For Self-employed, Freelancers & Small Business Owners

One key to your financial independence is saving for your retirement in a tax-deferred and therefore tax-advantaged plan, whether you are self-employed, running a small business, or just freelancing for extra cash.   You can benefit from valuable tax breaks, even if you don’t have a job with 401(k) or haven’t started one for yourself yet.

Then what’s the best one for your unique situation?  Here we recount a few most commonly seen scenarios to help you navigate this important decision.

For this discussion, we’ll assume that you’ve already decided you want to save more than the $5,500 you can save in an IRA.  And that you understand the contributions to your retirement plan are tax-deductible, and the money grows tax-deferred in the account until you withdraw it in retirement.  You’ll pay tax at ordinary income rates at that point.  However, there may be penalties for early withdrawals before age 59½, and for failing to take required minimum distributions beginning at age 70½.

Ok, now let’s dive in for the best combination of high contribution limits, flexibility and liquidity.

SEP (Simplified Employee Pension)

Best For:

• Freelancers who don't have any employees.

• Self-employed or small business owners whose tax structure has only self-employment income, i.e. no W-2 to themselves.

Pro: 

1. A SEP is a turbocharged IRA.  It is the easiest to set up and maintain, more financial institutions available to help you set one up.  You can buy the same investment vehicles as regular IRAs, e.g. stocks, bonds, mutual funds, etc. 

   -       Freelancers can contribute up to about 25% of their “net self-employment income”, up to a maximum of $57,000 in 2020.

   -       Same maximum contribution amount for self-employed or small business owners who only have self-employment income.
   

2. The SEP is flexible.  So if your cash flow is not stable year from year and there’s no money to contribute, you simply just don’t contribute. 
   

3. For freelancers that are moonlighting, SEP has no extra contribution limits if you max out a 401(k) at your day job. 

Con:

1. The SEP doesn't have catch-up contributions.  (Catch-up contributions apply only to employee elective deferrals, such as 401(k), 403(b).)
   

2. If you pay yourself W-2 in your S corporation to limit your self-employment tax, you’ll also limit your SEP contribution because it’s based on that lower salary amount. , you can contribute 25% of your “covered compensation,” which essentially means your salary. 
   

3. If you incorporate your small business, and if you’ve got employees, you’ll have to contribute for them, too. You generally have to contribute the same percentage for your employees as you do for yourself. However, if your income is significantly higher than that of your employees, you can use what’s called an “integrated” formula to make extra contributions for higher incomes.

SIMPLE IRA

Best For:

• Part-time or sideline businesses earning less than $54,000.

Pro:

1. This is another “turbocharged” IRA like the SEP.
   

2. You and your employees can defer and deduct 100% of your income up to $13,500. If your income is under $54,000, that may be more than you could sock away with a SEP.
   

3. If you’re 50 or older you can make an extra $3,000 “catch up” contribution.
   

4. There’s no set-up charge or annual administration fee for the plan. You’re simply establishing special IRAs for you and your employees. The money goes straight into employee IRAs. You can designate a single financial institution to hold the money or let your employees choose where to hold their accounts.

Con:

1. If you have employees, you have to match everyone’s deferral or make profit-sharing contributions. You can match employee contributions dollar-for-dollar up to 3% of their pay or contribute 2% of everyone’s pay whether they choose to defer or not. If you choose the match, you can reduce it as low as 1% for two years out of five.
   

2. The catch-up contribution limitation for SIMPLE plans is $3,000, vs. $6,500 in other plans.

Solo 401(k), a.k.a. Individual 401(k) / 401(k)

Best For:

• Small business owners who want to contribute more to their retirement.

• Especially if you operate your business all by yourself, with no employees other than your spouse, as you can establish it with less red tape.

• More mature businesses who want a more structured incentive/benefit plan to attract and retain talents.

• Business owners who want to receive tax credits for setting up a retirement plan.

Pro:

1. It lets you save more starting at lower income levels, or at a later stage in life.

   -       If you only earn a few thousand dollars in freelance income for the year, you can contribute much more to a solo 401(k) than you can to a SEP.  That means if you earned $15,000 from self-employment in 2020, you could contribute about $15,000 to the solo 401(k), but you could only contribute about $3,000 in SEP.

   -       If you're self-employed, you can make contributions as both the employee and the employer. You can contribute up to $19,500 as an employee (or $26,000 if 50 or older), plus about 25% of your net self-employment income as an employer, as long your combined contributions don't exceed the $57,000 limit.

   -       The solo 401(k) can also come out ahead if you earn more. For example, if you're a sole proprietor under age 50 whose net business profit is $100,000, you can contribute $25,000 to a SEP IRA or $44,500 to a solo 401(k) (which is $19,500 as the employee plus $25,000 as the employer).

   -       Catch-up contributions for age 50 and older. You can contribute more to a solo 401(k) as an employee if you're age 50 or older. You can add $6,500 in catch-up contributions, bringing the total of employee contributions to $26,000.
   

2. The 401(k) lets you contribute far more money, far more flexibly than either the SEP or the SIMPLE.

   -       You can choose to match contributions or make “profit-sharing” contributions up to 25% of everyone’s pay. (If you operate as an S corporation, you can contribute up to 25% of your salary, but not any pass-through distributions.) That’s the same percentage you can save in your SEP - on top of the $19,500 deferral.

   -       You can offer yourself and your employees loans, hardship withdrawals, and all the bells and whistles “the big boys” offer their employees.
   -       You can use “cross-testing” to skew profit-sharing contributions to favored employees. “Age-weighted” plans allocate more to older employees (on the theory that they have less time to save for retirement); “integrated” and “super-integrated” plans allocate more to higher-paid employees (on the theory that they get no benefit from Social Security for their income above the Social Security wage base); and “rate group” plans divide employees into groups (such as managers, administrators, and salespeople) and make different contributions for each group.
   

3. You could receive government subsidy in the form of tax credit to set up a 401(k). 
   -       An eligible employer may claim a “Small employer automatic enrolment credit” when it sponsors a qualified employer plan including an eligible automatic contribution arrangement.  Remember here, tax credits are dollar-for-dollar direct reduction of your tax liabilities. The credit equals $500 per year over a 3-year period beginning with the first tax year beginning after December 31, 2019, and could first be claimed on the employer’s return for the year 2020.

Con:

1. Fewer financial institutions offer solo 401(k)s, and you need to be careful about fees. Some firms have the same fees and investment choices in their solo 401(k)s as their SEPs, but some solo 401(k)s have extra fees and only offer a handful of mutual funds.

2. 401(k)s are true “qualified” plans, which makes them harder to administer than SEPs or SIMPLEs.  And you have to establish a qualified-plan trust to hold plan assets. The trust will have to file Form 5500, an informational return reporting contributions and assets, every year after the assets in the account reach $250,000.
   And there are complicated anti-­discrimination and “top-heavy” rules to keep you from stuffing your own account while you stiff your employees. 

3. With a solo 401(k), you may be limited in the employee's share of the contributions if you max out a 401(k) at another job – the $19,500 limit ($26,000 if 50 or older) applies to both the solo 401(k) and contributions you make to any other 401(k) you may have from another employer. This can limit your solo 401(k) contributions if you have a full-time job with a 401(k) and also do some freelance work on the side. But you can still contribute 20% of net income from self-employment to either a SEP or a solo 401(k), up to the $57,000 total for 2020.

 As they say, a picture is worth a thousand word, the graph below will compare for you at different income level which is the best retirement plan option.

If all these are confusing to you, and you like to talk to a financial advisor, first check out here our thoughts on selecting a trusted advisor.