Knowledge and Insights
Self-employed (SE) individuals have the opportunity to create a nest egg while potentially reducing their current tax liabilities. An added challenge to being self-employed is understanding the best way to save for retirement on your own. Determining which specific self-employed retirement plan is the right fit for your needs, goals and circumstances is dependent on a few variables.
- How much do want to save for retirement each year?
- How much can you afford to save based on your cash flow needs?
- Do you have employees in your business? How many?
- How much time and money do you want to invest in administering your retirement plan?
Once a self-employed individual has assessed their goals and needs, they can select the best plan to match their circumstances. There are several types of plans that range from simplistic to complex.
- Individual Retirement Accounts (IRAs): An IRA can be opened by anyone who earns income regardless of if self-employed or an employee. A traditional IRA offers a current tax break up to certain income levels. A Roth IRA provides tax-free income in retirement and current contributions are after-tax. Roth contributions are subject to income limitations. IRA contributions are not considered a business expense.
- Contribution Limits: For 2022, $6,000 per year, with an additional $1,000 in catch-up contributions for individuals who are 50 or over. For 2023, $6,500 and $1,000 catch-up. Contributions need to be made by April 15 for the prior tax year.
- Simplified Employee Pension IRA (SEP-IRA): The SEP IRA is a variation of the traditional IRA that offers much higher contribution limits and current tax benefits. It is popular with self-employed individuals without employees.
- Contribution Limits: In 2022, SE individuals may contribute up to 25% of their adjusted net earnings, minus one half of the social security and Medicare taxes they pay up to a maximum of $61,000. For 2023, $66,000. Contributions need to be made by the due date including extensions for the prior year tax return. A 2022 tax year contribution needs to be made by October 15, 2023, if the return has been extended.
- Contributing to a SEP-IRA does not preclude you from making a regular IRA contribution.
- Savings Incentive Match Plan for Employees (SIMPLE IRA): This plan is designed for SE individuals and small business owners with less than 100 employees.
- Contribution Limits: In 2022, SE individuals and their employees can contribute up to $14,000 with an additional $3,000 in catch-up contributions for individuals who are 50 or over. For 2023, $15,500 with $3,500 catch-up. SE individuals may also contribute an employer-sponsored match of either a 2% fixed contribution or 3% matching contribution.
- Solo 401(k): This plan is only available to a SE individual with no employees. The individual has the ability to make contributions as both the “employer” and” employee” resulting in a higher contribution.
- Contribution Limits: In 2022, the employee’s salary deferral portion of the contribution is limited to $20,500 with an additional $6,500 for those 50 and over. For 2023, $22,500 and $7,500 catch-up. As the employer, the SE individual can contribute up to 25% of their net income from self-employment. Total contributions between employee and employer portion cannot exceed $61,000 or $67,500 if 50 and over.
- 401(k): A SE individual with employees can offer this plan to their employees. In addition to the salary deferral benefit, the employer will receive a tax deduction for the employer match to the plan. A 401(k) can offer both traditional and Roth options.
- Contribution Limits: In 2022, the employee contribution limit is $20,500 with an additional $6,500 for those 50 and over. For 2023, $22,500 with a $7,500 catch-up for over 50. If contributing to a traditional 401(k), the deductions are pre-tax. If contributing to a Roth 401(k), the deductions are post-tax.
- Profit Sharing Plan: These plans are funded with employer contributions only. Each eligible employee receives a percentage of earnings. These plans are typically discretionary and the employer can decide to make a contribution on an annual basis. It is common to have a 401(k) with an associated profit sharing plan.
- Defined Benefit Cash Balance Plan: All the previously discussed plans are considered defined contribution plans. The cash balance plan is a defined benefit plan similar to the former pension plans companies had in place. The cash balance plan was created to modernize the defined benefit plan and provides the ability to dedicate dollars in excess of the 401(k) limits to retirement savings. The annual contribution is determined by an actuarial calculation.
The link below provides a table comparing the various plans produced by the Department of Labor: https://webapps.dol.gov/elaws/ebsa/plans/final.asp
Each type of plan has its own benefits and detriments. The more complex plans require a team of advisors—plan administrator, recordkeeper and an investment advisor as well as tax and DOL compliance. Self-employed individuals looking to put a plan in place for 2023 should start the process in the first quarter of 2023 to allow ample time to evaluate needs, select a plan and align with the necessary advisors. If you are considering a plan, would like to review your options, or have any questions, please reach out to your Mercadien tax advisor and we can review your needs and partner with benefit plan advisors.