- Start ASAP and you will need to contribute less.
- Schedule automatic savings to stay committed.
- A Roth IRA can be a great option if you’re just getting rolling.
- A SEP-IRA is just as easy to set up, and you may be able to save a lot more than what is allowed with a Roth IRA.
Leaving the traditional work construct of being an employee sure seems to be a mood enhancer.
A 2021 survey of folks who were working full-time as their own boss reported that nearly 9 in 10 say they are happier working on their own and nearly 8 in 10 feel they are healthier.
Of course, as anyone who has embraced the perma-gig life can attest there are plenty of challenges being the boss of you. “You basically have to be your own C-suite,” notes Catherine Collinson, president of the Transamerica Center for Retirement Studies (TCRS). In addition to being your own CEO, COO and CFO, you’ve signed on to be head of retirement benefits as well.
And that seems to be a tripping point for many. A survey a few years ago by the TCRS reported that while the estimated median household income for self-employed workers was a solid $72,000, just 55% of folks reported consistently saving for retirement. Another 30% said they saved from time to time, and 15% copped to not having any retirement savings set up.
Whether you’re a veteran of the self-employed life who wants to up your retirement savings game, or you’re part of the recent Great Resignation wave that is embracing the gig life for the first time, acing self-employed retirement planning 101 does not require eons of time.
We’ve got you covered in four (fairly) painless steps to set up your own retirement account.
Step 1: Start now. Not next year, or the year after.
It’s perfectly rational for anyone in their 20s or 30s to think they’ve got time to deal with this later. But starting to save now makes the whole chore a lot easier and less expensive.
Compound growth is the secret sauce of retirement saving. A dollar you save today has more time to grow than a dollar you save later.
Let’s say you’re 35 years old and you commit to saving $500 a month for the next 30 years. That’s $180,000 of your own hard-earned income you’re setting aside over the entire 30 years. The payoff is that if we assume a 6% annualized rate of return—that’s neither aggressive nor conservative based on historical returns for stocks and bonds—you will end up with more than $500,000. Not bad, eh?
But let’s say you keep putting it off, and you don’t start seriously saving for retirement until you are 45. To get to 65 with the same $500,000+, you will need to save $1,085 a month. That adds up to $260,000—$80,000 more than if you started earlier—of your own money to land at the same ending balance. All because you have 10 fewer years to let compound growth do more of the heaving lifting for your retirement.
Tip: Short on emergency savings? Financial advisor Dan Hawley in Walnut Creek, California, recommends making it priority No. 1 to build up an emergency savings fund that can cover at least six months of living costs. “Your life will change once you have that set aside. When there’s no fear, you open yourself up to being creative, which can be important when you’re self-employed.” No arguing with that. But if you’re itching to get rolling on retirement too, that’s fine: Calibrate your savings so you can contribute to both.
Step 2: Commit to consistency
Just like making rent, or making the mortgage payment, you need to commit to saving on a consistent basis, even if your cash flow is inconsistent.
“It’s natural to have peaks and valleys in your income when you’re self-employed,” Collinson acknowledges. “But the key is to have a system where you always save. In boom years you can save more, and in years where you are making less you can save less.”
Your first task is to decide how much you want to save each year. Research suggests that if you’re getting rolling in your 20s you want to set aside 10% of your income each year. Getting a later start? Aim for 15%.
Sure, you don’t know exactly what you’re going to make in a year, but you likely have a pretty good sense of what it might be at the low end. So aim for 10% to 15% of that. If business is better, you can adjust it higher as the year progresses.
It’s up to you how often you will send money from your checking accounts to a retirement account. You might find it most palatable to break it down into smaller, more frequent sums.
A team of academics ran a field experiment a few years ago where they asked nearly 9,000 gig workers who agreed to sign up for a retirement savings account if they wanted to save $5 a day, $35 a week or $150 a month. Those three options add up to exactly the same dollar commitment. But what the researchers found is that more participants were most comfortable saving $5 a day.
If that approach appeals, open a savings account at the same bank where you have your checking account (you can do this in minutes online) and set up an automatic daily transfer of whatever feels right. Then once a month, or once a quarter, you can zap the money in this account over to your retirement investment account (more on this in the next step).
