Retirement Strategies for Self-Employed Individuals: How to Plan For Your Financial Future
Self-employed individuals face other tax realities, including a higher Federal Insurance Contributions Act (FICA) tax rate, which includes both Social Security and Medicare taxes. As Brokamp noted, “Self-employed workers are responsible for both the employee and employer portion of FICA taxes. In other words, employees of companies pay a 7.65% rate whereas the self-employed pay 15.3% (though one-half is deductible).”
Self-employment opens up plenty of tax deductions, including the qualified business income (QBI) deduction, which can lower your taxable income. The QBI deduction allows you to deduct up to 20% of your qualified business income if you own a sole proprietorship, partnership or S corporation. Additionally, business owners can deduct their retirement contributions, but it’s important to understand what that actually means.
“While it’s true that retirement contributions reduce your income tax, they generally do not reduce your self-employment tax, since that tax is calculated on net profit before the retirement deduction comes out,” Dellaero said. “That surprises a lot of people who assume contributions would shrink the entire tax bill.”
How to invest retirement savings
The way you invest your retirement savings doesn’t necessarily need to differ from the standard advice just because you’re self-employed. The Securities and Exchange Commission recommends building a diversified portfolio that meets your risk tolerance and time horizon.
Kingan said that business owners should pay special attention to portfolio concentration.
“A self-employed person’s financial life might already be heavily concentrated in the business,” Kingan said. “The owner’s income, business value and future retirement prospects might all depend on the same company or industry. That can be a reason to diversify retirement assets away from the business rather than doubling down on the same economic risks.”
He also recommended keeping short-term liquidity separate from your retirement investments so that you can respond quickly to a business or personal emergency without pausing your contributions or taking an early withdrawal from your retirement account.
Within the account, Kingan suggested low-cost diversified funds or a target-date strategy as a solid foundation for anyone who doesn’t want to actively manage a complex portfolio.
Strategies for managing retirement savings with variable income
Variable income is one of the biggest challenges that self-employed individuals face, both in their day-to-day finances and when saving for retirement. Kingan recommended directing a percentage of each month’s income toward retirement savings, with some built-in targets.
“An owner can then use a three-part target: a minimum contribution they expect to make even in a weaker year, a standard percentage for normal income and a year-end true-up [i.e., an extra contribution] when profits are stronger than expected,” Kingan said. “That true-up should be coordinated with estimated taxes, cash reserves and the applicable contribution deadline.”
He also suggested keeping tax, retirement and operating reserves in separate accounts so long-term savings don’t get absorbed into your everyday business expenses.
Vient recommended a similar system that accommodates your fluctuating income rather than demanding equal monthly contributions.
“I recommend that my clients with variable income make either quarterly contributions to their retirement savings plans or a larger contribution at the end of the year, once we have a complete picture of the current financial year and their tax situation,” Vient said.
In the meantime, she suggested setting aside a portion of your income into a business account or high-yield savings account, and then transferring that money into your retirement account on the schedule that works best for you.
“In the first 3-5 years, folks are still getting a sense of how the business is growing and the rhythm of cash flows, so the end of the year is probably going to be the best option that offers the most control and peace of mind,” Vient said.
Wealth managers and other financial professionals offer plenty of services well suited to help small business owners manage and save for retirement with a variable income.
FAQ
What is the best retirement plan for a self-employed person?
There’s no single best retirement plan for all self-employed people. Instead, the best option for you depends on your income, whether your business has employees and how much you want to contribute each year.
Can a self-employed person contribute to a 401(k)?
Yes. Self-employed individuals with no employees other than their spouse can open and contribute to a solo 401(k). Because these accounts allow contributions as both an employee and employer, they might allow for higher contributions than some other accounts.
How much can a self-employed person contribute to a retirement plan?
Contribution limits for self-employed retirement plans range from $7,500 for traditional and Roth IRAs to $72,000 for solo 401(k)s and SEP IRAs. Contributions are often based on income, and some accounts require equal contributions for the business owner and any employees.
Many plans also allow catch-up contributions once you reach age 50, which range from $1,100 for traditional and Roth IRAs to either $8,000 or $11,250 for 401(k)s, depending on your age.
Can I have a retirement plan if I am self-employed with no employees?
Yes. Small-business owners with no employees can choose from any of the popular self-employed retirement accounts, including a solo 401(k). Having no employees also means you can contribute as much as you want to your own account, within the limits, without worrying about having to make equal contributions to your employees’ accounts.