How To Plan For Retirement When You Are Self-Employed
Retirement planning is critical for lifelong financial stability. Preparing well for the golden years of your life ensures a comfortable future when you are no longer actively working and earning. One of the most common ways to prepare for retirement is by investing in employer-sponsored retirement plans, such as the 401(k) retirement account. The account offers tax advantages, employer matches, convenience, and ease of investing, among other benefits. However, it can only be used by employees of a company. This leaves entrepreneurs and self-employed people on their own. While many employees benefit from employer-sponsored retirement plans, self-employed individuals have the responsibility of creating their own retirement plans.
A financial advisor can help you understand how to save for retirement as a self-employed person. This article also guides you in choosing the best self-employed retirement plans suitable for you to help you secure your finances in your non-working years.
Step 1: Understand your retirement needs
The first step in retirement planning is to evaluate your desired lifestyle and estimate your future financial needs. Everyone’s needs can differ, and you may have unique financial goals and responsibilities, such as buying a home, paying for your children’s higher education expenses, or securing your retirement financially. Make sure you understand your goals well so you can plan accordingly. It also helps to set specific retirement goals. Having clear goals helps guide your retirement planning and allows you to track your progress over time.
Here are some key factors to consider:
1. Think about your lifestyle and expenses in retirement
Start by evaluating the lifestyle you desire during retirement. Think about where you want to live, your daily routine, etc. This will help you estimate your expected expenses in retirement. You must consider factors such as housing, healthcare, taxes, travel, hobbies, and daily living costs, among other things.
2. Have a rough idea of the age at which you wish to retire
It is essential to have an idea of the approximate age at which you plan to retire. This can help you estimate the number of years you need to save for and the duration of your retirement. You must estimate your life expectancy to determine how long your retirement savings need to last. For instance, if you retire at 60, you must account for at least 20 to 30 years of retirement. Additionally, consider your health, family history, and lifestyle factors like smoking, drinking, etc., to determine the duration of your retirement.
3. Evaluate your income sources in retirement
Assess your potential income sources in retirement, such as pension plans, Social Security benefits, investment returns, and other savings. Calculate the expected income from each source to understand your financial standing.
4. Account for inflation
Inflation affects the purchasing power of your money. Therefore, it is essential to consider the impact of inflation on your retirement savings. You must invest in plans that can deliver inflation-beating returns and adjust your portfolio from time to time accordingly.
5. Make a plan for healthcare expenses
Healthcare costs tend to increase with age. The older you are, the more you may spend on prescription drugs, insurance premiums, long-term care, and other similar things. Remember to save enough for your healthcare needs, as they will account for most of your expenses in retirement.
6. Clear any debt and financial obligations
Outstanding debts, such as mortgages or loans, credit card dues, etc., can harm your long-term financial security. High-interest debt can eat into your retirement savings and interfere with your other financial goals. Therefore, ensure you do not carry any debt into retirement. Preparing for unexpected expenses with an emergency fund is essential to avoid falling into a debt trap in retirement.
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Step 2: Choose a suitable retirement plan
Now that you have a general roadmap of what your retirement looks like, it is time to look for suitable instruments that can get you to your goals.
Here are some retirement options for self-employed individuals to consider:
1. A solo 401(k) retirement account
A solo 401(k) is a tax-advantaged plan that helps you save for retirement. Also known as a self-employed 401(k), the account can be used by self-employed individuals, small business owners with no employees except for their spouse, and independent contractors. Freelancers can also apply for a solo 401(k) and save for their future financial needs. Similar to the 401(k), the solo 401(k) offers flexibility, ease of investment, high contribution limits, etc., to help you build your retirement nest egg. You can also take a loan from your solo 401(k).
You can open a solo 401(k) at any broker online or offline. The process is simple and straightforward and does not take much time. Solo 401(k)s offer two options – traditional and Roth. The former allows you to contribute your pre-tax dollars and your withdrawals are taxed in retirement. Contrarily, the Roth 401(k) lets you contribute your after-tax dollars, and you pay zero tax on your withdrawals. Withdrawals from a solo 401(k) may incur a 10% penalty if withdrawn before the age of 59.5 years.
The solo 401(k) has annual contribution limits set by the Internal Revenue Service (IRS). For 2023, the maximum contribution is $ $22,500 or $30,000 (catch-up contribution of $7,500) if you are 50 or older. These limits may change every year, subject to the prevailing provisions. You can contribute to your Solo 401(k) as both the employer and the employee. You can contribute up to $66,000 in 2023 as both employer and employee or 25% of your adjusted gross income (AGI), whichever is lower.
2. A SEP IRA
A SEP IRA (Simplified Employee Pension Individual Retirement Account) is perhaps the best IRA for self-employed people. It can be used by self-employed individuals and small business owners. Unlike the solo 401(k), it can also be used by owners of businesses with employees. However, the contribution limits are the same, i.e., $66,000 for 2023, and your total contribution should not be more than 25% of your adjusted net income for the concerned year. Having said that, the SEP IRA does not have any additional catch-up contributions for people aged 50 and above.
