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How to Plan for Retirement When You're Self-Employed

Here's a self-starter kit that will help you re-energize your retirement savings

Retirement often feels worlds away. But if you’re self-employed, you’re the only one responsible for yourself. With the number of self-employed people up 14% from 2001 to 2012, this issue is very of-the-moment.

We spoke to Crystal Stemberger of the personal finance blog Budgeting in the Fun Stuff and David Weliver of MoneyUnder30.com (who turned his own finances around and blogs about it) to see how real freelancers handle saving for retirement.

Stemberger and her husband are self-employed. Back when they had day jobs, she was contributing 12 percent of her income to a 401(k) plan and her husband was socking money into his retirement savings. They were both maxing out their Roth IRAs every year, too. Now that they can’t contribute to their company plans anymore, their next step is to open SEP (Simplified Employee Pension) IRAs, which will let them squirrel away even more. (We’ll show you how in a minute.)

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Should you follow in Stemberger’s footsteps, or would another plan make more sense? And what is a SEP IRA, anyway? Generally speaking, there are three main account options for retirement when you’re a freelancer, and we’ll walk you through each one to help you figure out which is right for you.

Roth or Traditional IRA

If you’re self-employed, an individual retirement account is one of your most flexible options. With a traditional IRA, your contributions are generally tax-deductible (so if you make $50,000 in income and contribute $5,000 to your IRA, you’ll only be taxed on $45,000 of your income this year).

With a Roth IRA, you don’t get a tax break in the current year, but your money grows tax-deferred, and assuming you leave it alone for at least 5 years and until you reach age 59 ½, it can be withdrawn tax-free. So, you’d be taxed on your full income now, but when your contribution grows massively, you won’t be taxed on the earnings at retirement. Since tax rates may be higher in the future, that’s an extra sweet deal.

There are income limits to know about: As of 2013, the amount you can contribute to a Roth starts phasing out when you hit $112,000 in income as a single person. For married couples, there are also income limits that restrict the deductibility of traditional IRA contributions when either spouse is covered by a qualified retirement plan. There are also contribution limits for IRAs in general. In 2013, the max you can contribute to any kind of IRA is $5,500, or $6,500 if you’re 50 or older.

Note that IRAs are available to anyone who brings in income, not just self-employed people, so the contribution limits are relatively low. If you want to save more than just $5,500, keep reading to learn more about retirement accounts created specifically for self-employed people. Working for yourself means forgoing any potential company matching on your retirement plan, so the government gives self-employed people the opportunity to play the role of both employee and employer.

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Consider an IRA if: You’re just getting started saving for retirement and want to do something easy. An IRA is also good for “unintentional” freelancers who hope to score a traditional gig again soon.

SEP IRA

SEP IRAs let self-employed people save a lot more than they could with a traditional or Roth IRA. In 2013, you can save up to 25% of your income or $51,000 (whichever is less). If you and a spouse are both self-employed, you can each save up to $51,000 separately. That is more than nine times the maximum for a regular IRA!

SEP IRAs can cover employees, too, if you end up hiring other people. (Though a SIMPLE IRA was created with small employers in mind, so check that out if you know that’s your goal.) You’ll be required to contribute the same percentage of your employee’s pay to their SEP IRA as your own, which can get expensive.

This option can also give you more wiggle room if you want to set up an account and make a retirement contribution for the year prior, even after the new year. That’s why David Weliver of MoneyUnder30 chose this route.

“I needed to open the account and make contributions for the prior tax year, which you can do until April 15th with a SEP. Although you can make prior year contributions to a solo 401(k) up until April 15th, the account must be established on or before December 31st (of the year before).” He also thought he might hire employees down the road, so the SEP would be a more fitting choice. Note that if you file an extension to your taxes, the I.R.S. actually gives you until the extension deadline to make your contribution.

Consider a SEP IRA if: You want to save more than $5,500 per year, which is a good idea if your budget can handle it. In particular, financial experts recommend having enough saved for retirement to cover at least 60 percent of your pre-retirement income.

For most people, that means saving over a million dollars. Unless you start maxing out your regular IRA at a very young age, you’ll probably find it difficult to save that much if you don’t contribute more than $5,500 each year. Additionally, a SEP IRA is a good choice if you might hire employees later but aren’t totally sure, since contributions are discretionary from year to year.

Solo 401(k)

Also known as individual 401(k)s, these let self-employed people get around some SEP IRA rules. With a SEP, you can choose to contribute a flat dollar amount, but if you make a relatively small self-employment income, the I.R.S. limits your contribution to 25 percent of that income. With a solo 401(k), you can contribute up to the annual $17,500 limit, just like a regular 401(k).

In 2013, the contribution max for a solo 401(k) is $51,000 ($56,500 if age 50 or over). That’s the same total as the SEP IRA, but the 401(k) gives you more flexibility in how you can achieve that maximum. You can only hit the max by adding the two parts of your contribution: a “salary deferral contribution,” or set dollar amount, and a percentage of profits. Both contribution types are flexible and you can change them at any time.

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In a solo 401(k), the individual plays the roles of both employee and employer. Here’s how it works:

  • As the employee: You can elect to defer up to 100 percent of your earned income up to the annual contribution limit ($17,500 for 2013).
  • As the employer: You can contribute up to 25 percent of compensation as defined by the 401(k) plan.

The total contribution — without counting catch-up contributions — cannot exceed $51,000 for 2013.

Weliver told us that he would rather have chosen a solo 401(k) for himself, except that he envisioned hiring employees in the future, which gave the SEP IRA a leg up. The I.R.S. will allow you to include your spouse in a solo 401(k), but not other employees. The reason he would have preferred a solo 401(k) is that it’s possible to open a Roth solo 401(k) but not a Roth SEP IRA. He noted that when he was doing his research, he found that some brokerages charge extra for this type of account, so he recommended looking carefully at the fee schedule before committing to anything.

If you’re self-employed and could use expert advice, consider talking to a financial advisor.

Consider a solo 401(k) if: You want to make larger contributions than with a regular IRA, and want more flexibility than in a SEP IRA. Also, a solo 401(k) is a good option if you’d like to have a Roth account with a greater contribution limit than a Roth IRA.

A Parting Word of Caution

No matter which plan you choose, remember that, while it’s crucial to save for retirement, it’s even more important to make sure you have a stable foundation now since freelancers lead a more unstable lifestyle without a guaranteed income. Before throwing everything against retirement, make sure you save up a plump emergency fund, which is extra important for freelancers.

Before saving yet more in their SEP IRA, Stemberger and her husband wanted to make sure they were financially secure. “Our emergency funds are healthy enough to cover us for at least a few months even if absolutely all income stops,” she says.

Tags: retirement
   
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