401k Substitutes For Self Employed Business Owners
Investing for retirement as a self-employed business owner may sound daunting. But there are several retirement options to consider for self-employed individuals.
Although you may not have the luxury of a company-sponsored 401(k) plan, several different retirement accounts are still available. Along with the fantastic tax benefits retirement accounts typically offer.
Popular Self-Employed Retirement Options
Solo 401(k)
Traditional or Roth IRA Account
SEP IRA
What is a Solo 401(K)?
A Solo 401(K) is designed for business owners with no employees. The only exception is that an employed spouse may contribute to your Solo 401(k) based on the compensation you receive from your business. Solo 401(K)’s are similar to a company-sponsored 401(K), except you are the one managing the plan.
Solo 401(K) highlights:
Max Contribution Limit: $61,000 in 2022 (If you are over 50, an additional $6,500 catch-up contribution is allowed).
The flexibility to elect a Traditional 401(k) or Roth 401(k).
Must be a business owner with no full-time employees to participate.
Solo 401(K) Pros:
The best part about Solo 401(k)s is the amount you can contribute. You can contribute up to $20,500 (in 2022) in your plan as an employee of your company, just as you would in a regular 401(k). But you can also add more to the plan.
Since you’re also your employer, you can make an employer contribution to your account, as much as 25% of the business’s income, up to a total account value of $61,000 (for 2022).
Solo 401(K) Cons:
Like most retirement plans, you won’t be able to make penalty-free withdrawals from your account until you hit age 59.5. Once you hit $250,000 in assets in the plan at the end of the year, you’ll need to start filing a special form with the IRS each year.
Traditional or Roth IRA
A Traditional IRA is a special retirement account that allows your earnings to grow tax-deferred. You don’t pay taxes on your contributions or investment gains until you make withdrawals at retirement.
The key benefit of Traditional IRAs: They lower your taxable income for the year.
A Roth IRA is another special retirement account that allows your investments to grow tax-free and tax-free withdrawals at retirement.
The key benefit of Roth IRAs: Tax-free withdrawals at retirement.
Traditional IRA highlights (pre-tax contributions):
With these plans, the max contribution limit is $6,000 (If you are over 50, an additional $1,000 catch-up contribution is allowed). There are also no income restrictions with Traditional IRAs, anyone can contribute to these unique retirement accounts. Although you can make pre-tax contributions and lower your annual taxable income, your retirement withdrawal will be subject to federal taxes.
Traditional IRA Pros:
Tax-Deferred Growth
Contributions can be deducted from your income (there are some limitations depending on your income)
Traditional IRA Cons:
Mandatory RMDs (Mandatory withdrawals are required by age 72).
Can’t Make Withdrawals Penalty Free until age 59.5 or later.
Roth IRA highlights (post-tax contributions):
Just like with Traditional IRAs, the max contribution limit is $6,000 (If you are over 50, an additional $1,000 catch-up contribution is allowed). There are income restrictions in place with Roth IRA accounts. Roth IRA contributions income phase-out ranges for 2022 are $129,000 to $144,000. If your income is too high, you could get around the limit by utilizing the Backdoor Roth strategy.
Roth IRA Pros:
You can withdraw contributions you made to your Roth IRA anytime, tax and penalty-free.
No RMDs
Easily transfer Roth IRA to beneficiaries; their withdrawals will be tax-free.
Roth IRA Cons:
Can’t Make Withdrawals of account earnings (penalty-free) until age 59.5 or later.
Withdrawals of account earnings must not be made until at least five years have passed since the first contribution.
Roth IRA contributions are made with after-tax money.
SEP IRA (Simplified Employee Pension)
The best way to think of a SEP IRA account is a mixture between a traditional IRA and an employer-sponsored 401k plan.
Either an employer or a self-employed individual can set up these unique retirement accounts. The best part about SEP IRAs is that they allow for higher contributions than standard IRAs.
If you have employees, you will have to equally contribute to their IRA plan if they meet the required employee qualifications.
SEP IRA Highlights:
Self-Employed Contribution Limits: 20% of your net income, up to $61,000.
If you are receiving W2 Income From Your Business: 25% of net income compensation, up to $61,000.
SEP IRA Pros:
High contribution limit.
Easier to set up and maintain than an employer-sponsored 401k plan.
All contributions are tax-deductible.
SEP IRA Cons:
There is no Roth version with these plans.
Mandatory RMDs (Mandatory withdrawals are required by age 72).
If you have employees, you will be required to provide them with the exact contribution match you do yourself.
My Thoughts As A Self Employed Investor
I personally use both a Roth IRA and Solo 401(K) to invest for my own retirement.
Solo 401(k)s are great for self-employed individuals who have no full-time employees. They have a high contribution limit and can offer you a great way to invest for your future and lower your taxable income at the same time.
SEP IRAs could be a good alternative if you have full-time employees but don’t want to go through the headaches of setting up an employer-sponsored 401(K) plan.
Also, sign up for my email list to be the first to know when I publish a new blog post!
Want to keep learning? Check out some of my other blog posts:
As Always: Buy things that pay you to own them.
-Josh
Blog Post: #037
