Daily Gains Letter

Three Easy Ways to Save for Retirement if You’re Self-Employed

By for Daily Gains Letter |

DL_John_310113Many dream about being self-employed; being their own boss, and making their own hours. But, being self-employed also means being responsible for your own retirement savings. Unfortunately, many self-employed Americans seem to have forgotten this or have maybe simply chosen to ignore it until a later date.

That could be a costly mistake.

At present, only 50% of the U.S. workforce is covered by an employer-sponsored pension plan, unchanged over the last three decades. Furthermore, 71% of small businesses with fewer than 25 workers do not sponsor a retirement plan. (Source: Lichtenstein, J., “Financial Viability and Retirement Assets: A Look at Small Business Owners and Private Sector Workers,” U.S. Small Business Administration web site, December 2012, last accessed January 30, 2013.)

More alarming is the fact that there are over nine million self-employed individuals without retirement plan coverage. (Source: Copeland, C., “Employment-Based Retirement Plan Participation: Geographic Differences and Trends, 2011,” Employee Benefit Research Institute Issue Brief 378, November 2012.)

This low level of involvement is not because there is a lack of self-employment retirement options. Quite the opposite. Despite the wide variety of options available for the self-employed, only a small percentage actually has a retirement plan. And a large number of those who are unprepared are actually on the cusp of retirement. Less than two percent of small business owners own a Keogh plan (retirement plan for self-employed individuals); only about 18% of business owners participated in a 401(k)/Thrift plan. (Source: Lichtenstein, J., “Saving for Retirement: A Look at Small Business Owners,” U.S. Small Business Administration web site, March 2010, last accessed January 30, 2013.)

What follows are three easy retirement plans that self-employed Americans can take advantage of.

1. Individual 401(k)

Similar to 401(k) plans offered by large companies, individual 401(k) plans are designed for those who are self-employed and have no employees (other than a spouse). Not designated just for those self-employed full-time, individual 401(k)s can be opened up if you have a regular job and are self-employed on the side.

Being self-employed means you are both the employer and the employee; therefore, you can contribute to an Individual 401(k) in two different ways. As an employee, the annual contribution limit in 2012 was $17,000. If you’re 50 or older, you can top it off with an additional $5,500—for a 2012 total of $22,500.

There are two different types of individual 401(k)s: traditional and Roth. One of the advantages of a traditional individual 401 (k) is its flexibility; there is no forced payment schedule. The retirement savings in an individual 401(k) are deposited on a pre-tax basis and aren’t taxed until the money is withdrawn.

One of the biggest differences with a Roth 401(k) is that your deposits are made after paying taxes—and your retirement savings grow tax-free.

2. SEP IRA

A Simplified Employee Pension Individual Retirement Arrangement (SEP IRA) is, in a nut shell, a pension plan funded by the employer. You can contribute up to 25% of your net self-employment income. In 2012, the maximum was $50,000. Employers of any size are eligible for this plan, and contributions are deductible as a business expense.

SEP IRAs are best suited for a one-person business or a small business with only a few employees; it is especially suited for those who want save a significant amount of money in a way that is inexpensive, flexible, and easy to maintain.

3. Keogh Plan

A little less popular and a little more complicated (though equally as effective), is the tax-deferred pension plan for self-employed individuals, or the Keogh plan. Just like an SEP IRA or individual 401(k), a Keogh is a private retirement plan that is meant to supplement your pension and Social Security incomes.

However, unlike SEP IRAs and individual 401(k)s, Keoghs are only for those self-employed individuals who have incorporated their business—even if it is just part-time.

There are some restrictions. Income earned overseas is not considered self-employment income. If you are an inactive owner in a business you cannot contribute to a Keogh plan. And, if you run more than one business, you need to set up a Keogh plan for each—and you have to contribute to all of them.

Why consider a Keogh if it’s more complicated and has restrictions? Contributions to Keogh retirement plans are tax-deferred, meaning that your earnings grow tax-free until withdrawn. But the main benefit of a Keogh plan, however, is that it has higher contribution limits; it is best suited for high income earners.

If a Keogh is your sole retirement plan, your annual contribution limit for 2012 was $50,000 or 100% of eligible compensation, whichever is less. In 2013, the limit has increased to $51,000 or 25% of your eligible annual compensation, whichever is less. While that extra $1,000 contribution a year may not seem like much, when compared to the SEP IRA, that $1,000 will compound and add up over time.

There are a wide variety of retirement plans available for those self-employed Americans who are looking to enter their golden years in comfort. Unfortunately, few seem to be taking advantage of these options. This seems counter intuitive. If anything, one would think entrepreneurial, self-employed individuals would be more forward-thinking when it comes to retirement.

To be successful in business you need to be proactive, not reactive. The same can be said about saving for retirement.

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