Best retirement plans for the self-employed

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A SEP IRA allows the business to make employer contributions to employees, including the self-employed person. The business can contribute the lesser of 25 percent of its profits or the annual maximum. It’s a widely available plan, with many brokers offering access. However, there is no Roth option and all employees must receive the same percentage contribution.

Who it may be best for: Better for the high-earning self-employed, especially those in one-person outfits.

SIMPLE IRA

The SIMPLE IRA is an easy way for small employers, including the self-employed, to offer employees a retirement plan. The SIMPLE IRA can be easier for an employer to set up than many 401(k) plans, which have complex rules. Employers with 100 employees or fewer earning more than $5,000 can set one up.

The SIMPLE IRA uses the rules of a traditional IRA, so it’s tax-deferred and has the same withdrawal requirements at retirement. Employees can have wages deducted from their paychecks and can defer up to $14,000 annually, with those over age 50 allowed a $3,000 catch-up contribution, as of 2022.

Employers must add to the account, and they have a couple choices: (1) They can match contributions up to 3 percent of salary, or (2) They can contribute up to 2 percent of a worker’s salary up to the annual compensation limit of $305,000 in 2022. Employees are fully vested as soon as they receive the money, so any contribution becomes theirs immediately.

Who it may be best for: Better for businesses with at least a few employees and may allow companies to offer a lower total retirement benefit than other plans do.

Other options for the self-employed

Those three defined contribution plans are among the most popular, but the self-employed should also be aware that they can set up a defined benefit plan. A defined benefit plan can allow you to sock away even larger amounts on a tax-deferred basis, but they’re better suited to consistently higher-earning individuals.

“These are worthwhile to consider if your self-employment income is substantial,” says Dan Sudit, a partner at Crewe Advisors in Salt Lake City. “The contribution limit is based on a variety of factors including age, income, and years in business, but the annual benefit limit can exceed $200,000 a year.”

However, defined benefit plans can be more cumbersome to set up and generally cost more to maintain. But if you contribute enough, those costs may be worth the trade-off.

“In certain circumstances, depending on whether you make consistent contributions versus a large lump-sum contribution, it can be an effective tool in contributing substantially more dollars to your retirement savings than the other standard qualified retirement plans,” Sudit says.

For most individuals, a defined benefit plan is not really a worthwhile option, but that depends on your individual financial situation and especially your income.

Which self-employed retirement plan is best?

The right self-employed retirement plan depends so much on your individual circumstances, but for those who are the company’s sole employee (also including a spouse), the solo 401(k) is a great pick. It allows you all the benefits of a “normal” company-sponsored 401(k) plan and then takes it up a few notches.

Sudit acknowledges the need to fit the plan to your personal circumstances, but says, “I have a preferential bias to the solo 401(k), because it offers the best of all worlds, taking the greatest benefits of all the other retirement deferral options listed above, with the ability to pick and choose what is best for you.”

He explains: “It allows the maximum contribution as an employee, the maximum combined employee/employer contribution, Roth optionality, and generally, tremendous flexibility and other significant advantages allowing self-employed earners to maximize their retirement contributions.”

Let’s unpack those benefits:

• With a solo 401(k), you’ll get to maximize the amount you put away for retirement by being able to make both an employee and employer contribution to the account.
• You can access a Roth 401(k) and take advantage of that plan’s attractive tax-free growth.
• You’ll be able to invest in a variety of asset classes, depending on the broker or sponsor you use, giving you maximum flexibility.
• A spouse employed in the business can also participate in the program, and that’s the lone exception to the “one employee” rule for the solo 401(k).

When you’re eventually ready to take distributions from your retirement account, you’ll want to consider the top withdrawal strategies that maximize your account and extend your savings.

A solo 401(k) may be better than a SEP IRA

The solo 401(k) even has another more subtle benefit that may make it a better pick than the SEP IRA for low earners or those who are using their business as a side gig.

The solo 401(k) allows you to contribute up to 100 percent of your salary, up to the employee’s annual maximum. In other words, in 2022 the first $20,500 that you earn can be stuffed away in the solo 401(k), saving you on taxes. In contrast, the SEP IRA allows you to contribute at a 25 percent rate, so you’d have to earn substantially more to reach the same contribution level.

On top of this benefit, the solo 401(k) allows you to max out the employer contribution, too. Once you hit the employee maximum, you can still contribute at a 25 percent rate from your company’s remaining profits, up to the annual maximum. So in contrast to the SEP IRA, you’re able to contribute more to your retirement plan at a lower level of income, all else equal.

Those are some of the biggest differences between the solo 401(k) and SEP IRA, but it can be useful to understand the full range of differences between the two popular programs.

Annual 401(k) maximum is capped

It’s worth noting that the annual maximum contribution to all 401(k) plans is capped, and you may not deposit the annual maximum at your main job and then sock away another annual maximum from your side hustle, too. So you get $20,500 (in 2022) across all your 401(k) plans.

That said, if you max out your employee contribution at your main job, a solo 401(k) does allow you to still make an employer contribution at the rate of 25 percent of your company’s earnings. So it’s a perfectly legal way to save even more through the power of a solo 401(k).

This self-employed retirement calculator can help you figure out which plan may be best for you.

IRAs are still an option for the self-employed

Even if you participate in a retirement plan as a self-employed individual – including the SEP IRA or SIMPLE IRA – you still have the ability to participate in a traditional IRA or a Roth IRA.

So you can max out your contributions in any of the above retirement plans and still take max advantage of your own personal IRA. For 2022, that means you can contribute up to $6,000 each year (plus a bonus $1,000 if you’re over age 50.)

You’ll enjoy all the benefits of an IRA, including tax-deferred growth, and can take advantage of what many experts see as the best retirement account going – the Roth IRA.

Bottom line

The retirement plan that works best for you depends on your situation. While the solo 401(k) is generally a great pick, it’s a non-starter if you employ more than you and your spouse. So to pick the right plan, you’ll want to think carefully about your needs and where your business is going.

“Choosing the right one requires thoughtful planning, because if you rush or are sold on one strategy versus carefully considering your needs and circumstances, you may find yourself feeling short-changed and ill-prepared for your retirement,” Sudit says.