Unlike many employees, self-employed individuals do not have access to an employer-sponsored retirement plan. Understanding your options will help you save enough to retire comfortably.
Types of Self-Employed Retirement Plans
The self-employed have several retirement plan options, many of which allow a self-employed retirement deduction.
Options available to the self-employed include:
- Traditional IRA. Anyone can open a traditional Individual Retirement Account (IRA). The money contributed gives a tax deduction that reduces Adjusted Gross Income (AGI). While quite easy to set up, traditional IRAs have contribution limits. You must contribute by your individual tax return deadline, which generally falls on April 15. Note that you can lose the deduction if you or your spouse has a retirement account through an employer and your income exceeds specific limits. Distributions taken after retirement age—59 ½—count as ordinary income for tax purposes. Early distributions usually incur an additional 10% tax penalty.
- Roth IRA. Roth IRAs act almost the opposite of Traditional IRAs. Roth IRA contributions generate no tax deduction—and therefore have no deadline. However, distributions do not count as income—meaning investments in a Roth IRA grow tax-free. Roth IRAs share the contribution limit with traditional IRAs—contributing to one will reduce the remaining yearly limit of the other. Income limits also apply to Roth IRA contributions.
- SEP IRA. Simplified Employee Pension (SEP) IRAs function similarly to traditional IRAs but enjoy much higher contribution limits. Any business or self-employed individual can set up a SEP IRA, which requires minimal paperwork but some planning. Businesses must make contributions for all employees at a fixed percentage of pay. The IRS defines net self-employment earnings as your net profit minus the SEP IRA contribution and half of self-employment taxes.
- SIMPLE IRA. Self-employed individuals and small businesses with 100 or fewer employees can set up a Savings Incentive Match Plan for Employees (SIMPLE) IRA. SIMPLE IRAs require some paperwork and planning but work like traditional IRAs in many respects. Unlike a SEP IRA, your employees directly contribute up to the annual maximum. However, business owners must make matching contributions.
- Solo 401(k). Only self-employed individuals and business owners with no employees—excluding spouses—may use a Solo 401(k). In tax terms, a traditional Solo 401(k) functions like a traditional IRA while a Roth Solo 401(k) works like a Roth IRA. However, a Solo 401(k) has substantially higher contribution limits, subject to limits based on income. Solo 401(k)s require significant planning and some ongoing paperwork with the IRS.
- Other Plans. Other options include profit-sharing plans, money purchase plans, and defined benefit plans. All offer significant potential tax savings but entail a very high compliance burden. For instance, a defined benefit plan means setting up a pension for yourself, including annual filing requirements.
How to Choose a Self-Employed Retirement Plan
Many people have experience with traditional IRAs, but they have lower contribution limits than other options. However, if this doesn't matter—or you don't have time to set up something more complex before the contribution deadline—consider a traditional IRA contribution.
Despite the low contribution limit, Roth IRAs allow for tax-free growth—a great option for those with many years before retirement.
SIMPLE IRAs work well for small and medium businesses with employees. If you don't have employees, other options likely make more sense.
Businesses with few employees often opt for SEP IRAs but remember you must contribute the same percentage of pay for all employees.
Solo 401(k)s and SEP IRAs both offer high contribution limits for self-employed individuals with no employees. Solo 401(k)s offer a Roth option, while SEP IRAs require less paperwork.
How to Claim the Self-Employed Retirement Deduction
The self-employed retirement deduction goes on line 16 of Schedule 1, Additional Income and Adjustments to Income of Form 1040 for SEP IRAs, SIMPLE IRAs, and Solo 401(k)s. Traditional IRAs use line 20 of the same schedule. Roth IRAs do not create a deduction.