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. 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.
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. Check out the complete guide to a Roth IRA for more info.
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.
Benefits of saving for retirement
When saving money in a retirement account you might qualify for a retirement savings credit (depending on the type of account you have) and a deduction for contributing to a self-employed retirement plan.
So see, being the boss does have it perks! To learn more secrets from successful retirees and how to make saving for retirement a priority, check out the newly released ebook, Retiree Next Door.