $10,000 to his standard 401(k) as an employee with Company A, he can only contribute up to $9,500 as an employee to his Solo 401(k) he operates for his side hustle. The $58,000 total contribution limit is separate for each plan unless the employer of one plan owns 80% or more of the employer for the other plan. In other words, if John owns 80% or more of both companies, the $58,000 limit is his total maximum across both of his plans.
Solo 401(k)s may also be more complicated to set up and manage than a SEP IRA and, depending on who provides the plan, may cost annual fees. They are also only available to owner-only businesses. Because of this, if you have a business partner or spouse who generates self-employment income in the business, he or she may also be able to open a Solo 401(k) account alongside you. Speak to a tax advisor to ensure your plan is set up properly.
The SECURE Act, which took effect in 2020, now makes it possible to establish a Solo 401(k) until your tax filing deadline, plus extensions. While employer contributions can be made until that time as well, note that employee deferral contributions must be formally elected by December 31 of the tax year, which requires that the plan is established by that time. Be mindful that employer contributions to a Solo 401(k) may also affect your qualified business income (QBI) deduction.
MAKING A CHOICE
The flexibility built into a Solo 401(k), as well as the ability to make an additional catch-up contribution after age 50, makes it an easy winner in many self-employment circumstances. Nonetheless, it is important to weigh the pros and cons of SEP IRAs and Solo 401(k)s in your situation to determine which, if either, is appropriate for you. At Day Hagan, we’re happy to help if you have any questions or are interested in opening a SEP IRA or Solo 401(k).
Best,
Natalie Brown, CFP®
Director of Client Services
Day Hagan Private Wealth
—Written 12.09.2021.
Print PDF Copy of the Article: Day Hagan Private Wealth Insights: Saving For Retirement When You’re Self Employed (pdf)
Disclosure: The data and analysis contained herein are provided “as is” and without warranty of any kind, either express or implied. Day Hagan Private Wealth (DHPW), any of its affiliates or employees, or any third-party data provider, shall not have any liability for any loss sustained by anyone who has relied on the information contained in any Day Hagan Private Wealth literature or marketing materials. All opinions expressed herein are subject to change without notice, and you should always obtain current information and perform due diligence before investing.
Investment advisory services offered through Donald L. Hagan, LLC, a SEC registered investment advisory firm. Accounts held at Raymond James and Associates, Inc. (member FINRA, SIPC) and Charles Schwab & Co., Inc. (member FINRA, SIPC). Day Hagan Asset Management and Day Hagan Private Wealth are both dbas of Donald L. Hagan, LLC.