The Best Retirement Savings Plans for the Self-Employed

There are a number of good retirement savings plans available to the self-employed. The challenge is in knowing which one may be the best for you.

There are principally four options available, listed here and discussed separately below:

• Self-Employed Pension (SEP, or SEP-IRA).
• Savings Incentive Match Plan for Employees (SIMPLE IRA Plan).
• A One-Participant 401(k), also called Individual 401(k), Solo-401(k), or Uni-401(k).
• A Roth version of the One-Participant 401(k).

Self-Employed Pension (SEP, or SEP-IRA)

A SEP-IRA is a type of Traditional IRA for the self-employed. Unlike a Traditional IRA, which has a reduced contribution limit, a SEP allows for contributions of as much as 25% of your net earnings from self-employment up to a limit established each year. For example, in 2014 the contribution maximum limit is set at $52,000.

SEP-IRAs are available to both the self-employed (eg. freelance workers) and to small business owners with one or more employees. Employees, however, are not able to contribute.

SEP-IRAs are appealing because they are easy and inexpensive to create and administer. Further, you can choose how much to contribute or not contribute each year, from zero to the maximum amount that you qualify for.

Contributions to SEP-IRAs are tax-deductible in the tax year for which they are made. At retirement, withdrawals of contributions and investment income earned within the account are taxed as ordinary income, much like the Traditional IRA and Traditional 401(k).

Savings Incentive Match Plan for Employees (SIMPLE IRA Plan).

Like a SEP-IRA, a SIMPLE IRA is a type of Traditional IRA for owners of small businesses and the self-employed. Unlike SEP-IRAs, SIMPLE IRAs allow employees to make contributions as well.

What makes a SIMPLE IRA stand out from the crowd, even from the Traditional and Roth 401(k), is that the employer is required to make a contribution on behalf of the employee. Further, the employer contribution is required even if the employee makes no contribution of their own.

If the employee makes a contribution, then the employer must make a dollar-for-dollar matching contribution of up to 3% of the employee’s salary. Or, if the employee makes no contribution, the employer must make a contribution equal to 2% of the employee’s pay.

SIMPLE IRAs have higher contribution limits than Individual or Roth IRAs, though lower contribution limits than SEP-IRAs. In 2014, the contribution limit is set at $12,000, with an additional contribution of $2,500 available to those 50 years of age or older.

A SIMPLE IRA can be a good option for a small business owner who wants to offer a retirement plan to future employees without the high cost and administration complexity associated with 401(k) plans. A self-employed person with a SEP-IRA who begins to hire employees faces a number of challenges with continued participation in the SEP-IRA. A self-employed person with a Solo-401(k) who begins to hire employees that aren’t that person’s spouse, must stop funding the Solo-401(k) and convert the plan into the more expensive and complex Traditional 401(k) plan.

A One-Participant 401(k) – (Individual 401(k), Solo-401(k), or Uni-401(k))

The Individual 401(k) works much like the Traditional 401(k), except that it is strictly for the self-employed who have no employees. One exception exists in that the spouse of the self-employed participant can work as an employee and also make contributions within the plan.

An Individual 401(k) allows for a greater annual contribution than either the SEP-IRA or SIMPLE IRA. The participant (i.e. the self-employed individual) is allowed to make two types of contributions, one as the employee and one as the employer. Like the Traditional 401(k), contributions are tax-deductible in the tax year that they relate to and withdrawals made during retirement are taxed as ordinary income (i.e. a tax-deferred retirement account).

As the employee, an annual contribution of up to $17,500 can be made for the tax year 2014. An additional $5,500 can be made if you are 50 or older. As the employer, an additional contribution of up to 25% of your net earnings from self-employment to a maximum limit of $52,000 for the tax year 2014. These contribution amounts are discretionary, meaning you can choose to save up to the maximum in good years or make no contribution at all in a down year.

Another feature of the Individual 401(k) is that it can be set up to allow access to your account balance for certain types of loans as well as for hardship distributions.

An important consideration with an Individual 401(k), something that must be considered with all decisions related to all retirement accounts, is that of the investment options available to the account holder. Corporate 401(k)s can offer a large number of investment options and some offer self-directed investments. Some providers of Individual 401(k)s have a considerably limited number of investment options and others a nearly unlimited number. Be careful in your research and consult an independent financial advisor when appropriate.

A Roth version of the Individual 401(k)

A Roth Individual 401(k) operates nearly the same as the Individual 401(k) except that contributions are made on an after-tax basis and, hence, offer no tax savings in the tax year of the contribution. And like other Roth versions of IRAs and 401(k)s, properly taken withdrawals during retirement are not taxed. See our articles on the differences between Roth and Traditional retirement accounts for more information.

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How to Build Wealth Using Retirement Savings Accounts
What is a Traditional IRA?
What is a Traditional 401(k)?
What is a Roth 401(k)?
What is a Roth IRA?
What is the difference between Traditional and Roth 401(k)s and IRAs?
401(k) rollover options when making a job change

About the Author

Todd E. Frank, CPA/PFS, MBA is the President and CEO of Frank Financial Advisors, a Registered Investment Advisory Firm (RIA) serving clients nationwide from our headquarters in Carlsbad, San Diego, California. As an RIA, Frank Financial Advisors is able to offer truly independent, fee-only financial advisory services.