We all know the importance of retirement planning. Compound interest is basically magic. There’s a million and one books and blogs out there belaboring the point on why we need to start saving literally every spare cent we have beginning on our date of birth.

You get it. So I won’t harp on the “why” here. I’m going to assume that if you’ve found your way to this post, you’ve been convinced by others and are ready to start saving.

As such, our focus will be on exploring the different options for self-employed individuals when it comes to retirement savings. But before we get there…

 

Some Cautionary Notes

I’m a big believer in doing things in the right order. For example, do you really want to get deep into investing if you have hate mail from the IRS and past credit card companies rolling in daily? Probably not.

Our brains tend to work best when we can focus on a singular goal at a time. This is why books like “The One Thing” are all the rage. Narrowing focus works really well for two reasons:

(1) When we focus, it’s simply simpler to do the work. It’s easier to know what we need to be doing. Things don’t get overly complicated.

(2) We can feel the accomplishment of doing the one thing, which provides a physiological boost to go on and do the next thing.

This second point is what’s made Dave Ramsey’s debt snowball method so successful.

So, while I’ll encourage you to finish reading this blog post, I’d suggest holding off on further action until you take an audit of your current processes.

Ask yourself:

Do I have a system to set aside a specified percentage of my business income for estimated state and federal taxes?

Am I up to date on my past tax returns and tax payments? (If no, check out this post).

Am I free of consumer debt? (think everything except mortgages and students loans)

Do I have an emergency fund of at least $1,000 saved?

If you answered yes, continue with vigor. If you answered no, I’d recommend starting with my free masterclass. It’ll teach you how to begin working on these steps to unf*ck your biz. 

Because, that’s the first logical starting point in our journey to be financially free.

Alrighty, I’m now off my soapbox. Let’s explore the most popular retirement savings tools.

 

401(k)s

401(k)s aren’t really for self-employed folks. But I still address them here because they’re the most common savings tool. It’s important for us as human people to know what they are and how they work. Also, I’ll cover some key concepts in this section that will help with the rest of this post, so don’t skip ahead.

So what’s a 401(k)? It’s literally just the name of a section of tax code. 26 U.S.C Section 401, Subsection K, or, in other words section 401(k) of the U.S. tax code provides rules under which employers can help their employees get some kickass tax deals while saving for their retirement. And yes, kickass is a very technical term.

When you contribute to a 401(k), the amount contributed is deducted from your taxable income. Let’s take a minute to break down what this actually means because you know I’m passionate about making taxes make sense.

Assume you profit $100,000. That’s your sole income. Specifically note that we’re talking profit. That’s business income minus deductible business expenses.

Now, there are a few other deductions you can use to shave down that income. One such benefit is student loan interest. Assume you paid $2,000 towards student loan interest during that tax year. You deduct the $2,000 from the $100,000, so that taxable income is $98,000. Simple right?

When we say, in regard to a retirement contribution” that “the amount contributed is deducted from your taxable income,” it’s treated the same as that student loan interest.

If your taxable income was $98,000, and you also made an $8,000 contribution to a 401(k), your taxable income is now $90,000.

What does this mean for the taxes you’ll actually owe? Assume that you end up paying 10% of your income towards taxes. 10% tax on the $98,000, the income before the 401(k) contribution is $9,800, while 10% of the $90,000 is $9,000.

In other words, in this hypothetical, the $8,000 contribution saves the taxpayer $800 in taxes. Note that these are made up numbers for easy math.

Is the tax savings in the present day awesome? Totally! But what’s even more awesome is the compound interest that will be earned by those contributions in the many years to come.

The real magic with a 401(k) is the employer match

Many employers will match their employees 401(k) contributions up to a certain amount. This is basically free money. It’s like if mom said, “if you take $100 of your birthday money and put it in your college savings, I’ll also put $100 in savings into the account.”

