Financial Planning for the Self-Employed
Entrepreneurs and independent contractors tend to be a proactive bunch. However, they can sometimes neglect seemingly mundane administrative tasks, such as setting up a retirement plan or getting the right kinds of insurance coverage. Those items may not be passion points, but they’re vital to long-term security.
Being the steward of your own financial fate isn’t easy, but it isn’t rocket science, either. In fact, it boils down to a few basics:
Rob Williams, managing director of financial planning, retirement income, and wealth management at the Schwab Center for Financial Research, says the self-employed should do the same thing all workers should: Start saving for retirement today. “If you can’t save a lot, save a little,” Rob says. “The most important thing is to save regularly.”
This can be especially challenging if you’re self-employed and have highly variable income. One solution is to put away a portion of the windfall you receive—for example, a bonus on a consulting contract or an unexpected tax refund—straight toward retirement. Another approach is to treat your retirement like any other recurring expense: Cut a check for a set amount on the same date each month.
“Employers spend considerable effort helping their employees make forward-thinking financial decisions, like automatically enrolling them in the company 401(k) plan,” Rob says. “When you’re self-employed, it helps to create those kinds of behavioral reinforcements for yourself.”
Four retirement plans for the self employed
Whether you’re a small-business owner or a full-time freelancer, you can find a plan to fit your income and retirement goals. You’ll want to weigh the pros and cons regarding contribution limits,1 tax considerations, and employing others, and then discuss the finer points with a tax professional before deciding what’s best for your situation.
As the name implies, Individual 401(k)s work much like the 401(k) plans employers offer. The difference is that the individual is considered both the employee and the employer and can contribute more as a result.
As an employee, you can put away up to $19,500 a year—plus an additional $6,500 if you’re over age 50 (a so-called catch-up contribution). As an employer, you can also contribute as much as 25% of your salary, but your combined maximum tax-advantaged contribution (X% of your salary + $19,500 + $6,500 catch-up contribution) is limited to $58,000 a year.
Individual 401(k)s are generally best if you’re self-employed and working alone. If you have employees, your own retirement contributions are limited by how much you set aside for your workers.
The setup and administration of a SIMPLE IRA lives up to its acronym (if not its official name, Savings Incentive Match Plan for Employees Individual Retirement Account). This is an easy way for a small-business owner to set up a retirement plan that can be used to match employee contributions dollar-for-dollar up to 3%. Alternatively, you could make a 2% minimum contribution to each employee earning at least $5,000 a year.
A SIMPLE IRA is most appropriate for small businesses with up to 100 employees. That said, employee contribution limits are relatively low ($13,500 a year, plus another $3,000 in catch-up contributions for those age 50 and over); you’re required to make contributions every year; and penalties may be more severe for withdrawals from SIMPLE IRAs before age 59½ than those for 401(k)s or SEP IRAs.1
A Simplified Employee Pension Individual Retirement Arrangement (SEP IRA) is easy to set up, and the tax-advantaged contribution limit is the lesser of 25% of your earnings (20% if you’re self-employed) or $58,000 a year. You’re not required to contribute to a SEP IRA every year, which can be helpful if you happen to hit a dry patch. However, if you’re using a SEP IRA to provide employees with retirement benefits, only the employer can contribute; there’s no provision for employee contributions.
Personal Defined Benefit Plan
Although somewhat anachronistic, it’s possible to set up a defined benefit pension plan. This option entails higher administrative costs and greater responsibilities, but it can be a boon to older, self-employed workers with a stable cash flow who want to contribute considerable sums toward retirement.
You set the benefit you want in retirement—up to $230,000 a year—and then hire an actuary to determine your annual contributions based on age and expected investment returns. However, unlike Individual 401(k)s, which give the self-employed the flexibility to contribute more in a good year and less in a bad year, a Personal Defined Benefit Plan establishes a set schedule of predetermined contributions.
Self-employed workers typically buy health insurance because the consequences of not doing so can be catastrophic. However, they’re less likely to look down the road and consider disability or long-term-care coverage.
“The cost of disability insurance varies greatly, depending on your chosen profession, age, and income,” Rob says. “But while the expense can be quite high for, say, an older surgeon making high six figures, less lofty policies can be had for far more reasonable rates.” You also want to assess the pros and cons of either pre-tax or after-tax disability insurance premium payments.
Depending on your type of work, you may also want to consider general liability insurance, which protects your business from claims, including personal injury, bodily injury, property damage, and other liabilities. Additionally, if you own commercial property, you may consider bundling the insurance plans into a comprehensive Business Owner’s policy.
All of this coverage can add up. However, it helps that most business and health insurance premiums are deductible. Even Medicare and Medigap insurance for self-employed workers 65 and older are tax-deductible up to earned income. For more information, see IRS Publication 535.
“I’ve found that those just starting out, in particular, are hesitant about hiring other professionals to help with insurance, retirement, and even taxes,” Rob notes. “But it’s usually better to put your time into what you know—building your business—and find an expert to handle company benefits. Just because you’ve finally hung out your own shingle, doesn’t mean you need to do all the legwork yourself.”
1Contribution limits pertain to the 2021 tax year.
2Early withdrawals from 401(k)s and SEP IRAs are subject to income tax and a 10% penalty. Early withdrawals from SIMPLE IRAs are also subject to income tax and a 10% penalty—unless the withdrawal is made within the first two years of participation in the plan, in which case the penalty is 25%.