I once asked a group of local working moms, many who are self-employed, about their money and financial planning questions. The very first question was around saving for retirement:
When I left my corporate position to become self-employed, I sacrificed contributing to a [company-sponsored] 401(k). I know I could pursue a self-employed 401(k), but I have no idea how that works. I don’t get matching now and it makes me wonder if it’s even worth it. My husband is saving to his. Do I need to resume, too? So, my question would be – do you recommend any options? Is there a bare minimum someone should save?
I love that this woman is proactively thinking about more than just the day-to-day operations of her business. Many entrepreneurs resist making quarterly estimated tax payments, let alone set aside money they may not touch for 20 to 30 years. A 2017 survey by Manta, an online community for business owners, reported that 34% of entrepreneurs didn’t have a retirement savings plan. The biggest reason: they don’t make enough profit to save for retirement.
Yikes!
Profit is a function of your top-line revenue less your operating expenses. A few ways to increase profitability is to raise prices, lower expenses, or cut less profitable services lines or products. I realize pricing is an entire blog post of its own! As a crash course, it should take into account your business and living expenses, reinvesting in the business, debt repayments, taxes, and saving for short- and long-term financial goals.
Before discussing where to save, let’s tackle how much should be saved for financial independence or retirement. Yes, you may plan on selling your businesses to fund retirement. Or perhaps you don’t plan on ever retiring. Since there are no loans for retirement and Social Security may change, you are in control of your own savings destiny.
How Much to Save
One quick rule of thumb is that you need to have saved 25 times your annual expenses to cover retirement. Consider your basic needs like rent, insurance, and groceries. Also plan for things you’d like spend your money on: travel or donating to charitable causes. The spreadsheet in this blog post will help you do the math.
If there’s a disconnect between your target and actual savings, how will you bridge the gap? If it’s time to increase prices, think about ways you can you add more value to your services. Can you take some classes to improve your skills? If you need to take on additional projects, is it possible to outsource some of the administrative tasks so you can spend more hours performing revenue generating work? Or are some of your current expenses truly necessary?
Where to Save
Many of the following accounts can be opened at brokerage firms like Vanguard, Betterment, TD Ameritrade, or Fidelity. Each financial institution has their own mix of investments and fees, so compare your options or consult with an advisor prior opening an account.
Traditional or Roth IRA
Contributing to a traditional or Roth IRA is an easy way for anyone with earned income to start saving for retirement. Individuals have until April 15, 2021 to make a contribution for the 2020 tax year. For 2020, you can contribute up to $6,000 ($7,00 if you’re age 50 or older) or your taxable compensation for the year, if it’s less than this dollar limit.
Traditional IRAs are appealing because of the income tax deduction. However, that deduction may be limited if you or your spouse are covered by a retirement plan at work and your income exceeds certain levels. Review the IRS guidelines for more details.
Roth IRAs are fantastic because you can withdraw your money tax-free when you’re in retirement. However, a Roth IRA contribution might be limited based on your tax filing status and income.
Also, if you’re a new business owner, you may find yourself in a lower tax bracket than when you were at your corporate job. That means it might be a good time to convert an old 401(k) or traditional IRA into a Roth. That means you can capture lower taxes today and withdraw that money from your Roth tax-free when you’re in retirement.
If you have more money to contribute to retirement than $6,000 ($7,000 if you’re age 50 or older), then you may want to invest in one of the following retirement accounts.
The Solo 401(k)
The Solo 401(k) is a traditional 401(k) plan covering a business owner with no employees (or that person and his or her spouse). A business owner who is taxed as a sole proprietor can make the following contributions:
- Elective deferrals of up to 100% of earned income (which considers self-employment tax) up to a maximum annual contribution of $19,500 ($26,000 if you’re age 50 or older) in 2020. These can be either pre- or post-tax Roth contributions; plus
- Employer non-elective contributions up to 25% of compensation (earned income less contributions for yourself),
With total contributions not to exceed $57,000 ($63,500 for those 50 and older) for 2020.
If you are the sole owner and employee of an S Corp, your contributions will depend on your W-2 wages:
- Employee elective deferrals of up to 100% of W-2 wages up to a maximum annual contribution of $19,500 ($26,000 if you’re age 50 or older) in 2020. These can be either pre- or post-tax Roth contributions; plus
- Employer non-elective contributions up to 25% of W-2 wages,
With total contributions not to exceed $57,000 ($63,500 for those 50 and older) for 2020.
Note that these elective deferral limits apply per person, not per plan. Let’s say you’re starting your business while still employed at your corporate job. The employee contributions you make to your day job’s 401(k) plan will count against the limit for employee contributions to an individual 401(k) or SIMPLE IRA.
