Raleigh NC Financial Advisor: Self-employed Retirement Options
Being self-employed gives you a certain measure of freedom. But it doesn’t give you an excuse to skip out on saving for retirement. In fact, it makes putting money away for retirement that much more crucial. And you might think you'll eventually sell the business and use that money to fund retirement, but what if you don't?
Consider a retirement account a cushion and a tax-advantaged way to reduce income in your high-earning years.
Solo 401(k)
The Solo 401(k) operates similarly to a traditional 401(k) plan, but with some unique features. A Solo 401(k) is a retirement plan for self-employed individuals. This includes sole proprietors, partnerships, and small business owners. They must have no employees other than themselves and their spouse.
With a Solo 401(k), the business owner can contribute both as the employer and the employee. As an employee, the owner can contribute up to $22,500 of their compensation. If they are age 50 or over, they can also make an additional catch-up contribution of $7,500. As the employer, they can make a profit-sharing contribution of up to 25% of their compensation or up to a total combined contribution limit of $66,000, whichever is lower.
Solo 401(k) plans offer several benefits to self-employed individuals, but there are also some potential drawbacks to consider. Here are some of the main pros and cons:
Pros of Solo 401(k)
High contribution limits: As both the employer and employee, the self-employed individual can make contributions up to $66,000 or 100% of their self-employment income, whichever is less.
Tax advantages: Contributions made to a Solo 401(k) are tax-deductible, which can reduce taxable income.
Investment options: Solo 401(k)s offer a wide range of investment options, including stocks, bonds, mutual funds, and more.
Catch-up contributions: Those age 50 or over can make additional catch-up contributions of up to $7,500.
Loan option: A Solo 401(k) also offers the option for the individual to borrow from their account if needed.
Cons of Solo 401(k)
Administration and costs: A Solo 401(k) comes with administrative responsibilities and costs that the self-employed individual will need to manage, including setting up the plan, filing annual paperwork, and potentially hiring a plan administrator.
Limited to self-employment income: Solo 401(k)s are designed for self-employed individuals or small business owners with no employees (other than the owner and their spouse).
Plan termination: If the business grows and hires employees, the Solo 401(k) may need to be terminated or converted to a different type of retirement plan to comply with IRS regulations.
Limited investment options: While Solo 401(k)s offer a wide range of investment options, the investment choices are still limited to those selected by the plan sponsor.
Tax implications of withdrawals: While contributions to a Solo 401(k) are tax-deductible, withdrawals in retirement are subject to income tax.
Defined Benefit Plan
A defined benefit plan is an employer-sponsored retirement plan. It promises to pay employees a predetermined benefit amount at retirement. The formula used to calculate this amount takes into account factors like salary and years of service.
In a defined benefit plan, the employer is responsible for making contributions to the plan and ensuring that there are sufficient funds to pay the promised benefits at retirement. The employer invests the plan's assets in a diversified portfolio. This portfolio includes stocks, bonds, and other assets. The purpose of this is to generate returns and make sure there are enough funds to pay promised benefits.
Defined benefit plans have both advantages and disadvantages for both employers and employees. Here are some of the main pros and cons:
Pros for Employees
Guaranteed income stream: Defined benefit plans offer employees a predictable income stream at retirement.
Professional management: The employer is responsible for managing the investment risk and ensuring that there are sufficient funds to pay the promised benefits.
Generous contribution limits: Defined benefit plans have higher contribution limits than other retirement plans.
Cons for Employees
Limited control: Defined benefit plans offer limited control over the investment of plan assets.
Inflexibility: Unlike defined contribution plans, such as 401(k) plans, employees cannot withdraw funds from the plan before retirement, without significant penalties.
Vesting: Defined benefit plans typically have a vesting schedule, which means that employees may not be fully vested in their retirement benefits until they have worked for the employer for a certain number of years.
Pros for Employers
Recruitment and retention: Offering a generous defined benefit plan can be a valuable tool for attracting and retaining talented employees.
Tax benefits: Employers can take tax deductions for their contributions to the plan.
Investment responsibility: The employer is responsible for managing the investment risk and ensuring that there are sufficient funds to pay the promised benefits.
Cons for Employers
Cost: Defined benefit plans can be more expensive to administer than other types of retirement plans.
Complexity: Defined benefit plans can be complex to administer and require specialized expertise.
Liability: Employers are responsible for ensuring that there are sufficient funds to pay the promised benefits, which can be a liability if investment returns are lower than expected or if employees live longer than anticipated.
Cash Balance Plan
A cash balance plan is a type of defined benefit retirement plan. The annual contribution limits for a cash balance plan are much higher than those for a 401(k) plan. Each year, the employer contributes a fixed percentage of an employee's compensation to a hypothetical individual account. This contribution is based on a predetermined formula.
