Self-employed individuals often put retirement planning on the back burner when first starting out, sometimes due to the financial uncertainty of starting a business and sometimes because they are unsure where to invest without access to employer-sponsored plans. This is understandable because starting a new business takes so much energy. Even if you do not yet have the cash flow to fully fund your retirement goals or are short on the time needed to research how to invest in yourself, though, you need to think about retirement planning.
Fortunately, there are many retirement plans available to self-employed individuals beyond funding the typical individual retirement account (IRA) that is available to anyone with earned income (or a spouse with earned income, if filing a joint return). Read on for a brief overview of the most popular options to see what is right for your situation.
Simplified Employee Pension (SEP IRA)
The SEP is the easiest plan to set up and maintain. You simply contribute a percentage of your net earnings from self-employment to the plan—up to 25%, subject to a $66,000 maximum for 2023 ($69,000 for 2024). SEP contributions are a deductible expense. Because SEP contributions are pre-tax money, your SEP IRA is functionally equivalent to a traditional IRA with different contribution limits.
If you are a sole proprietor for tax purposes (including the default treatment of a single-member LLC), meaning you report your income and expenses on Schedule C of your personal tax return, this means 20% of your bottom-line profits for the year. For example, if you have $100 in profits after all expenses, you may contribute a maximum of $20 towards your SEP. You then have $80 in profits remaining after factoring in the $20 SEP deduction, so your contributions end up being 25% (i.e., $20 ÷ $80) of your net profits. On the other hand, if you have a net loss for the year, your profits are $0, and your allowable SEP contribution for the year is also $0.
If you are a partner in partnership for tax purposes, only your distributive share of net earnings that is subject to self-employment tax counts as “net earnings from self-employment” for purposes of the 25% limit. Your share of capital gains, for instance, do not qualify.
If you own all or part of an entity taxed as an s-corporation, your SEP contribution limit is 25% of your wage income subject to Social Security and Medicare taxes (i.e., boxes 3 and 5 of your W-2). Your distributive share of net profits from the s-corporation do not impact your SEP contribution limit because they are not subject to self-employment tax.
You can contribute throughout the year, wait until the year is over when you can determine the exact amount of your maximum contribution, or both. The deadline to establish and contribute to a SEP is the due date, including extensions, of your business tax return. My recommended approach is to fund your SEP throughout the year to take advantage of dollar-cost averaging when investing, and then “top it off” to the maximum amount once you calculate the final numbers.
If you are on extension, the window closes when you actually file the return or the extension deadline, whichever comes first. However, you still have until the regular filing deadline to make your SEP contributions even if you file before then.
How do you set up a SEP? Simply call your brokerage of choice—Vanguard, Fidelity, and Schwab are your best bets—tell them you want to set up a SEP, and they will walk you through the process.
Savings Incentive Match Plan for Employees (SIMPLE IRA)
The SIMPLE IRA is another popular small business retirement plan, and has the additional advantage of being available to employees as well as owners.
With a SIMPLE IRA, owners can contribute all their net earnings from self-employment, and employees can contribute their full salary amount, to the plan, up to a maximum of $15,500 for 2023 ($16,000 for 2024), plus an additional $3,500 in catch-up contributions (for either 2023 or 2024) if the participant will be at least 50 years old by the end of the year.
Additionally, the employer must make either a 2% fixed contribution to the SIMPLE accounts of all eligible participants (even if the participants contribute none of their own earnings) or a matching contribution of the first 3% of each participant contribution.
As an employer, you can switch between making fixed or matching contributions each year, but you must treat all eligible participants the same within a given year.
Participant contributions are funded with pre-tax money, similar to traditional 401(k) or traditional IRA contributions. They reduce the amount subject to income tax, but not Social Security or Medicare (i.e., payroll and self-employment) tax.
Employer contributions, whether under a fixed or matching approach, are deductible business expenses and pre-tax (traditional) to the employee.
Under SECURE 2.0, employers may now also offer a Roth SIMPLE IRA that is funded with after-tax contributions.
401(k)
A 401(k) plan is not restricted to large employers. Even a company with only one employee—you!—can sponsor a 401(k) plan.
A “solo 401(k)” or “individual 401(k)” is a 401(k) plan covering only the business owner and their spouse.
Participants in 401(k) plans can make elective deferrals up to 100% of their compensation. Elective deferrals are limited to $22,500 for 2023 ($23,000 for 2024), plus an additional $7,500 in catch-up contributions (for either 2023 or 2024) if the participant will be at least 50 years old at the end of the year.
For individuals receiving a W-2, including owners of entities taxed as an s-corporation, compensation means wages subject to Social Security and Medicare tax.
For partners in a partnership, compensation means earnings subject to self-employment tax.
For sole proprietors, compensation is “earned income,” which is net earnings from self-employment after deducting one-half of self-employment tax.
Elective deferrals can be designated as traditional (pre-tax), Roth (post-tax), or some combination of the two.
Employers can also make non-elective contributions of up to 25% of net earnings from self-employment, for a total of $66,000 for 2023 ($69,000 for 2024), not including any catch-up contributions by participants at least 50 years old.
Other Options
If that is not enough, there are options beyond the SEP, SIMPLE, and 401(k) plans! Other defined contribution plans include a profit-sharing plan or money purchase plan. Additionally, employers can still offer a defined benefit plan (i.e., a traditional pension), although these are becoming increasingly rare.
Any pitfalls I should watch out for?
The elective deferral limit that applies to SIMPLE and 401(k) plans is a per-person, per-year global limit, not a per-plan limit. You can have both plans, or plans with multiple employers, but $22,500 is the maximum amount you can personally contribute among all those plans combined for 2023 ($23,000 for 2024).
The annual deferral limit does not include the additional $7,500 in catch-up contributions (for either 2023 or 2024) if you will be at least 50 years old by the end of the year.
Also, once you transfer money into your small-business retirement plan, be sure to actually invest those funds rather than letting them sit in cash equivalents.
Which is the best plan for my situation?
The best plan for your small business depends on your timeline, goals, and bandwidth for managing the plan. (Reach out to me for help deciding which plan is right for you!) For instance, if you want to set up a plan but the year has already ended, a SEP is your only option. You can also offer more than one plan, or switch from one plan to another in a different year. You are never permanently locked in. Call up your brokerage of choice and set up a plan!
This chart from Fidelity provides a quick side-by-side comparison. (Scroll down a bit and click on the “compare plans” link to see the chart.)
All else being equal, I favor the 401(k). It is slightly more complicated than either the SEP or SIMPLE options, but it offers all the advantages and has the highest contribution limits, and most of that extra complication is on the front end when setting up the account. Additionally, having a 401(k) allows you to sidestep the pro-rata rule when considering a backdoor Roth. (Balances in SIMPLE, SEP, and traditional IRAs count against you for the pro-rata rule, but not 401(k) accounts, even if the 401(k) includes pre-tax money.) Finally, you can design your 401(k) plan to include any parameters you wish, such as allowing for plan loans and hardship distributions.
Whatever your choice, offering a small-business retirement plan will help you retain employees and move you closer towards your personal long-term goals.
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