A SEP IRA is taxed in the same manner as a traditional IRA. This means the contributions grow tax-deferred until withdrawal, and withdrawals from a SEP IRA made in retirement are taxed as ordinary income. In addition to this, any withdrawals that you make before the age of 59.5 years are levied a 10% penalty.
SEP IRAs are relatively easy to establish and administer. There are no complex reporting requirements or annual filings with the IRS. But it is still important to consult with a financial advisor to understand the specific rules and conditions of SEP IRAs and determine if it is the right retirement plan for you.
3. A Traditional or Roth IRA
Other than a SEP IRA, you can also opt for a traditional or Roth IRA. A traditional IRA allows you to contribute pre-tax dollars, which lowers your taxable income in the year of contribution. The contributions and any earnings grow tax-deferred until withdrawals are made during retirement. However, when you withdraw funds from a traditional IRA, your distributions are subject to ordinary income tax based on the tax bracket you fall into at that time. Additionally, you also pay a 10% penalty on withdrawals made before the age of 59.5 years. Traditional IRAs are subject to Required Minimum Distributions (RMDs) from the age of 73 as of 2023. However, the age is projected to increase to 75 by 2033.
A Roth IRA, on the other hand, is funded with after-tax dollars. Contributions to a Roth IRA are not tax-deductible, but qualified withdrawals made after the age of 59.5 years in retirement are tax-free, including the earnings on those contributions. You must fall within the income limits to be eligible to contribute to a Roth IRA. Unlike traditional IRAs, Roth IRAs are not subject to Required Minimum Distributions (RMDs) and offer potential tax-free growth for life. You can also leave the funds from the account as an inheritance for your loved ones, as you are not mandated to take out your savings at any time.
Traditional and Roth IRAs can offer unique benefits. You can choose one depending on your current and future tax situation, time horizon, and financial goals. If you want immediate tax deductions and anticipate being in a lower tax bracket in retirement, a traditional IRA may be more suitable. But a Roth IRA may be more advantageous if you wish to have tax-free withdrawals in retirement. A financial advisor can help you evaluate your specific circumstances and determine the best IRA for self-employed people.
4. A SIMPLE IRA
A SIMPLE IRA (Savings Incentive Match Plan for Employees) is another retirement savings plan that can be used by self-employed people. It is specifically designed for small businesses with up to 100 employees. It offers an easy and affordable way for employers to provide retirement benefits to their employees while also allowing employees to contribute to their own retirement savings.
The employer can choose to match employee contributions dollar-for-dollar up to 3% of the employee compensation or make a non-elective contribution of 2% of each eligible employee’s salary. There is an annual limit set by the IRS for employee contributions, subject to change every year. For 2023, employees can contribute up to $15,500 ($19,000 for those aged 50 or older) or 100% of their compensation, whichever is less. To be eligible to participate in the plan, employees should have received at least $5,000 in compensation during any two preceding years and are expected to earn at least $5,000 in the current year.
The SIMPLE IRA offers relatively lower contribution limits than other accounts. However, it does provide more tax benefits. For instance, under the Setting Every Community Up for Retirement Enhancement (SECURE) Act of 2019, you can get a maximum tax credit of $500 per year as an employer if you have a SIMPLE IRA plan with automatic enrollment.
The importance of retirement planning for self-employed individuals
Creating a stable source of self-employed pensions is crucial for all self-employed individuals. This can only be done by sound retirement planning. Unlike employees who may have access to employer-sponsored retirement plans, regular and consistent salaries, and job security, self-employed individuals may lead relatively uncertain lives. As a self-employed individual, you are solely responsible for building your own retirement savings.
Self-employed individuals do not have the benefit of employer-sponsored retirement plans such as 401(k)s, employer-provided health insurance benefits, and other pensions. Moreover, self-employment often comes with fluctuating income streams. You may notice income inconsistencies throughout your life. Retirement planning can smooth this out and help you follow a systematic approach to saving for retirement, irrespective of your current income. Retirement planning ensures financial security during your post-work years and enables you to maintain your desired lifestyle when you no longer have a regular income source.
A well-planned retirement allows you to achieve financial independence so you do not have to work in your later years and can enjoy the flexibility to pursue your personal interests or spend time with loved ones. It helps you accumulate wealth over time. By consistently saving and investing, you can leverage the power of compounding and potentially grow your retirement nest egg. Contributions to retirement plans for self-employed, such as the SEP IRA, Solo 401(k), or SIMPLE IRA, also offer tax advantages, reducing your current and future taxability.
Having a well-thought-out retirement plan can allow you to focus on your professional and personal goals. Therefore, remember to take proactive steps to save and invest for retirement.
To conclude
It is important for self-employed people to understand the rules and requirements of all retirement accounts and then select one that serves your purpose the best. Remember to review their contribution limits, tax benefits, withdrawal rules, and eligibility to determine the best option for your needs. No matter what you choose, it is highly recommended to be consistent with your contributions and save regularly. While your income may fluctuate from time to time, try to be as linear in your savings as possible. It can be tough for self-employed individuals to plan for retirement effectively. Consider consulting with a financial advisor or retirement planning professional to get personalized guidance and help determine the most appropriate retirement savings vehicle.
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