‘To find yourself, think for yourself’ – Socrates
‘Freedom cannot be bestowed, it must be achieved’ – Elbert Hubbard
By Peter Fisher
Peter Fisher is the founder of Cortus Advisors, a strategic management consultancy that partners with organizations to identify, develop, and pursue new sources of growth in revenue, profitability, and entity value; he also serves on the Wharton Pension Research Council Advisory Board.
Self Employment in the US is Widespread
More Americans are becoming self-employed as a result of growing entrepreneurial interests, a desire to enhance income, phased retirement, and tax advantages. This can be seen in the rise of the “gig” and “sharing” economy, including pervasive peer-to-peer spot service markets and platform-based sharing services (e.g., ride hailing, short-term rentals of private residences). The total number of workers who are in the “gig economy” varies depending on the definition and time period (e.g., primary vs. supplemental work, currently involved vs. the past month, permanent vs. temporary plans, whether ever involved, in growth or recessionary economy). However, the total number of self-employed Americans is significant, ranging from 10 million to 41 million depending on definitions, sources, and time periods used.
Retirement Security is Crucially Important for the Self-Employed
In the gig economy, it is key to continue uninterrupted and prudent retirement savings and investing patterns. Many individuals making this employment transition are in later stages of their working lives: for instance, one study found that 35 percent of those self-employed were age 53 in 2017. This is a time when interrupting retirement contributions can be particularly costly, and when many people assumed they would be saving aggressively for retirement as their adult children finally achieve financial independence.
Fortunately, there are many retirement savings options for the self-employed, including methods to insure tax efficiency at both the personal and business levels, while keeping administrative expenses and overhead to a minimum. Choosing the right option depends on your specific circumstances and objectives.
Retirement Savings Options for the Self Employed
Below are several of the most popular options beginning with the simplest and proceeding to the more complex.
- Traditional or Roth IRA: These common savings vehicles are available to small business owners as well as individuals, with annual contribution limits of $6,000 and an additional $1,000 if for those age 50+. Traditional IRA contributions can be tax-deferred for the individual, while Roth IRAs are funded out of after-tax income. These are the simplest options for the self-employed but they also have the lowest contribution limits.
- Solo 401(k): If your small businesses is a limited liability company, and you have no employees (other than your spouse), a solo 401(k) is a simple and inexpensive vehicle for maximizing retirement savings. Annual contribution limits are $19,000 with an additional $6,000 possible for those age 50+. In addition, the business owner as the employer may contribute as a match up to an additional 25% of compensation (subject to some IRS limits) for a total maximum of $56,000 in 2019. The employer contribution is also tax deductible to the business. In some cases, the owner’s spouse can contribute as well, potentially doubling the couple’s total annual contribution. For this reason, the solo 401(k) is a very rich source of retirement saving capacity and tax efficiency for small business owners with no employees or those who employ only their spouse. Finally, solo 401(k)s can be set up either as traditional pre-tax or as Roth post-tax accounts, offering tax diversification as well.
- SEP IRA (Simplified Employee Pension): This can be a good option for business owners having no, or only a few, employees. Annual contributions must be set at the same percentage of compensation for all employees, including the business owner, and they are made only by the employer. Contribution limits are up to $56,000 annually with some limitations tied to compensation levels. Employer contributions can be treated as a business expense. There is no Roth option.
- SIMPLE IRA (Saving Incentive Match Plan for Employees): This option is usually used by larger businesses with up to 100 employees. An employer would establish accounts for employees who then make contributions that can be matched by employers. Contribution limits in 2019 are $13,000 with an additional $3,000 for an employee age 50+. Employer contributions are deductible as a business expense and employers are generally obligated to make some types of contributions each year, limiting flexibility.
- Defined Benefit Pension: This option tends to be more complex and generally seen as more suitable for a higher-income business owner with no employees, and who would like to save aggressively for retirement. Contribution limits are determined by an actuary who must account for the business owner’s age, expected return on investment, and expected annual benefit in retirement (maximum annual retirement benefits are currently set at $225,000). Contributions are tax deductible and benefits are taxed as income when received. Establishing these accounts can be expensive with higher annual administrative costs. The primary attraction of such a plan is the ability to save aggressively at $60,000 or more each year.
Other Things to Consider when Selecting a Self-employment Retirement Vehicle
- When to retire: How long do I intend to continue working?
- Saving: How much should I and can I afford to save for retirement, each year?
- Flexibility: How much flexibility would I like to have from year to year in how much I save?
- Employees: Do I have any employees in my business other than my spouse? If so, how do I provide for them?
- Administration: How much will the retirement plan cost in annual account administration and expenses each year?
- Business expense: How valuable is it to deduct some contributions as a business expense?
The Outlook
Being self-employed and owning one’s own business is very attractive for a growing share of the US labor force. There are also many attractive choices that the self-employed can use to establish and maintain the continuity of good retirement saving behaviors, as we have shown above. Such retirement vehicles allow for generous savings levels, offer significant tax benefits both at the individual and business level, and, in many cases, require relatively small administrative costs. These retirement savings vehicles should be a crucial component of running your own small business, while securing your future retirement income.
Additional Resources:
Retirement Plans for Self-Employed People, Internal Revenue Service website.
“Why Self Employment Keeps Accelerating,” Forbes website, June 13 2017.
“The State of Independence in America,” MBO Partners, 2017.
“Was the Gig Economy Overblown?”, Wall Street Journal, June 7 2018.
Legal Disclaimer: This article not meant to convey tax advice. Please consult IRS materials and your tax professional for definitive information about the tax treatment and parameters of your retirement account options.
Views of the Pension Research Council’s Guest Bloggers are theirs alone, and not of the Pension Research Council, the Wharton School, or the University of Pennsylvania.