Step 3: Get a tax break for your retirement savings
The three most common retirement plans with valuable tax breaks for self-employed workers are a traditional Individual Retirement Account (IRA), a Roth IRA and a Simplified Employee Pension IRA (SEP-IRA).
Tip: You can set up any of these retirement accounts in minutes, online at a discount brokerage, such as Fidelity, Schwab, TD Ameritrade or Vanguard, but you’ll also need to decide how to invest the money in your accounts. Other options are robo-advisors such as Betterment, SoFi and Wealthfront, which will handle the investment decisions for you.
With all three, the money you invest grows without any tax due. But the federal government (and potentially your state as well) insists on collecting tax once—either right when you make a contribution, or later when you are retired and withdrawing money from the account.
A quick spin through essential details:
Traditional Individual Retirement Account (IRA). In 2022 you can contribute up to $6,000 ($7,000 if you’re at least 50). You get a tax break when you contribute: The amount of your contribution is deducted from your income for that year. For example, if you have $70,000 in income and contribute $6,000 to a traditional IRA, your federal taxable income for the year drops to $63,000, which effectively will reduce your tax bill. You pay your tax later: Every dollar you withdraw from a traditional IRA is taxed as ordinary income.
Tip: Self-employed workers married to someone who is covered by a retirement plan at work: You can deduct the full amount of your contribution to a traditional IRA only if you report joint modified gross income below $204,000 in 2022.
Roth IRA. Your tax break comes later. The money you contribute this year is from “after-tax” money. (Translation, it’s money that gets counted as income in the year you make a contribution.) But in retirement, when you withdraw money there will be zero tax due.
Roth IRA contribution limits are the same $6,000/$7,000 a year as with the traditional IRA. But there’s a catch: You need to have modified adjusted gross income below $129,000 if you’re single, and $204,000 if you’re married filing a joint federal tax return, to save that much in a Roth IRA.
SEP-IRA. In terms of taxes, this works just like a traditional IRA: You get an upfront tax break, but every dollar withdrawn in retirement will be hit with income tax. There is no Roth version of a SEP.
The main advantage of a SEP-IRA is that you may be able to save more than $6,000/$7,000. In 2022 any self-employed individual can contribute up to 25% of their net earnings, with a maximum contribution of $61,000.
Tip: If you have a SEP-IRA and hire employees who are at least 21 years old, you must fund a SEP-IRA for them as well (at the same percentage contribution you made to your own account) if they have worked for you in at least three of the past five years.
OK, we’re done with the down-in-the weeds explanations. Now let’s cut to the chase: which type of account is best.
The short answer: It depends. That’s not a cop-out. “The right one each year depends on your income and your tax situation,” says Beau Henderson, a retirement planning specialist at RichLife Advisors in Gainesville, Georgia. “You might do a Roth IRA one year and another year a SEP-IRA makes the most sense.”
A decision tree you might consider:
Planning to save no more than $6,000 this year (or $7,000 if you’re at least 50) and you are in a low federal income tax bracket? “A Roth IRA makes sense since you wouldn’t get much benefit from making a tax-deductible contribution to a traditional IRA,” says Henderson.
Planning to save no more than $6,000 (or $7,000 if you’re at least 50) and you are in a high federal tax bracket? A traditional IRA might be best.
Planning to save more than $6,000/$7,000? This is where a SEP-IRA comes into play, assuming that 25% of your net earnings will be more than $6,000.
Tip: While a SEP-IRA doesn’t have a Roth option, some brokerages—including TD Ameritrade and Vanguard—offer Roth Solo 401(k)s for self-employed workers.
Step 4: Save automatically
Once you decide on the account(s) you want to contribute to for a given year, set up automatic transfers from your checking account straight into your retirement account. It’s a free service provided by the firm that handles your retirement accounts. Nor will your bank charge for the transfer out.
Polish off those four key steps and you should take a bow. You’ve set yourself up to start building the savings that will land you in retirement with the money you want to live the life you deserve.