When I started my career after college, retirement was the last thing on my mind. I was 22, and it hardly seemed important. Luckily my employer (the state government) required that I contribute to my retirement account — otherwise, I probably wouldn’t have!
As I learned more about finance, I began to see the importance of saving and investing early.
By my late twenties, I was contemplating quitting my job to run my own business. One of the biggest things holding me back was the fear of being on my own to save for retirement.
I spent months researching, learning everything I could about the best way to save for retirement when I was self-employed. And today, I feel confident that I’ll be able to retire comfortably — and probably earlier than if I had stayed at my government job.
In this article, I’m sharing that knowledge with you and talking about how to save for retirement when you’re self-employed.
Saving for retirement when you’re self-employed
The unfortunate truth is that most people aren’t saving enough for retirement. Data from the Federal Reserve shows that only about 36% of Americans think they’re on track with retirement savings.
The numbers get even bleaker when you look at self-employed individuals. Data from Pew shows that only about 13% of solopreneurs contribute to a retirement plan. For some workers, it’s that they simply know what options are available to them. And then there’s the fact that when you’re self-employed, you don’t have an employer to contribute to your account as people with more traditional jobs often do.
With this article, I’m hoping to help people understand what options are available to them so they can finally start preparing for retirement.
Saving vs. investing for retirement
Before I dive into the retirement plans for self-employed individuals, I first want to make a quick clarification.
When we talk about retirement, we typically use the phrase “save for retirement.” In reality, you should actually be investing for retirement.
When you invest, your money grows. And each year, your earnings compound — that means that your earnings also begin to earn money. Over time, you have more and more money earning money, meaning it grows faster and faster.
Let’s look at a quick example. Imagine you saved $200 per month from ages 25 to 65. Instead of investing the money, you put it into a bank account where it doesn’t earn anything. By the time you’re 65, you’d have $96,000.
But what if you put that same $200 into the stock market? Using the Securities and Exchange Commission’s estimate for average annual stock market returns, you would reach age 65 with more than $1 million.
Retirement plans for self-employed people
SEP IRA
A Simplified Employee Pension (SEP) IRA is a type of retirement account specifically designed for self-employed individuals. SEP IRA contributions are tax-deferred, which means your contributions are tax-deductible, and then you pay income on the money you withdraw during retirement.
Using a SEP IRA, entrepreneurs can contribute up to 25% of their annual income each year, with a maximum contribution of $61,000 per year as of 2022.
A SEP IRA is perfect for solopreneurs, but there are special rules for people with full-time employees. If you have a full-time employee, you must contribute to their account at the same percentage you contribute to your own.
A SEP IRA is what I personally use for my business!
SIMPLE IRA
A Savings Incentive Match Plan for Employees (SIMPLE) IRA is another type of retirement account designed for small businesses. With this type of account, you can contribute up to $14,000 per year as of 2022. Like the SEP IRA, your contributions are tax-deductible. If you have employees, you must also contribute a small percentage to each of their accounts.
SOLO 401(k)
A Solo 401(k), also known as an Individual 401(k), is another way that entrepreneurs can save for retirement. Like the SEP IRA, participants can contribute up to $61,000 per year as of 2022. Contributions are also tax-deductible.
The big difference distinction with the Solo 401(k) that separates it from the SEP IRA is that you can contribute as both the business and an individual. First, as an employee in your business, you can contribute up to $20,500 up to 100% of your income. Then your business can also contribute up to 25% of your income, with a maximum combined contribution of $61,000.
TRADITIONAL OR ROTH IRA
The three plans I described above are specifically designed for self-employed individuals. They’re the best option if you work for yourself because they have high contribution limits — especially for the SEP IRA and Solo 401(k).
But another option is to set up a traditional or Roth IRA. These accounts are available to anyone, not just self-employed people. They also have significantly lower contribution limits at just $6,000 per year.
The one benefit to using this type of account (perhaps alongside one of the options above) is that you can contribute to a Roth IRA. With a Roth IRA, you contribute with post-tax dollars, meaning there’s no tax deduction. But then the money grows tax-free, and you don’t pay taxes on it during retirement. The other self-employed IRAs don’t have a Roth option.