The account balance grows each year with an annual credit, typically a fixed percentage of the employee's salary, and an interest credit, which is usually a fixed rate specified in the plan. The benefit at retirement is based on the employee's account balance and the plan must guarantee a minimum rate of return on the account balance, typically around 4% per year.
Cash balance plans have both advantages and disadvantages for both employers and employees. Here are some of the pros and cons.
Pros for Employees:
Predictable benefit: Cash balance plans offer employees a predictable retirement benefit based on a predetermined formula.
Generous contribution limits: Cash balance plans have higher contribution limits than other retirement plans.
Portability: Cash balance plans are generally more portable than traditional defined benefit plans.
Cons for Employees:
Limited investment options: The investment of cash balance plan assets is typically managed by the employer, which can limit investment options.
Lack of flexibility: Cash balance plans are generally less flexible than other types of retirement plans and employees may face penalties if they want to withdraw funds before retirement.
Complexity: Cash balance plans can be complex and difficult for employees to understand.
Pros for Employers:
Recruitment and retention: Offering a generous cash balance plan can be a valuable tool for attracting and retaining talented employees.
Tax benefits: Employers can take tax deductions for their contributions to the plan.
Investment responsibility: The employer is responsible for managing the investment risk and ensuring that there are sufficient funds to pay the promised benefits.
Cons for Employers:
Cost: Cash balance plans can be more expensive to administer than other types of retirement plans.
Complexity: Cash balance plans can be complex to administer and require specialized expertise.
Liability: Employers are responsible for ensuring that there are sufficient funds to pay the promised benefits which can be a liability if investment returns are lower than expected or if employees live longer than anticipated.
SEP IRA
A SEP IRA, or Simplified Employee Pension Individual Retirement Account, is a type of retirement plan for self-employed individuals or small business owners with no employees, other than the owner and their spouse.
With a SEP IRA, the employer makes contributions on behalf of their employees. The employer is not required to make contributions every year and can vary the contribution amounts from year to year based on business profits. These retirement plans are typically easy to set up and administer and they offer a wide range of investment options, including stocks, bonds, mutual funds, and more.
SEP IRA plans offer several benefits to employers, but there are also some potential drawbacks to consider. Here are some of the main pros and cons:
Pros of SEP IRA
High contribution limits: SEP IRAs offer high contribution limits of up to $66,000, which is higher than the contribution limits for many other types of retirement plans.
Contributions made to a SEP IRA are tax-deductible.
Easy to set up and administer: Simple to set up and have minimal administrative requirements, with no annual filing requirements.
Flexible contribution amounts: Employers have the flexibility to vary the contribution amounts from year to year based on business profits.
Investment options: SEP IRAs offer a wide range of investment options, including stocks, bonds, mutual funds, and more.
Cons of SEP IRA
Limited employee contributions: Employees cannot contribute to a SEP IRA on their own behalf, so the entire burden of retirement savings falls on the employer.
Required contributions: While the employer has the flexibility to vary the contribution amounts from year to year, they are required to make contributions for all eligible employees.
Tax implications: While contributions to a SEP IRA are tax-deductible, withdrawals in retirement are subject to income tax.
Limited investment options: While SEP IRAs offer a wide range of investment options, the investment choices are still limited to those selected by the plan sponsor.
Sole proprietorship: A SEP IRA may not be suitable for businesses with employees or those looking to hire employees in the future, as it is designed for self-employed individuals or small business owners with no employees other than the owner and their spouse.
Bottom Line
Saving for retirement when you’re self-employed can often be an uphill battle and statistics show that too many self-employed individuals forgo saving for retirement altogether. But it doesn’t have to be that way. No matter which option you choose, the key is to start saving for retirement as soon as possible. The earlier you start, the more you can save and the greater the potential for growth.
Additionally, it is important to take advantage of the tax incentives and contribution limits associated with each type of retirement plan. With the right plan in place and the help from a financial advisor or financial planner, you can ensure a secure retirement for yourself and your family.
Sources
https://smartasset.com/retirement/best-retirement-plans-for-self-employed
https://www.forbes.com/advisor/retirement/best-self-employed-retirement-plans/
https://www.nerdwallet.com/article/investing/retirement-plans-self-employed
Disclosures:
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This material is provided as a courtesy and for educational purposes only. Please consult your investment professional, legal or tax advisor for specific information pertaining to your situation.
These are the views of the author, not the named Representative or Advisory Services Network, LLC, and should not be construed as investment advice. Neither the named Representative nor Advisory Services Network, LLC gives tax or legal advice. All information is believed to be from reliable sources; however, we make no representation as to its completeness or accuracy. Please consult your Financial Advisor for further information.
