Participating in an employer-sponsored retirement plan is one of the best ways to save for retirement – especially if your employer matches your contributions.
But what about those who are their own employers?
Self-employment is on the rise. The number of self-employed U.S. adults is just under ten million, according to the latest figures released by the U.S. Bureau of Labor Statistics, as of February 2022. That represents a 4.59% annual increase, which is faster than the previous month.
Thankfully, there are some powerful and flexible retirement plan options available for the self-employed – and for their employees.
Here’s a breakdown of four plan types: SEP IRAs, SIMPLE IRAs, Solo 401ks, and Defined Benefit plans.
Simplified Employee Pension (SEP) IRA
What is a SEP IRA?
A SEP IRA (Simplified Employee Pension Individual Retirement Account) is a profit-sharing plan that allows business owners to contribute to both their employees’ retirement savings and their own.
Like traditional IRAs, SEP IRAs generally allow any earnings to grow tax-deferred until you withdraw them later. Keep in mind that contributions must be cash and cannot be property.
Despite their similarities, SEP IRAs and traditional IRAs are very different when it comes to contribution limits. Anyone can contribute to a traditional IRA, but only the employer can make profit-sharing contributions to a SEP IRA. Some SEP IRA plans also allow regular traditional IRA contributions for those that don’t want to open a separate traditional IRA account. Keep in mind SEP IRAs have some eligibility requirements that make them a little more restrictive than other available plans. Consult a professional for a complete list.
SEP IRA Contribution Limits
Contribution limits are the same if you are contributing to your employee’s SEP IRA or if you are self-employed and contributing to your own. As of 2022, contribution limits cannot exceed the lesser of:
- 25% of compensation, or
- $61,000 for 2022 ($58,000 for 2021)
You can use the IRS’s resource for determining contributions for yourself. If you’re self-employed, contribution calculations can get more complicated. A professional tax advisor could be a great resource for helping to clarify your specific situation.
Benefits & Challenges of SEP IRAs
SEP IRAs were created specifically for self-employed individuals and small business owners who wanted to offer retirement plans to employees. Many small business owners don’t employ enough people to justify the cost of a full 401k, so a SEP IRA is a great benefit to offer in a small business setting due to its minimal administration costs.
A SEP is also a great vehicle if you want to actively manage investments, since all trades are made with no tax consequences. Many SEP providers offer a wide range of investment choices.
Contributions are not required in a given year, but it’s important to note that if a contribution is made, all employees must receive the same percentage of earned income or compensation (up to 25%), so these plans can be expensive. Additionally, SEP IRAs do not allow catch-up contributions for those over age 50.
What is a SIMPLE IRA?
A SIMPLE IRA plan allows individuals to contribute to traditional IRA plans if they are self-employed small business owners or work for a small business. It was created as a solution for small employers who do not currently sponsor a retirement plan.
SIMPLE IRAs are relatively easy to establish and available to any small business with fewer than 100 employees. The employer cannot have any other retirement plan if they are setting up a SIMPLE IRA.
SIMPLE IRA Contribution Limits
According to the IRS, contributions to a SIMPLE IRA include:
- Salary reduction employee contributions: This type of contribution is limited to $14,000 in 2022. If you are 50 or older, you are eligible for a $3,000 catch-up contribution.
- Employer contributions: Can be either matching contributions or nonelective contributions.
- The employer is generally required to match an employee’s contribution up to 3% per year.
- Alternatively, an employer can also make non-elective contributions of 2% of each employee’s compensation per year, regardless of whether the employee contributes or not. Employees must be given sufficient notice before changing the employer contribution method.
Benefits and Challenges of a SIMPLE IRA
SIMPLE IRAs do not have the start-up and administrative costs that traditional retirement savings plans often have. There are also no filing requirements associated with a SIMPLE IRA so the plan is simpler to maintain than some other traditional retirement savings vehicles.
