From time to time when working with self-employed clients or those that have a side business, I find that the retirement plans they are using aren’t optimal. Sometimes they’ve outgrown the plan they started with. In other cases they didn’t know a better option existed. Whatever the situation, if you’re self-employed or do some freelance work and it’s been a while since you reviewed the options, you might find a better fit for your needs.
Although sometimes it may not feel like it, when you’re self-employed, whether full or part-time, you have a small business. As such there are a number of retirement plans at your disposal. The IRS and SBA have a nice overview.
At first glance, the number of options available may seem a little overwhelming. However, for solo entrepreneurs and those who do some work on the side, the best choice usually comes down to a few plans. Let’s narrow them down based on your situation and goals.
There are quite a few options available but 2 usually make the most sense. If you are just starting your business or otherwise don’t have much to set aside for retirement, the simplest thing to do is to just open an IRA.
For 2020, you can contribute up to $6,000, $7,000 if you’re over 50. And if you’re married, you can effectively double these contributions with a spousal IRA. You can use either a Traditional or, depending on your household income and other retirement accounts, a Roth. Which is best for you is a separate discussion in itself.
In the past, if you wanted to put away more than that in a retirement account, the next logical choice was either a SIMPLE IRA or a SEP-IRA. Part of their popularity was (and is) that they are easy to set-up and can allow you to put more into tax-deferred savings than a Traditional IRA.
The SIMPLE IRA allows you to contribute up to $13,500 per year ($16,500 if over 50) as an employee. Additionally, as the employer, you then make a matching contribution of 3% of your net income. There is no Roth option.
The SEP-IRA allows you to make a contribution of up to 20% or 25% of your income for the year, depending on how your business is structured (Sole proprietorship or S-Corp). The maximum contribution amount is $57,000 for 2020. Like with the SIMPLE, there isn’t a Roth option.
Better than the SEP or SIMPLE
In my opinion, an individual 401(k) plan is a better solution than either the SIMPLE or the SEP for solo entrepreneurs. Although they take a little more paperwork to set-up and operate, they provide more flexibility and potentially have a much higher savings potential.
While 401(k) plans have now been around for more than 40 years, I still don’t see them used as much as they should by small businesses and especially the self-employed. In the early years they were expensive to set-up and maintain so only the largest companies had them. However, costs have come down substantially, allowing them to become available to any size business.
If set-up correctly, the beauty of the individual 401(k) is that you are able to make contributions as an employee and employer. As the employee, you may contribute up to 100% of your net income subject to the maximum annual deferral amount ($19,500 per year in 2020, $26,000 if over 50).
Then, if you’d like to save more than that, you can make additional annual contributions up to the total IRS allowed contribution amount. For 2020 it’s a total of $57,000, 63,000 if over 50. Depending on how you’ve set-up your plan, the contributions can be all traditional, a combination of traditional and Roth, or even all Roth.
And if your business is very successful, the 401(k) makes it fairly easy to add on a cash balance pension plan. Depending on your age and income, this could allow you to defer a total of $200,000 per year or more. For those in the 35% or 37% marginal tax bracket, a combination of a 401(k) plan and cash balance pension plan could save you $70,000 or more in taxes each year.
One last thing. Although it’s called an individual 401(k), your spouse can also be part of the plan as long as they are working in the business and receiving income.
Employed with income from a side business
I’m running across more people who work full-time and have a side business as well. For example, I work with a number of clients who are currently employed by Virginia Tech and Radford, or are former faculty or staff. Some generate additional income, usually from consulting or receiving royalties from a textbook they’ve written. Although what follows is written with them in mind, the same concepts apply to corporate employees with a side gig as well.
The most common retirement savings plan I see associated with outside business activities is a SEP-IRA. As long as they are also maxing out their contributions to the university’s retirement plan, that’s a sound strategy.
The SEP-IRA allows them to put away up to 20% of their outside income, subject to the annual limit ($57,000 in 2020). This is in addition to whatever contributions they are making to their employer retirement plans (i.e. 403(b), 457, 401(k) or 401(a)).
Alternatively, an individual 401(k) plan with a profit sharing option could be used. However, they wouldn’t be able to save any more on a pre-tax basis than with the university 403(b) and SEP combo. The IRS limits the total deferrals by an employee regardless of how many employer plans they have available to them. In 2020, this is $19,500 ($26,000 if over 50), which by design is the maximum that may be contributed to a single plan.
So, if they’ve already maxed out their employee deferral with the university plan, they would not be able to make an employee contribution to an individual 401(k). However, if set-up appropriately, they could still make an employer profit sharing contribution to an individual 401(k) equal to 20% of their outside income. In effect, it would offer the same benefit as the SEP.
Things change after retirement
Once they leave their job, if they continue to have consulting or other freelance income, a SEP may no longer be the best option. Unfortunately, what I have found is that many continue using their SEP instead of switching to an individual 401(k).
Since they no longer have access to their employer’s plan, they’ve lost the ability to make tax-deferred contributions as an employee. However, an individual 401(k) allows the same employee contributions as their previous plan. And, as with a SEP, they can also make an employer contribution of up to 20% of their profits.
Let’s look at an example. Professor Plum, age 60, is getting ready to retire from Virginia Tech. In addition to his salary, for the past several years, he’s been earning an additional $50,000 a year by doing some part-time consulting work. He maxes out his 403(b) contribution each year. For 2020 it was $26,000 ($19,500 plus the $6,500 catch-up for being over 50).
When he began consulting, his CPA recommended he set-up a SEP-IRA. This allowed him to save an additional $9,294 per year pre-tax (20% of $50,000 less $3,533 self-employment tax). That, added to his 403(b) contribution, totaled $35,294 in tax-deferred savings this year. Since he was in the 32% tax bracket, that knocked off over $11,000 from his tax bill.
Now that he’s retiring, he plans to continue consulting. Between his wife’s salary and his pension, he doesn’t need to draw on his consulting income and would like to save as much as possible pre-tax.
However, since he no longer has access to VT’s 403(b) plan, the only amount he can save would be his SEP-IRA contribution of $9,294. His tax savings from retirement plan contributions (SEP only) now total about $3,000.
If he stops contributing to his SEP and opens an individual 401(k), he would be able to defer the same $35,294 as before. The 401(k) has the same contribution limits as his old 403(b) plan, allowing him to contribute $26,000 as an employee. And since he controls the 401(k) plan set-up, he can add a 20% employer profit-sharing contribution, the same as the SEP. With the change of plans, he’d be back to saving as much in his retirement accounts, and on his taxes, as he was before.