Self-Employed Pension Plans: 3 Investment Vehicles to Consider

Being self-employed offers unparalleled flexibility and freedom. You have the opportunity to do what you love, build your business as you see fit, and be your own boss. However, this independence comes with unique challenges, particularly when it comes to financial planning.

Unlike employees of large companies with HR departments handling retirement planning and contributions, self-employed individuals must take charge of their own financial future. This includes creating and contributing to a pension plan independently. Understanding how self-employed pension plans work is a great steps towards building for your retirement.

Our goal is to help you navigate the complexities of self-employed retirement plans. We recognize that every self-employed individual’s situation is unique, and we’re here to provide guidance tailored to your specific needs and goals.

The Importance of Retirement Planning for Self-Employed Individuals

As a self-employed individual, you’re responsible for every aspect of your business, including your own financial future. While the day-to-day operations of your business may take precedence, it’s crucial not to overlook long-term financial planning, especially when it comes to retirement.

Here are some key reasons why retirement planning is particularly important for the self-employed:

1. No employer-sponsored plans: You don’t have access to traditional employer-sponsored retirement plans, so you need to be proactive in creating your own retirement savings strategy.
2. Irregular income: Many self-employed individuals experience fluctuations in income, making consistent saving challenging. A well-structured retirement plan can help you navigate these variations.
3. Potential for higher savings: Self-employed retirement plans often allow for higher contribution limits compared to traditional employee plans, giving you the opportunity to save more for your future.
4. Tax benefits: Many self-employed retirement plans offer significant tax advantages, which can help reduce your current tax burden while saving for the future.
5. Business succession planning: For business owners, retirement planning often goes hand-in-hand with succession planning, ensuring a smooth transition and financial security.

Understanding Self-Employed Pension Plans

A self-employed pension is a retirement savings plan designed specifically for individuals who work for themselves. These plans differ from traditional employer-sponsored pensions in that the self-employed individual acts as both the employer and employee.

The most common types of self-employed retirement plans include:

1. Simplified Employee Pension (SEP) IRA
2. Solo 401(k)
3. Savings Incentive Match Plan for Employees (SIMPLE) IRA

Each of these plans has its own set of rules, contribution limits, and potential benefits. Let’s take a closer look at each option, starting with the most popular: the SEP IRA.

Simplified Employee Pension (SEP) IRA: A Detailed Look

What is a SEP IRA?

A Simplified Employee Pension (SEP) IRA is the most common type of pension plan for self-employed individuals working alone or with a small group of employees. This plan allows employers to set aside money for retirement for both themselves and their employees.

How Does a SEP IRA Work?

SEP IRAs can be used by employers and employees of any size business. They offer several advantages:

• Low start-up and operating costs compared to other retirement plans like 401(k)s
• Flexible contribution limits
• Tax-deductible contributions

As of the 2023 tax year, you can contribute up to 25% of an employee’s compensation or $66,000, whichever is less. However, it’s important to note that you must contribute an equal percentage of salary to all eligible employees, including yourself.

Benefits for Self-Employed Individuals

SEP IRAs can be particularly beneficial for self-employed individuals due to their flexibility. The amount contributed each year can fluctuate, which is ideal for small business owners or freelancers whose profits and cash flow may vary significantly from year to year.

In exceptionally profitable years, you can choose to contribute up to the maximum amount. During leaner years, you have the flexibility to reduce your contributions without penalty. This flexibility allows you to adjust your retirement savings strategy based on your business’s performance and your personal financial situation.

Eligibility and Participation Requirements

For SEP IRAs, employees may be eligible if they:

• Are over 21 years old
• Have worked for you in at least three of the last five years
• Have earned $600 or more from you in the last year

It’s crucial to understand these requirements, especially if you have employees or plan to hire in the future. The equal contribution requirement means that if you decide to contribute 10% of your own salary to your SEP IRA, you must also contribute 10% of each eligible employee’s salary to their SEP IRA.

