Retirement Saving for the Self-Employed
When someone works a W-2 job, much of their retirement savings are automated through their employer plans. This may be a 401(k), a 403(b), a pension, or something else. However, when someone is self-employed, especially if they own their business, saving for retirement relies completely on their initiative. There is no HR department to walk them through the process of saving for retirement, there are no accounts already in place for them, and all of this comes down to their planning.
So what kinds of options do business owners and self-employed individuals have to save for retirement? There are many different options, but each will depend on your situation, your business, and the structure of your compensation. First, it’s important to discuss what a “retirement account” actually is. Retirement accounts allow you to invest in stocks, bonds, crypto, money market funds, and others with particular tax benefits. Most of the time, retirement accounts are in one of two categories: Roth or traditional. Traditional accounts allow you to contribute funds pretax. This means that the money you contribute will not be taxed at your income tax levels this year. However, whenever you withdraw money from the account, you will have to pay income taxes on the amount that you withdraw. You will also be subject to a 10% penalty if you withdraw before age 59.5. The second kind of account is a Roth account. The contributions you make are post-tax, which means that you will have already paid income tax on the money. Since it’s already been taxed, the money you withdraw (as long as it’s after age 59.5) is tax-free. With that piece of information out of the way, let’s talk about some specific accounts that you could use to save for retirement as a business owner.
SEP-IRA
A SEP-IRA is a traditional account that only allows contributions from the employer. If you own a business, your business can contribute to the account on your behalf, and that money grows tax-deferred. However, you can only contribute 25% of an employee’s compensation or $69,000 (whichever is less). SEPs can become more complex if you have employees. This is because whatever you do for one employee, you must do for all employees (as long as they meet certain criteria). So if you contribute 25% of your salary, you must also contribute 25% of all eligible employees. One of the other things this account lacks is the ability to have a Roth account. Several different accounts we will discuss will also allow you to contribute to a Roth account under the same plan. A SEP does not have this feature. However, a SEP is also straightforward to set up and manage, so this can be a good option for small businesses wanting to start somewhere.
Solo 401(k)
While a solo 401(k) has some similarities to a SEP, there are some very notable differences. First, a Solo 401(k) allows contributions from both the employer and the employee. In the case of a Solo 401(k), you would be wearing both hats: the employer and the employee. When you contribute money as an employee, you can contribute up to 100% of earned income, up to $23,000 in 2024. While you may think this is lower than the SEP IRA, this doesn’t include contributions as the employer. Since you are both in the case of a Solo 401(k), you are also able to contribute (as the employer) up to 25% of your compensation. With both of these together, you can contribute significantly more money into these accounts than a SEP (which only allows you to contribute 25% of your compensation, without any employee contributions). One of the other perks is that a Solo 401(k) also allows you to contribute to a Roth account. If there are years when your income is lower, this may be a good option since your overall tax rate may be lower than in other years when you earn more. Deferring taxes may not make the most sense in those years. There is one stipulation with this account. As the name would imply, you can’t have a “Solo” 401(k) if you have employees that would qualify under ERISA guidelines (21 years old, have one year of service, and work 1,000+ hours per year), because everyone would need access to the plan as well as the employer match.
Taxable Account
Sometimes your options are limited. If you have full-time employees, your retirement savings options are confined to whatever benefits your employees can access. A type of “last resort” is a taxable account. This isn’t to say that you should only contribute to a taxable account if you have no other options, but rather using a taxable account as one of your primary savings vehicles for retirement is a last resort. Why? Because there are no specific tax advantages contained in these kinds of accounts. The funds you contribute are post-income tax, and the account does not grow tax-free but is subject to capital gains taxation. However, a couple of benefits to this account don’t exist in the others.
However, before we talk about those benefits, let's define exactly what capital gains taxation is. Capital gains tax applies to assets that are sold at an increase in value. So for example, if I purchase a stock at $10 and sell it when it is worth $15, I will owe a tax on the increase of $5. There are two kinds of capital gains taxes: short-term and long-term. Short-term gains are taxed according to your regular income tax bracket. However, long-term capital gains are taxed at a 15% tax rate. So what determines one from the other? Long-term capital gains are applied to assets that are held for over a year, whereas short-term is applied to assets held for less than. Another important note is that you may not owe long-term capital gains taxes at all if you make under a certain threshold of income. If you are single, that threshold is $47,025, and if you are married that number is $89,250.
The first (and arguably the biggest) benefit to these accounts is that there are no penalties for accessing the funds early. The funds are usually pretty liquid and accessing the funds only opens you up to capital gains tax, if it even applies to you. This means that these accounts are a good option for storing capital for pre-retirement goals.
Even if you are in a position where you may have to pay capital gains tax, there is a way to limit the exposure: tax loss harvesting. When you sell positions for a profit, you can offset those gains with other positions you may have sold with a profit (with exceptions). The way this is accomplished is by utilizing something called “direct indexing”. While index funds are funds that track a particular benchmark, and usually consist of hundreds of companies, direct indexing is replicating the companies represented in an index fund, but purchasing them all individually in small, fractional amounts. Even though an entire index may be up, many companies may individually be down. This allows you to sell those positions at a loss and replace that position with a similar one with specific rules. This allows someone to defer their capital gains further into the future.
Conclusion
It’s difficult for business owners, especially those who are still in the trenches of building something successful, to even think about saving for goals that might be 20, 30, or 40 years in the future. But one of the biggest advantages someone can have, especially when it comes to investing for retirement, is time. The more time you can spend setting aside money, the less money you will have to set aside overall. The idea here is to give an overview of what some options might be depending on your situation.