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Four ways to invest for retirement if you are self-employed

Financial Wellness

If you are one of 9.6 million self-employed Americans, you have four great options to save for retirement:  an IRA, a solo 401(k), a SEP IRA, and a SIMPLE IRA.  If all this sounds like gibberish to you right now, don’t worry.  This post will go over everything you need to know to pick the right retirement savings plan for you.

The important thing is not to put off saving for retirement.  If you work until you’re 85, it should be because you absolutely love what you do and not because you can’t afford to retire.

A quick reminder to consult your CPA before making any decisions.


Things to consider when choosing a plan

When choosing the right self-employed retirement plan, consider which of these factors meet your needs:

  • Do you have employees or not?
  • The amount you wish to contribute.
  • How much flexibility do you need? For example, can you skip a year of contributions if you’re having a tough year?
  • Do you prefer to make tax-deductible contributions or have tax-free withdrawals?
  • How much administrative burden are you willing to tolerate?

How to open a retirement account

These days it’s straightforward to open a retirement investment account if you are self-employed.  Any major online brokerage firms, like Vanguard, Fidelity, Charles Schwab, etc., have an easy step-by-step process of opening a retirement account in a few minutes.


Most popular types of retirement accounts for self-employed

There are four main choices for the self-employed or small-business owners: an IRA (traditional or Roth), a Solo 401(k), a SEP IRA, and SIMPLE IRA, listed in the order of increasing number of employees you have.  Let’s break it down.


Traditional or Roth IRA (Individual Retirement Account)

Best for:  If you’re just starting out and would like to save a modest amount of money for your retirement each year.  It’s the easiest way for self-employed people to start saving for retirement.

Who can contribute:  Anyone with earned income.  This account can be funded in addition to the accounts listed below.

2021 contribution limits: $6,000 ($7,000 if you’re 50 or older).  A side note:  Roth IRA plans have income limits for eligibility – under $140,000 for single tax filers and under $208,000 for married and filing jointly.

Administrative burden:  There are no special filing requirements.

Other considerations:  Traditional and Roth IRA accounts have different tax treatments.  Contributions to Traditional IRA are tax-deductible. Contributions to Roth IRA are made on an after-tax basis, but withdrawals in retirement are tax-free.

Roth IRA might be a good choice if your business is in the early stages and you are not making much money yet (you’ll pay less in taxes now).  It all depends on expectations of your income levels in the future vs. now.


Solo 401(k)

Best for: A business owner or self-employed person with no employees except for a spouse. There can be no other employees.

Who can contribute: You get a chance to contribute as both an employee and an employer.

2021 contribution limits:  This plan offers the highest contribution limits because you can contribute as a business owner and as an employee, with the total equaling $58,000.  Here is the breakdown of possible contributions:

  • As an employee, you can contribute up to $19,500
  • As an employer, you can make an additional contribution of up to 25% of compensation.

There is a special rule for single-member LLCs. You can contribute 25% of net self-employment income (your net profit less half your self-employment tax and the plan contributions you made for yourself).  I would consult my CPA on calculating this one.  There is a limit of $290,000 on compensation that can be used to factor your contributions.

Administrative burden:  This plan is easy to set up and simple to administer.  You would need to file Form 5500 with IRS annually once the plan’s assets reach $250,000.

Other considerations:  This plan offers either pretax or after-tax (Roth) contributions.

Also, solo 401(k) is a flexible plan that allows you to save a lot of money during the years when your business is booming and less in others.


SEP IRA (Simplified Employee Pension)

Best for: Self-employed people or small-business owners with no or few employees.

Who can contribute: If you have employees, you have to contribute the same percentage to their accounts that you contribute for yourself. Employees cannot contribute to the account.  You, as the employer, make all the contributions.

2021 contribution limits:  the lesser of $58,000 or up to 25% of compensation or net self-employment earnings.  You must contribute an equal percentage of salary for each employee.  That means if you contribute 15% of your compensation for yourself, you must contribute 15% of each employee’s compensation.

Administrative burden:  SEP IRA plan is easy to set up with minimal paperwork.

Other considerations:  Like the solo 401(k), SEP IRAs are flexible in that you do not have to contribute every year.

SEP IRA is easy to maintain as there are no annual IRS filings.

The downside of SEP IRA is that you have to make contributions for employees equal to the ones you make for yourself in percentage terms. Thus, it could be costly if you have more than a few employees or if you’d like to put away a great deal for your retirement.


SIMPLE IRA (Savings Incentive Match Plan for Employees)

Best for: Larger businesses, with up to 100 employees.

Who can contribute: the plan is funded by employer contributions and employee deferrals.

2021 contribution limits:  $13,500 ($16,500 if you are 50 and older). The contribution limits are lower than those for a 401(k) ($19,500), allowing employees to contribute up to $19,500.

Administrative burden:  SIMPLE IRA has a bit heavier paperwork load than other plans.

Other considerations:  Like a 401(k), this account offers tax-deferral and pretax contributions.

Unlike the SEP IRA, the contribution burden isn’t entirely on you. Your employees can contribute as well.

Employers are required to make either matching contributions of up to 3% of employee compensation or fixed contributions of 2% to every employee (in this case, an employee does not have to contribute to earn your contribution).


The Bigger Picture

I hope now you have more clarity on which retirement investing option works best for you.  The good news is that flying solo gives you plenty to choose from.  The important thing is to get started!

I’ve put together a table that summarizes and compared four main types of retirement investment accounts.  Don’t get stuck.  Just pick one option, open an account, and start saving for your future.

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