Solo 401(k): For the Self-Employed with No Employees

What is a Solo 401(k)?

A Solo 401(k), also known as an Individual 401(k) or Self-Employed 401(k), is designed for self-employed individuals with no employees (except a spouse). This plan combines the features of a traditional 401(k) with profit-sharing, allowing for potentially higher contribution limits.

How Does a Solo 401(k) Work?

With a Solo 401(k), you can make contributions as both the employer and the employee:

1. As an employee, you can contribute up to $22,500 in 2023 (or $30,000 if you’re 50 or older, thanks to catch-up contributions).
   As an employer, you can contribute up to 25% of your compensation.
2. The total combined contribution cannot exceed $66,000 in 2023 (or $73,500 if you’re 50 or older).

Benefits of a Solo 401(k)

• Higher contribution limits: The ability to contribute as both employer and employee often results in higher overall contribution limits compared to SEP IRAs.
• Loan options: Many Solo 401(k) plans allow you to borrow from your retirement savings, which isn’t an option with SEP IRAs.
• Roth option: Some Solo 401(k) plans offer a Roth option, allowing for tax-free withdrawals in retirement.

Considerations for Solo 401(k)s

While Solo 401(k)s offer many benefits, they also come with more administrative responsibilities. Once your plan balance reaches $250,000, you’re required to file Form 5500-EZ annually with the IRS. Additionally, if you plan to hire employees in the future, you may need to convert your Solo 401(k) to a traditional 401(k) plan.

SIMPLE IRA: For Small Businesses with Employees

What is a SIMPLE IRA?

The Savings Incentive Match Plan for Employees (SIMPLE) IRA is designed for small businesses with up to 100 employees. This plan allows both employer and employee contributions, making it a good option for self-employed individuals who have a few employees.

How Does a SIMPLE IRA Work?

Under a SIMPLE IRA plan:

• Employees can contribute up to $15,500 in 2023 (or $19,000 if age 50 or older).
• Employers must make either matching contributions of up to 3% of an employee’s compensation or non-elective contributions of 2% of each eligible employee’s compensation.

Benefits of a SIMPLE IRA

• Easy administration: SIMPLE IRAs have fewer administrative requirements compared to 401(k) plans.
• No filing requirements: Unlike Solo 401(k)s, SIMPLE IRAs don’t require annual filings with the IRS.
• Mandatory employer contributions: This can be an attractive feature for recruiting and retaining employees.

Considerations for SIMPLE IRAs

The main drawback of SIMPLE IRAs for self-employed individuals is the lower contribution limits compared to SEP IRAs or Solo 401(k)s. Additionally, the mandatory employer contributions can be costly if you have several employees.

Setting Up a Self-Employed Pension Plan

Setting up a self-employed pension plan involves 5 steps:

1. Choose a financial institution: Select a reputable financial institution to administer your plan. Look for providers that offer a range of investment options and reasonable fees.
2. Complete the necessary paperwork: This typically includes IRS forms specific to your chosen plan type. For example, SEP IRAs require Form 5305-SEP.
3. Inform eligible employees: If you have employees, you’re required to provide them with information about the plan, including eligibility requirements and contribution details.
4. Make contributions: Establish a system for making regular contributions to your plan. Remember, consistency is key in building your retirement savings.
5. Maintain records: Keep detailed records of your contributions and any changes to your plan. This will be crucial for tax purposes and ensuring compliance with IRS regulations.

Tax Considerations and Benefits of Self-Employed Pensions

Self-employed pension plans offer significant tax advantages that can help you save money now while building your retirement nest egg:

1. Tax-deductible contributions: Contributions to SEP IRAs, Solo 401(k)s, and SIMPLE IRAs are typically tax-deductible, reducing your taxable income for the year.
2. Tax-deferred growth: Your investments grow tax-deferred until withdrawal in retirement, potentially allowing for greater compound growth over time.
3. Potential tax credits: The IRS offers a tax credit for small businesses that start a new retirement plan, which could offset some of the initial setup costs.
4. Roth options: Some plans, like Solo 401(k)s, offer Roth options. While contributions are made with after-tax dollars, qualified withdrawals in retirement are tax-free.