As a heads up, your solo 401(k) must be set up by December 31st and funded by your tax return due date in order for contributions to apply for that year.
And a solo 401(k) plan is generally required to file an annual report on Form 5500-SF if it has $250,000 or more in assets at the end of the year. A solo 401(k) with fewer assets may be exempt from the annual filing requirement.
Group 401(k)
This plan is ideal if your business has multiple employees and you’d like to offer all the tax, savings, and retirement benefits of a typical 401(k). While the contribution limits are the same as a solo 401(k), the setup and administrative costs (not to mention responsibilities) of a group 401(k) are greater than other retirement plans.
Simplified Employee Pension Plan (SEP IRA)
A SEP IRA is like a traditional IRA, but it is funded solely by employer contributions. Meaning, these contributions are deductible as a business expense. The SEP IRA is a great option for those who do not qualify for a solo 401(k), or who have employees and are looking for a retirement plan for their whole company. And there’s not an annual contribution requirement.
A business owner sets up an IRA for each qualifying employee and can contribute up to the lesser of 25% of each employee’s wages or $57,000. There are no “catch-up” contributions like the solo 401(k).
This is an important distinction for S Corp owners/employees because the employer contribution is based on W-2 wages, not income reported on the K-1.
If your business is taxed as a sole proprietorship or partnership, you can contribute up to the lesser of 20% of your self-employment income adjusted for self-employment taxes, or $57,000.
SEP IRAs offer a bit more flexibility than a solo 401(k) or SIMPLE IRA because the business owner has until the company’s tax filing deadline (plus any extensions) for the tax year to open and contribute to a SEP IRA. Business owners just need to file a form with the IRS (Form 5305-SEP) and open a SEP IRA at a bank or financial institution.
Savings Incentive Match Plan for Employees (SIMPLE) IRA
A SIMPLE IRA is a retirement plan available to any small business with 100 or fewer employees that doesn’t currently maintain any other retirement plan. It’s a great starter plan that encourages contributions by employees. The plan is funded by employee salary reduction contributions and/or employer contributions.
Employees can decide how much they’d like to contribute, up to $13,500 ($16,500 for employees age 50 or older) or 100% of compensation in 2020.
Employers have two options:
- Match up to 3% of each eligible employee’s compensation (which can be reduced to as low as 1% in any two out of five years). The amount, however, can’t exceed $13,500 in 2020; or
- Contribute 2% of each eligible employee’s compensation. The amount, however, can’t exceed $6,000 in 2020.
A SIMPLE IRA must be established by October 1 (usually with Form 5305-SIMPLE) and the employer contributions must be made by the company’s tax filing deadline (plus any extensions) for the tax year. Employee contributions need to be deposited promptly into the employees’ accounts.
Taxable Brokerage Account
If early retirement or financial independence is on your radar, you should also consider investing in a taxable brokerage account. While it doesn’t offer the tax savings like some of the other retirement accounts, a brokerage account offers some flexibility around when you can withdraw funds. For example, you can’t tap into a Traditional IRA, SEP IRA, SIMPLE IRA, or 401(k) until age 59 1/2 without triggering early withdrawal penalties and additional taxes. Though there are some hardship exemptions.
How to Choose
Yes, contributing to a retirement account takes some cash, but doing so can help you save money on taxes. Not to mention letting time do its work and help your accounts grow thanks to the magic of compound interest.
Which tax-advantaged retirement plan should you use? That depends on how much you plan on contributing. Also, consider the nature and size of your business (are you solo or do have employees?) and the eligibility requirements of the plan. On a personal level, think about your tax filing status, age, and participation in other retirement plans. And since some plans require more administrative and fiduciary responsibilities, you may want to choose one retirement plan over another due to simplicity.
Pay Yourself First!
Finally, in order to reach your financial goals, you need to pay yourself first. This is important even if you aren’t a business owner! You can achieve this by setting up automatic transfers to your savings, retirement, and/or investment accounts.
As an entrepreneur, your income may vary, so allocate your savings based on percentages instead of dollar amounts. For example, make it a goal to set aside 5% of every client payment. This will automatically help you save more dollars when your income is higher and keep you from overextending yourself during leaner months.
I realize that your other dreams and goals matter, too. Let’s create a financial and tax strategy that’s grounded in reality — but structured in a way that aligns with the lifestyle you want now and in the future. Together, we do a lot more than just file your taxes every year. We collaborate on big-picture business planning so you can get exactly what you want from your life as an entrepreneur.
