How to Rock Retirement When You’re Self-Employed

This is a guest-post by personal finance blogger Jim who writes at Blueprint For Financial Prosperity.

With all the talk of Social Security becoming insolvent and our retirements lasting into the 80s and 90s, there’s no question that proper retirement planning is crucial for everyone.

If you have an employer, you probably have some sort of defined contribution plan (401k, 403b) and, if you’re lucky, might even have a defined benefit plan (pension).

If you’re a freelancer, or an aspiring freelancer, you don’t, and won’t, have access to either of those great plans.

So, what’s a freelancer to do?

Luckily America was built on the backs of small business and there are plenty of retirement programs available.

I’ll go through the major ones today so you get a good feel for them and are able to research them further.

For the purposes of today’s discussion, we’ll assume that you’re a sole proprietorship or pass-through LLC entity.

Disclaimer: Before you make any financial decisions of any kind, please consult your accountant or tax attorney first. There may be inaccuracies in this post but I have tried to be as accurate as possible. Just remember, I am not a professional tax attorney or financial adviser, I’m a freelance writer.

Roth and Traditional IRA

You may already be familiar with the Roth and Traditional IRAs as they’ve seen plenty of press lately. Both share the same contribution limits of $5,000 a year, meaning your total contributions to Roth and Traditional IRAs must be less than or equal to $5,000.

If you contribute $1,000 to your Roth, you can only contribute $4,000 to the Traditional. These limits are also based on your earned income, here is a listing of the contribution limits for both IRAs types.

The difference between the two is significant. A Roth IRA takes post-tax dollars but grows tax-free.

The Traditional IRA tax pre-tax dollars but grows tax-deferred. When you contribute $1 to your Traditional IRA, you are able to deduct $1 from your taxes.

As the Traditional IRA grows, you will not be taxed on anything inside it, it’s tax-deferred. When you begin taking disbursements, or payments, in retirement, you will pay your tax rate on those earnings as income.

With a Roth IRA, you do not deduct the contributions in the beginning but you are not taxed on the earnings when you begin taking payments in retirement.

SEP-IRA

A SEP IRA, the retirement plan I use, is a type of Traditional IRA. It was designed specifically for the self employed and small business.

It’s a Traditional IRA from the employee perspective, sharing the $5,000 contribution limit, and contributions are tax deductible.

It gets more interesting from the employer perspective. The 2008 employer contribution limit for a SEP IRA is $46,000 or 25% of your net adjusted self employment income, whichever is smaller.

This means that while you can only contribute $5,000 as an employee, you can contribute far more as an employer.

When you set up a brokerage account to handle a SEP IRA, you will have the opportunity to mark contributions as either employer or employee.

The downsides to the SEP IRA are for those business that have ‘eligible’ employees. An eligible employee is someone who is 21+ years old, has had 3 years of service in the last 5 years, and earned over $450 in compensation.

The amount you contribute as an employer must be the same for all employees. If you say you are contributing 10% of income, you must contribute 10% to each and every employee.

Individual or Solo 401(k)

An Individual 401(k) is very much like a SEP IRA. The difference is that it comes with greater administrative rules but may allow for a bigger contribution and the ability to borrow (much like a regular 401k) against the funds.

The difference between the SEP IRA and Individual 401(k) is in the employee contribution. Participants can contribute, as an employee, 100% of the first $15,500 of compensation, much like the regular 401(k).

Then, the employer can kick in the same 25% SEP IRA calculation – meaning you could contribute more towards your retirement with an Individual 401(k).

Other Plans

There are a lot of retirement plans out there but I feel the Individual 401(k), SEP IRA, and Roth IRA, capture the major pieces of the retirement puzzle for us freelancers.

If you are interested in something like a pension or defined benefit plan, check out the Keogh Plan.

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