It’s important to consult with a tax professional or financial advisor to fully understand the tax implications of your chosen retirement plan and how it fits into your overall financial strategy.

Common Considerations and Pitfalls

When setting up a self-employed pension plan, be aware of these potential pitfalls:

1. Equal contribution requirement: For SEP IRAs, you must contribute the same percentage for all eligible employees, which could be costly if you have several employees.
2. Lack of catch-up contributions in SEP IRAs: Unlike some other retirement plans, SEP IRAs don’t allow for additional catch-up contributions for individuals over 50.
3. Impact of business size: As your business grows and you hire more employees, you may need to reassess your chosen retirement plan.
4. Contribution deadlines: Each plan type has specific deadlines for making contributions. Missing these deadlines could result in lost opportunities for tax deductions.
5. Over-contribution penalties: Contributing more than the annual limit can result in penalties from the IRS.
6. Early withdrawal penalties: Withdrawing funds before age 59½ typically results in a 10% penalty in addition to regular income taxes.
7. Required Minimum Distributions (RMDs): Most retirement plans require you to start taking distributions at age 72, which could impact your tax situation in retirement.

Strategies for Maximizing Your Self-Employed Pension

To make the most of your self-employed pension plan, consider these strategies:

1. Start early: The power of compound interest means that the earlier you start saving, the more your money can grow over time.
2. Contribute consistently: Even in leaner years, try to contribute something to your retirement plan. Consistent contributions can add up significantly over time.
3. Take advantage of catch-up contributions: If you’re 50 or older, make use of catch-up contributions in plans that allow them to boost your savings.
4. Diversify your investments: Don’t put all your eggs in one basket. A diversified portfolio can help manage risk and potentially improve returns over the long term.
5. Regularly review and adjust: As your business and personal circumstances change, review your retirement plan to ensure it still aligns with your goals.
6. Consider multiple retirement savings vehicles: Depending on your situation, you might benefit from combining different types of retirement accounts to maximize your savings potential.

Why Choose Riverbend Wealth Management for Retirement Planning

At Riverbend Wealth Management, we understand the unique challenges faced by self-employed individuals. Our team of fiduciaries offers personalized retirement planning services tailored to your specific needs. We take a comprehensive approach to financial planning, considering not just your retirement goals but also estate planning, tax strategies, and investment management.

We specialize in:

• Personalized retirement plan selection and setup
• Ongoing portfolio management and rebalancing
• Tax-conscious investment strategies
• Integration of your retirement plan with your overall financial goals
• Regular reviews and adjustments to keep you on track

We work with you to create a retirement strategy that not only secures your financial future but also aligns with your business goals and personal values. If you’re interested in learning more, schedule a free 15-minute consultation with our team.

Starting Today is the Best Time to Save For Your Retirement

As a self-employed individual, planning for retirement requires self-discipline and proactive decision-making. While it may take effort to set aside a portion of your earnings each year, establishing a pension plan is a crucial step towards achieving financial independence in retirement.

Remember, your financial future is just as important as everyone else’s. By understanding your options and making informed decisions about self-employed retirement plans, you can potentially build a comfortable and fulfilling retirement.

The journey to retirement starts with a single step: saving. Whether you’re just starting your self-employed career or you’ve been your own boss for years, it’s never too late to start planning for your future. With the right strategy and professional guidance, you can build a retirement plan that potentially satisfies your future goals.

Content in this material is intended for general information purposes only and should not be construed as specific investment advice or recommendations for any individual.  Please contact your advisor with any questions or specific recommendations regarding your own circumstances. Asset allocation does not ensure a profit or protect against a loss. Investing involves risks, including possible loss of principal.