If you choose to open a Roth IRA, I would open it in addition to another self-employed retirement plan.
Where to open your self-employed retirement plan
Not only are there plenty of different types of self-employed retirement plans, but you also have plenty of options for where to open your plan.
This might be confusing, so let me explain it in a simpler way. Think of your brokerage firm (meaning where you open your account) as a piece of land. The specific type of retirement plan you choose (SEP IRA, Solo 401(k), etc.) is the house you put on the land. And the individual investments you invest your money into is the furniture you fill the house with.
When choosing a brokerage firm, you have two primary options. If you want to be a hands-on investor, you can choose a traditional brokerage firm like Vanguard, Schwab, or Fidelity. You choose what to invest in, and typically pay very low fees.
A popular option for retirement savings is a target-date fund, which is a type of mutual fund that corresponds with your retirement year. For example, if you planned to retire in 2050, you would find a target-date fund associated with the year 2050.
Target-date funds have a fund manager who changes the asset allocation as time passes to ensure it’s appropriate for the time horizon. As 2050 nears, the fund manager will decrease the number of high-risk investments in the fund and increase the number of low-risk investments.
If you prefer a more hands-off approach, you can use a robo-advisor. Your robo-advisor will ask a few questions about your age, investment goals, and more and then choose your investments on your behalf. The fees are a bit higher, but it takes way less time and research on your part. My favorite robo-advisor is Betterment.
How much to save for retirement when you’re self-employed
One of the most challenging parts of saving for retirement is figuring out how much you need to save. After all, you have no idea how much money you’ll need or how much you’ll money will grow in the stock market.
Luckily, there’s a took to make it easier for you.
Personal Capital has a retirement calculator that can help you estimate how much you should save each month to retire comfortably. It uses information such as your age, current savings, desired retirement age, and spending habits to predict how much you’ll need. And using average stock market returns, it will give you an estimate of how much you should save monthly to get there.
What I love about the calculator is that you can adjust different factors to see how that changes things. You can increase your decrease your desired retirement age or the amount you want to spend each year while retired to see how that influences the amount you need to save.
Retirement saving tips for self-employed people
DON’T WAIT UNTIL YOU’RE DEBT-FREE
Before I dive into the steps to take to start saving for retirement, I first want to address the question of whether you should start investing while you still have debt.
Some personal finance leaders (okay, one personal finance leader) say that you should wait until you’re debt-free to start investing for retirement. This couldn’t be further from the truth.
Remember above where we talked about compound interest and how it helps to take the amount you invest and grow it into way more?
Well, compounding only happens when your money is in the market for many years. And unfortunately, many people are paying off debt well into their 30s, 30s, 50s, and even later.
If you want until your debt is gone to start saving, your money doesn’t have time to grow.
As a general rule, compare the interest rate on your debt to the average return of the stock market (10%, according to the Securities and Exchange Commission). If your debt interest rate is higher than that, pay it off first. If it’s lower, you can invest at the same time because your investments will be growing faster than your debt.
SET UP AUTOMATIC MONTHLY CONTRIBUTIONS
It’s easy to tell yourself that you’ll set aside money each month for retirement. But more often than not, something comes up that stops you from doing so.
The best way to make sure you’re saving consistently is to make it automatic. Decide how much you want to save each month to hit your goal, and then set up an automatic monthly contribution in that amount.
It’ll automatically come out of your bank account each month, so you never have to think about it, and you won’t have a chance to talk yourself out of it.
DEDUCT YOUR CONTRIBUTIONS
Retirement accounts come with tax advantages that you should be aware of. Most retirement accounts have tax-deductible contributions. You can deduct everything put into the account throughout the year, which reduces your taxable income and, therefore, your tax liability.
The one exception to this is if you’re contributing to a Roth account. In that case, you contribute with post-tax income and the tax advantage comes when you withdraw the money during retirement.
Final Thoughts
Retirement savings is something many people don’t really think about when they dream of leaving their jobs to become self-employed.