While the SIMPLE IRA is a great option for many people, it’s important to note that the contribution limits are quite a bit lower than the alternatives. Another caveat to note: if you plan to make an early withdrawal within the first two years of participation, you may face a penalty of up to 25%.
Solo 401k/Roth Solo 401k
Solo 401k Contribution Limits
Here are the contribution limits for solo 401k accounts.
- Employee Contributions: $20,500 in 2022 ($19,500 in 2021), or $27,000 in 2022, if you’re age 50 or older. Notably, this age 50 catch-up provision is not available in a SEP IRA.
- Employer Contributions: 25% of compensation as defined by the plan.
- Self-Employed Contributions: You must make a special calculation to determine your employee deferral and employer profit-sharing contributions. When you’re calculating the contributions, compensation is your earned income. It’s your net earnings from self-employment after deducting both:
- one-half of your self-employment tax
- contributions for yourself
You can use free IRS worksheets for determining your allowable contribution rate and tax deduction.
The total contribution amount is not to exceed $61,000 in 2022.
Benefits and Challenges of a Solo 401k Plan
A Solo 401k can offer higher contribution limits than a SEP or SIMPLE plan. Contribution options are also more flexible, meaning that you are able, but not obligated, to contribute as much as legally allowed. Many Solo 401k plans also offer the ability to take loans.
Solo 401k plans come with relatively simple administration versus a regular 401k plan, but they can still be complicated to set up and maintain.
Make sure you do your research before opting into one of these plans, and consider retaining the services of a professional retirement plan administrator to handle the plan’s recordkeeping and keep it compliant with any regulatory changes.
After-Tax Rollovers: the Mega Backdoor Roth
Certain modern, custom Solo 401k plan designs allow for extra after-tax employee contributions over and above the standard limit of $20,500. These after-tax dollars can then be rolled into a Roth Solo 401k or Roth IRA, providing tax-free growth and tax-free withdrawals someday.
This process is similar to a regular backdoor Roth IRA conversion, but potentially much larger — hence its common title of “mega” backdoor Roth.
While total contributions are still subject to the limit of $61,000, annual mega backdoor Roth rollovers can serve to supercharge retirement savings, despite the slightly higher cost from utilizing a custom plan design offering this option.
However, be aware that Solo 401k plans employing this strategy require specialized retirement plan accounting and technical expertise, so several different partners need to be involved in their implementation. Consult a professional to learn more about the mega backdoor Roth strategy.
Defined Benefit Plans
What is a Defined Benefit Plan?
A defined benefit plan is a pension targeting a specific payout amount at retirement. A small business owner can choose to draw an income stream from the plan at retirement or simply close it down and roll its assets into a traditional IRA.
Defined benefit plans have by far the highest contribution limits of any retirement vehicle, allowing income tax deferral through large employer pre-tax contributions. These plans calculate annual contribution amounts based on a number of factors, including business revenues and the participant’s age. Older small business owners with high revenues could potentially contribute hundreds of thousands of pre-tax dollars to a defined benefit plan in a single year.
Benefits and Challenges of a Defined Benefit Plan
Defined benefit plans are complex and costly to run, as federal law requires involvement of an enrolled actuary in their administration. Annual contributions for all employees are mandatory, so a business should have consistent revenues before considering a defined benefit plan.
For “owner-only” businesses, a defined benefit plan can be paired with a Solo 401k plan to allow for even greater retirement savings and tax deferral potential — especially when also employing the mega backdoor Roth strategy.
Implementing this combination of retirement plans has a great many moving parts, so make sure to work with specialized retirement plan professionals familiar with these mechanics to analyze which plan options make the most sense for your business.
If you are self-employed or operate a small business, you have a lot of flexibility in choosing retirement savings vehicles. The SEP IRA, SIMPLE IRA, Solo 401k, and defined benefit plans all have benefits and drawbacks, so it’s important to thoroughly research which option works best for your unique situation before making a decision.
A financial advisor can help you navigate this and determine which account is the best fit for your overall financial life.