A lot of self-employed people forgo the stability & security of a "regular" job for the freedom of being able to follow your dreams and do things your own way. But, as Spiderman's uncle Ben famously pointed out, with great power comes great responsibility. Charting your own path means both building a business from scratch (even if you're a freelancer) and finding your own solutions for the workplace benefits that employers often provide, like health insurance, paid time off, and, of course, retirement plans.
A previous blog post shared how you can use investments as ballast to balance out income ups & downs for tax purposes. This one is in the same vein, but with potentially a lot more juice behind it. If you are self-employed in any way – whether you're a freelancer receiving a 1099, a sole proprietor, an LLC member, or an S-Corp shareholder – you can use employer-sponsored retirement plans (in which you are both employer and employee) to save a ton of money for the future while also reducing your tax bill.
Here's the overview: employee contributions (when allowed) reduce your personal income for the year, while employer contributions are treated as expenses and therefore reduce the amount of flow-through profit that hits your tax return. In other words, self-employed retirement accounts allow you to transfer current year business profits to yourself without incurring current year income taxes. (You will owe ordinary income taxes on distributions in retirement, but that's the trade-off for getting a current year tax break.)
We'll look at two types of retirement plans today: SEP IRAs and 401(k)s. If you have a one-person business, you can own all the same stuff in these accounts as in any other investment account. If you have multiple employees, the rules about which investments can be offered are a little more complicated, but you can still have a diversified portfolio balanced appropriately for your risk tolerance and time horizon. (There's another type of retirement plan for small businesses called a SIMPLE IRA, but it's honestly way more complicated & limited in what you can contribute, so let's ixnay that one.)
SEP IRA – the Simplified Employee Pension Individual Retirement Account, or SEP IRA, is not a pension at all. It's basically the exact same thing as an IRA except that 1) only employers can contribute (so no employee portion) and 2) the maximum contribution limit is based on total compensation and not a fixed dollar amount. If you're an S-Corp shareholder, the maximum annual contribution is 25% of your payroll compensation. The maximum contribution for sole proprietors and LLC members is a little different and works out to 18.59% of your share of total profits. (I'd be happy to share that math if you're curious, but it's honestly super wonky.) One important thing to note is that everyone covered in a SEP IRA program needs to receive the same percentage contribution, so a business owner with multiple employees needs to be as generous with employees as they are for themselves. Also, SEP IRAs do not offer catch-up contributions for people over age 50.
401(k) – Yes, it's true: a self-employed person can open a 401(k), usually called a Solo 401(k) or Individual 401(k), in which you are both employer and employee. Unlike SEP IRAs, 401(k)s can have contributions from both employer and employee. (Technically employee contributions are called deferrals, but you get the idea.) The maximum employee deferral in 2024 is $23,000 (with an additional $7,500 catch up for people 50+) and the maximum employer contribution is 25% (18.59% for sole proprietors & LLC members) of compensation. You can see how adding both the employee and employer portions could allow you to save a lot more than with a SEP IRA. The pros for a 401(k) are that you can potentially contribute much more money each year. The cons are that it's slightly more complicated than a SEP IRA for a one-person business and much more complicated for businesses with employees. (There are a bunch of rules for businesses with employees to make sure you stay compliant with federal employment law that I don't want to get into here, so if you have questions about that please shoot me an email.)
Let's look at a scenario to compare what you can do with a SEP IRA versus a Solo 401(k). Let's say the sole member of an LLC is under age 50, generates $100,000 in profit during 2024, and wants to save as much as possible for retirement. With a SEP IRA, the maximum employer contribution is $18,590 – not bad! If this person opened a Solo 401(k), though, they could defer $23,000 as employee and contribute an additional $18,590 as employer, for a total of $41,590. In the case of a sole proprietor or LLC member, both employer & employee contributions offset current year income at tax filing time.
(Again, I don't want to get into the math of it here, but it gets a little trickier if you elect to be treated as an S-Corp for tax filing purposes. If that's you and you have questions, please send me a message and we can discuss how it works for S-Corps owners.)
If you think you could benefit from opening a self-employed retirement account, I strongly urge you to start researching your options several months before the end of the year. It takes some time to figure out the best plan type for you and I highly recommend that you open & fund the account with at least $1 before December 31 (even if you plan to contribute more before filing taxes) to firmly establish the plan in this tax year.
Whew, so much information! It can be a complicated topic, so please drop me a line if you have questions. Or if you'd like a live-and-in-person conversation without the pressure of a sales call, sign up for weekly Office Hours.
Thanks,
Timothy Iseler, CFP®
Founder & Lead Advisor
Iseler Financial, LLC | Durham NC | (919) 666-7604
Iseler Financial helps creative professionals remove stress while taking control of their financial lives. We'll help identify current your strengths and weaknesses, clarify and refine your long-term goals, and prioritize decisions to improve your financial well-being now and later. Reach out today to take the first step.
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