Saving for Retirement: Investing in a Roth IRA When You’re Self-Employed

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There are many awesome benefits to working for yourself, but there is one big pitfall compared to being an employee: saving for retirement.

You don’t get the traditional benefits of having an employer match your 401(k) contributions, allowing you to get “free money”. However, just because you’re a self-employed business owner or freelancer doesn’t mean you can use that as an excuse for not saving for retirement.

We can no longer rely on Social Security income or the government to fund our retirement, so it’s up to us to stash away money while we’re young.

You’re responsible for your own retirement, because let’s fact it, the government isn’t going to give you a hand out. I expect that I won’t even receive much Social Security benefits once I hit retirement age (I’m 30 years old right now).

On top of this, you can’t depend on family or friends to take care of you and your business financially, either. So as business owners, the responsibility to save and invest for our future, falls squarely on our own shoulders.

According to a survey done by MoneyTips.com, 14% of successful retirees were self-employed and had their own businesses prior to retirement (with 17% of those continuing to work).

How much should you save for retirement?

Most financial experts recommend using around 80% of your current income to estimate how much money you’ll need to live on comfortably in retirement.

In the same survey by MoneyTips.com, one in ten retirees withdraw 5% or more of their retirement nest egg each year to fund living expenses. Are you saving enough for retirement to live off this amount? Here’s how to find out.

This safe withdrawal rate (which is currently between 4-5%) is calculated based on the stock market’s history of returns between 8-10% each year. If you apply this withdrawal rate to the amount of your annual salary, you can calculate exactly how much you need to save to retire comfortably.

For instance; if your annual income right now is $50,000 then divide that by 0.05 (or 5%), which is the safe withdrawal rate, and your total will be $1,000,000.

So, if you want to keep up the lifestyle you have now, you’ll need to save at least $1 million for retirement in order to withdraw a $50,000 a-year-income from your account and not see a large dent in your principal. If you factor in inflation, this figure will be even higher.

Of course, the younger you start saving, the easier it will be to hit that mark, and the longer you’ll have to gain compound interest on your investments.

Below are three options for retirement plans that are available to self-employed individuals.

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1. Roth IRA

If you’re still a sole-proprietor (or an LLC that files as a sole-proprietor), you can use an individual Roth IRA to save for retirement.

I use Betterment’s service which has a preset basket of mutual funds and stocks to invest the funds. Then I set up an automatic savings plan where funds are transferred into the account each month.

I also have a separate Roth IRA account with Edward Jones that it more actively managed and consists of growth and income mutual funds. I will soon be moving the rest of these funds to Betterment since Edward Jones has a very high yearly management fee.

The good news about a Roth IRA is that the money you earn in interest over the years is completely tax-free! And you can take out qualified distributions for things like buying a first home or going to college.

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2. Simple IRA

If you have a small business entity, and are incorporated or an LLC, then a SIMPLE IRA (or Savings Incentive Match PLan for Employees) might be a good choice. It works similarly to a 401(k) for small businesses and is relatively simple to set up. They also do not have the high startup and operating costs of regular retirement plans.

The maximum amount an employee can contribute is $12,000 with the employer required to match between 1-3% of the amount saved. Even if you don’t have any other employees, you can set up and run a SIMPLE IRA for yourself and your spouse.

An alternative of a SIMPLE IRA is a Simplified Employee Pension (SEP) plan.

3. Solo 401(k)

This type of Individual 401(k) functions much like a regular 401(k) plan, and you can choose between a Traditional or Roth account inside the plan. This gives you the option to contribute pre-tax funds (that will be taxed when you withdraw the money) or post-tax funds that will be tax-free.

With a Solo 401(k) you can make a contribution of up to $17,500 (for 2014) as the employee, and another $17,500 contribution as the boss, in addition to 25% of your net business income with a limit of $50,000 per year. (Your total contributions are capped at 100% of your net earnings.)

That’s a lot of money you can stash away for retirement that won’t be subject to regular income tax.

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Investing in a Roth IRA

The simplest choice is to get started with a Roth IRA account. Thanks to robo-advisor startups, like Betterment, you can open a free account online in less than 5 minutes, and start contributing as little as $10 per month towards your retirement.

Here’s a step-by-step guide to getting starting with your first Roth IRA.