Pretty cool! Although, I doubt my 8 year self would have taken the deal. I’d much prefer the immediate gratification spending the cash on Pokemon toys. This is the same challenge that we face as adults, but hopefully, with maturity, we would stash the cash and take the match.

I noted earlier that 401(k)s are for employees. If your only income source is through self-employment, this option won’t be on the table. However, if you or a spouse is employed, look into a 401(k), and specifically determine whether your employer has any type of matching plan.

IRAs

IRA is an abbreviation for “individual retirement account.” They’re similar to 401(k)s. You can open one to save for retirement, and you get a tax deduction for your contributions.

The difference is that IRAs are not dependent on employment. Thus, self-employed folks may open IRAs. IRAs also offer more flexibilities in the type of investments contributors can make.

The reason IRAs are inferior to 401(k)s is because there’s no matching component.

 

Roth IRAs

If you’ve had a chat about retirement, you’ve likely heard mention of Roth IRA. They’re pretty awesome. Here’s the difference between a Roth and regular IRA or a 401(k).

Roth IRAs don’t get a tax deduction when you contribute to them. Hold up. Did I just say “don’t?” Yes, yes I did. But stick with me. Since you don’t take a tax deduction on the front end, this means you are paying taxes on the amount contributed to a Roth IRA.

But you don’t pay taxes when you withdraw the funds years later, which means that the funds grow and multiply tax free. Let’s tax a look at an example.

Assume you contribute $5,000 a year into retirement averaging an 8 percent annual rate of return. After 30 years of contributions with compound interest, you would have $505,365 in a regular IRA.

That’s a lot of money! But how about if you invested that same $5,000 into a Roth IRA letting the money grow tax free? After 30 years, you’d have $611,729. Pretty awesome!

This begs the question, when wouldn’t you want a Roth IRA? Let me give a simpler hypothetical to explain a key understanding here.

Assume that you anticipate that you’ll make $50,000 this year and $100,000 next year. You decide you’re going to put $5,000 into savings at the start of this year. I tell you “you can choose if you want to pay tax on the $5,000 now or you can pay tax on whatever the $5,000 turns out to be when you withdraw it at the end of next year.” What do you do?

Without being a tax buff, you likely know that our tax system is progressive. Meaning, the more you earn the higher your relative tax percentage. Thus, you’ll be paying a higher percentage of tax earning $100,000 than you would at $50,000.

Now ask yourself again, do you want to pay the tax on the $5,000 when you’re at $50k in income or when you bump up to the $100,000?

You’d want to pay it when your income is $50k because your tax rate would be lower. Make sense? We run this same analysis when asking if we want a Roth or a regular IRA. Remember the Roth is the equivalent of saying, “I’ll pay the tax when I’m still down here at 50k in income.”

And this usually makes sense, particularly if we start saving early on in our careers when salary is low. We’d expect to earn more in retirement after years of increasing our take home pay.

But what if you’re a high income earner now and you expect to be making less in the years to come when you’ll be withdrawing funds from the account? In that case, there’d be no advantage to a Roth.

Ultimately, my hope is that you understand this conceptually. You can then consult a licensed professional to help determine which account is really best for you.

 

Regular Taxable Account

Above we noted that the balance after investing $5,000 for 30 years at an 8% rate of return would be $611,729 for a Roth IRA and $505,365 for a regular IRA.

Let’s now consider if you’d invested in a regular taxable account, which provides no tax benefit. The money is subject to tax when contributed and when withdrawn.

In this case, the ending balance would be $429,560. The logical response to this is “why would anyone ever choose this option then!?”

Answer: Because 401(k)s and IRAs have contribution limits.

In 2021, the contribution for a 401(k) is $19,500 and the limit for IRA accounts is $6,000. You can’t contribute $6,000 to both a regular and a Roth IRA. You could instead, for example, contribute $3,000 to each. I wouldn’t necessarily recommend that. This is just an example. You’d likely want to pick the one type of IRA that makes the most sense.

 

Options for the Self-Employed

We now know that employees have pretty great benefits with 401(k)s, but what about us self-employed individuals? We have a few options ourselves.

