What retirement plan is available to self-employed individuals?

One of the benefits that self-employed individuals enjoy is flexible working hours. However, unlike employees who get an employer-sponsored 401(k) plan, self-employed individuals do not have an outright retirement plan option. Instead, they have several plan options that they can use to save for retirement.

The retirement plans available to self-employed individuals include solo 401(k), SEP IRA, SIMPLE IRA, traditional and Roth IRA, as well as defined benefit options. These options have different contribution limits, and the contributions and withdrawals are treated differently.  

Retirement plan options for self-employed individuals

Traditional or Roth IRA

If you recently started a business, an IRA is the easiest account to set up. The main types of IRAs include traditional IRA and Roth IRA.

A traditional IRA is a tax-deferred retirement plan, and it allows self-employed individuals to contribute pre-tax money to the account. You will only pay taxes on the retirement savings when you withdraw money from the account.

A Roth IRA is funded with post-tax dollars, and you pay taxes upfront on the contributions you make to the account. You can withdraw the contributions tax-free at any time. However, for investment earnings, you will only take tax-free distributions if you make a qualified withdrawal.

The annual contribution limit for IRA contributions in 2022 is $6,000, or $7,000 if you are above age 50.

Solo 401(k)

A solo 401(k) is similar to a 401(k) plan, and it is ideal for a self-employed individual with no other employees. You can choose between a solo traditional 401(k) that you contribute pre-tax dollars or a solo Roth 401(k) that you contribute pre-tax dollars.

You can make employer and employee contributions to a solo 401(k). As an employee, you are limited to the annual contribution limit of $20,500 in 2022, while as an employer, you can contribute up to 25% of the business earnings. The cumulative contributions can go up to $61,000. Older employees above 50 can also make an extra $6,500 catch-up contribution. If your spouse is involved in running the business, he/she can make similar contributions to their solo 401(k) accounts.

You will be required to file paperwork with the IRS for each year the solo 401(k) balance exceeds $250,000.

SEP IRA

A SEP IRA is ideal for businesses with few employees. This type of IRA has higher contributions than a traditional IRA. You can contribute the lesser of 25% of net self-employment income or the annual maximum. The contribution limit for a SEP IRA is $61,000 in 2022, up from $58,000 in 2021.

If the business has several employees, the business owner must contribute an equal percentage to each employee. In this case, the business owner is also considered an employee of the business. If the business owner contributes 15% to his or her SEP IRA, they must make a similar percentage contribution to all employees of the business.

On the downside, a SEP IRA does not have a Roth option, and there are no catch-up contributions for employees above age 50.

SIMPLE IRA

If you own a large business with up to 100 employees, a SIMPLE IRA may be a good option for you. This retirement plan has a bigger contribution limit than traditional IRAs, and the business owner can contribute more to his/her SIMPLE IRA account than to those of employees.

Unlike a SEP IRA that requires the employer to contribute a fixed percentage to employees' retirement accounts, a SIMPLE IRA requires employees to contribute to their accounts via salary deferral. The employer can match contributions up to 3% of employee salary, or make fixed contributions of 2% to all eligible employees’ SIMPLE IRA accounts. The employer contributions become vested immediately.

In 2022, you can contribute a maximum of $14,000 to a SIMPLE IRA, and an extra $3,000 in catch-up contributions if you are 50 or older.

Defined benefit plan

Self-employed individuals also have access to defined benefit plans. These retirement plans promise to pay a specific dollar amount each month or year over your lifetime once you retire.

Defined benefit plans are ideal for individuals with a large income who want to make higher retirement contributions. The contribution limit is determined based on the benefit you will receive in retirement, your current age, and the expected investment earnings.

Contributions to a defined benefits plan are usually deductible, and withdrawals in retirement are considered an income for tax purposes. When establishing this type of plan, you must work with an actuary to calculate the deduction limit.

Where to open a retirement plan if you are self-employed

Once you have decided the type of retirement plan to open, you must figure out where to open the account.

Generally, most online brokerages allow you to open a retirement account as a self-employed individual. The main types of retirement plans you can open at online brokerages include traditional or Roth IRA, Solo 401(k), SEP IRA, and SIMPLE IRA.

When opening a retirement account with a brokerage, you will be required to file paperwork with the IRS to make sure you comply with the tax rules.