  1. Get educated and take your time. Take your time understanding the process of an IRA and what it means for your finances. You always want to be comfortable with how/where you invest your money. Then, after you get educated, and more comfortable with investing and building wealth for retirement, you can start investing with other companies for diversification. Local banks, and some online banks, offer less risky IRA options like CD’s.
  2. Find a local brokerage or bank. I opened my first Roth retirement account in 2005, however, I didn’t start contributing to it until 2009 when I sat down with a local broker at Edward Jones. In my opinion, sitting face to face and talking with a Financial Advisor in person, is the best thing to do if you’re just starting out. The only downside is that you will pay a premium for this advice and help.
  3. Use an discount online brokerage account. Many online discount brokerage accounts like Fidelity, Charles Schwab and Scottrade, offer lower fees and more flexibility than a traditional bank or brokerage firm. If you have a basic understanding of DIY investing, and have the time to be more hands on, a discount online broker could be a great choice.
  4. Try a new investment program like Betterment. In November 2012, Betterment.com launched their Roth IRA account, and I jumped at the chance to open a second account. Since that time, I rolled over all of my investment funds (from Edward Jones) into Betterment’s service — and saved myself over $1,000 in advisor fees. Now I can choose the amount of risk, by adjusting the meter between a preset investment basket of stocks and bonds. Stocks are riskier and bonds are more conservative.

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Best investment options inside a Roth IRA

Depending on your age, personal situation, financial goals, and retirement needs, you may want to have a more or less risky investment approach. Here are the most popular investment options for Roth IRAs.

  • Securities, like stocks and bonds (most risk). As mentioned above, stocks and bonds are the traditional route when it comes to investing within a Roth IRA. It took me awhile to understand how it all works, but basically you can choose any type of investment vehicle, which is covered by a Roth IRA blanket. You get the same benefits as a normal investment, without having to pay the capital gains tax on dividends.
  • Mutual funds (some risk). Investing in individuals stocks on the stock market, is very risky. If you want to get in on the “stock market action” but take less risk, you can invest in mutual funds. In my opinion, good growth stock mutual funds are some of the best, and it’s what I put my money into.
  • Certificates of deposits (less risk). Opening a Roth IRA with a CD comes with the least amount of risk. It’s also great to use, if you invest in other methods and want a little diversification. Of course with less risk, comes less reward and using a Certificate of Deposit won’t create much of a return on your money. Although, this option does let you have more control of your investing and assures a steady, solid rate of return.

Here’s how I’ve divided my stock options. I prefer to have riskier portfolio, since I’m young and plan to keep my money in there for many years.

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Roth IRA contribution limitations and rules

If you think the Roth IRA sounds too good to be true, well it kind of is. If you make more than a certain amount of income, your contributions will be limited or even phased out completely.

There are ways around this limitation (like opening a nondeductible Traditional IRA and converting it to a Roth), but this is more advanced and somewhat complicated.

Always be sure to check the eligibility requirements first, so you aren’t penalized for putting in too much. I would suggest finding a tax professional, financial advisor or CPA to help.

No matter what amount of income you make, the contribution limit is $5,000 per year, or $6,000 for anyone age 50 or older (for 2012).

Advantages

  • Direct contributions can be withdrawn tax-free at any time
  • A lifetime maximum of $10,000 in earnings can be withdrawn tax-free, when used to buy a principal residence, for a first time home buyer
  • You can invest in a 401(k) at the same time as a Roth IRA
  • For estates subject to higher income taxes, having a Roth IRA can reduce the overall taxes due, since the taxes have already been subtracted
  • There is no RMD (required minimum distribution) rule with a Roth IRA

Disadvantages

  • Contributions to a Roth IRA are not tax deductible
  • Investing in a Roth does not reduce your total Adjusted Gross Income (AGI)
  • If you live in a state with a state tax, you will have to pay taxes on the amount to state as well
  • In the future, Congress may change the rules that currently allow for tax free withdrawals

Building wealth for retirement

If you haven’t opened a Roth IRA, now is the best time! The younger you are, the more time you will have to save and build wealth. Even putting in a small amount each month is worth it.

Right now, I’m only contributing $50 per month into my Betterment Roth IRA, since I’m a self-employed freelancer now and my income is inconsistent. But still, can you imagine how much even $25 a month can add up over the next 30-40 years?

Small changes can make a big impact. 

Take action now and join the #RothIRAMovement by opening a Roth IRA with Betterment. It’s free to get started!

CLICK HERE TO LEARN MORE ABOUT BETTERMENT

 

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2 comments

  1. YourFinancesSimplified says:

    Great job Carrie!  The other benefit of the Roth is if you pass it on when you pass away the person who inherits it has some tax free money!

  2. Guest says:

    Carrie, be wary of full-service brokers like Edward Jones. They charge a lot in loads (sales charges to buy a mutual fund), management fees, trades, and they steer you into questionable funds for which Jones gets kickbacks. Given your zeal to save and cut expenses, this might be a topic to investigate more–how to keep more of your savings and give less of it to the financial services industry.

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