 

Solo 401(k)

Solo 401(k) are created for the solopreneur. The tax benefits are the same, but a solo 401(k) allows contributions up to $58,000 per year (in 2021). If you have employees, you may not be eligible for a sole 401(k).

 

SEP IRA

SEP stands for Simplified Employee Pension. It’s designed for small businesses, and, unlike a solo 401(k), works for businesses with employees. It provides the same tax benefit of a traditional IRA but with greater contribution limits. You can contribute $58,000 or 25% of your compensation, whichever is less.

Translation, if you pay yourself less than $232,000, your contribution is capped at 25% of your compensation. Example, if I pay myself a $100,000 salary, my SEP IRA contribution limit is $25,000.

 

SIMPLE IRA

SIMPLE is an acronym for Savings Incentive Match Plan for Employees. I know, I’m also glad it has a simple (wink, wink) acronym. Ok that was terrible. Don’t hate me.

SIMPLE IRAs operate a lot like SEP IRAs and also provide the same tax advantages. Instead of boring you with all the nuanced differences between SEPs and SIMPLEs, I’ll summarize by sharing that SIMPLEs tend to have more advantages for small businesses with employees.

If you plan to be a solopreneur for some time, a SEP is likely a safe bet. If you have or plan to soon have employees, consult with a certified financial planner about which option might be best.

The Magic of S Corps

Over  in my blog all about medical insurance costs and tax deductions, I share about us business owners pay both self-employment tax and income tax. And how business deductions are better than adjustment, which are better than itemized deductions. It builds on what I cover in my s corp blog post.

Single member LLCs, partnerships, and sole proprietorship cannot take a business deduction for self-employed retirement contributions. However, the individual business owner does get an adjustment. In normal language, what this means is that owners of these entities get to save income taxes after making retirement contributions, but not self-employment taxes.

S corps, on the other hand, can take a business deductions for contributions made towards employees' SEP IRA, SIMPLE IRA, or Solo 401(k). Remember, as the owner of an s corp, you are an employee put on payroll. This will help you save both income and self-employment tax on those retirement contributions.

The Investing Roadmap

I love a good roadmap, so to bring this all together, I want to give you the, more or less, definitive step-by-step on how to get started investing.

 

For the Employed

Step 1: Contribute up to your 401(k) match

Step 2: Max out a Roth IRA

Step 3: Max out your 401(k)

 

For the Self-Employed

Step 1: Max out a Roth IRA

Step 2: Begin contributed to a self-employed retirement plan

 

As you can see, the steps are fairly straightforward. If you have an employer with a 401(k) match, start by stashing out the cash to get the match. It’s free money.

The next step (and first step for us self-employed people) is to max out a Roth IRA. The max in 2021 is $6,000. But I have one important wrinkle here. 

You must be under certain income limitations to qualify for a Roth IRA. The limit to in 2021 is modified adjusted gross income $140,000 for single tax filers and $208,000 for married filers. We won’t fully define modified adjusted gross income here. Start by just considering your take home pay or business profit. If you’re not close to those figures, don’t sweat it. If you are close, do some independent research. If you determine yourself to be over that amount, you’ll skip the Roth step in the roadmap.

After your Roth, it’s time for your self-employed retirement plan. This is where you introduce something like a SEP or SIMPLE IRA. If/when you’re ready for this step, do some more advanced research or consult a professional.

 

Your Next Step

I shared above my stake-in-the-ground belief. You must unf*ck your biz before you begin fancy retirement savings.

I’m writing this blog in the middle of a “money series” on my podcast and in the middle of reading several personal finance books about which I will likely write more blogs.

There seems to be a general consensus that we should generally prioritize debt and emergency savings before saving for retirement. I go one step further and encourage my students to unf*ck their biz first since it can be done in a month or two.

If you’re ready to get started, learn the steps you need to take, and put your business on the path towards success, start with my free masterclass.