How to Build Your Own Retirement Plan

The joys of self-employment are many, but so are the stressors. High among those: The need to plan for retirement entirely on your own. You are in charge of creating a satisfying quality of life post-retirement. And when it comes to building that life, the earlier you start, the better.

According to a study by Freshbooks, a developer of financial software for freelancers, by the year 2020, 42 million Americans may choose to be self-employed professionals, which is roughly a third of all working Americans. While the spirit of entrepreneurialism is to be applauded, less laudable is the fact that a substantial 40% of self-employed workers save for retirement only sporadically; by contrast, just 12% of traditionally employed workers are sporadic savers. Scarier still, 28% of the self-employed, versus 10% of traditionally employed workers, say they aren’t saving for retirement at all.

And that's unfortunate. If you are self-employed, you are busy—crazy busy, probably—but retirement savings has to be a priority. Luckily, there are several retirement plans for those who run their own business. They aren't quite as obvious or automatic as they are for corporate employees, but they do exist. Not only do they offer tax-sheltered earnings, but you can also potentially save a higher dollar amount and/or a higher percentage of your income than you could as a staff worker.

The reasons given for not saving towards retirement won’t be a surprise to any self-employed person. The most common include:

• Lack of steady income
• Paying off major debts
• Healthcare expenses
• Education expenses
• Costs of running the business

Plus, setting up a retirement plan—like just about everything an entrepreneur undertakes—is a do-it-yourself job. No handy Human Resources staffer walking you through a 401(k) plan application, or whatever the company-sponsored retirement program is. No matching contributions, no shares of company stock, and no automatic paycheck deductions. You'll have to be highly disciplined in contributing to the plan, and because the amount you can put in your retirement accounts depends on how much you earn, you won’t really know until the end of the year how much you can contribute.

Still, if freelancers have unique challenges when it comes to saving for retirement, they have unique opportunities too. Funding your retirement account can be considered part of your business' expenses, as is any time or money you spend on establishing and administering the plan. Even more importantly, a retirement account allows you to contribute pre-tax dollars, which lowers your taxable income. And many of these plans allow you, as a business owner, to contribute more annually than you could to an individual IRA.

There are four retirement savings options favored by the self-employed. Some are basically single-player 401(k) plans while others are IRA-based. They are:

• One-Participant 401(k)
• SEP IRA
• SIMPLE IRA
• Keogh Plan

With all four of these options, your contributions are tax-deductible, and you won’t pay taxes as they grow over the years (until you cash out at retirement). To avoid penalties, you’ll need to leave your savings in the account until you are 59½—early withdrawals carry penalties—although there are certain hardship exemptions.

Their complexity and suitability varies, depending on the size of your business, both in terms of personnel and earnings. Let's look at each in more depth (full details are delineated in IRS Publication 560).

A One-Participant 401(k), as it's officially dubbed by the IRS, also goes by the names Solo 401(k), Solo-k, Uni-k or individual 401(k). It is reserved for sole proprietors with no employees, other than a spouse working for the business.

How It Works

The One-Participant plan closely mirrors the 401(k)s offered by many larger companies, down to the amounts you can contribute each year. The big difference—you get to contribute as the employee and the employer, giving you a higher limit than many other tax-advantaged plans.

To elaborate: If you participate in a standard corporate 401(k, you would make investments as a pre-tax payroll deduction from your paycheck and your employer would have the option of matching those contributions up to certain amounts. You get a tax break for your contribution and the employer gets a tax break for its match. With a One-Participant 401(k) plan, since you're both the boss and the worker, you can contribute in each capacity, as an employee (called an elective deferral) and as a business owner (an employee non-elective contribution).

Elective deferrals for 2019 can be up to $19,000, or $25,500 if age 50 or older. Total contributions to the plan cannot exceed $56,000, or $62,000 including the catch-up contribution for people age 50 or older. If your spouse is working for you, he or she can also make contributions up to the same amount, and then you can match those. So, you see why the Solo 401(k) offers the most generous contribution limits of the plans.

Setting It Up

“Generally, 401(k)s are complex plans, with significant accounting, administration and filing requirements,” says James B. Twining, CFP®, founder and wealth manager of Financial Plan, Inc., Bellingham, Wash. “However, a solo 401(k) is quite simple. Until the assets exceed $250,000, there is no filing required at all. Yet a solo 401(k) has all the major tax advantages of a multiple-participant 401(k) plan: The before-tax contribution limits and tax treatment are identical.”

Some paperwork is required, but it's not too onerous. To establish an individual 401(k), a business owner has to work with a financial institution, and that institution may impose fees and certain limits as to what investments are available in the plan. Some plans, for instance, may limit you to a fixed list of mutual funds (typically sponsored by that institution), but a little bit of shopping will turn up many reputable and well-known firms that offer low-cost plans with a great deal of flexibility.

Officially known as a Simplified Employee Pension, a SEP IRA—as the name implies—a variation on a basic, individual IRA. As the easiest plan to establish and operate, it's an excellent option for sole proprietors, though it allows for one or more employees too.

How It Works

In a SEP IRA, the employer alone contributes to the fund, not the employees. So, unlike the Solo 401(k), you'd only contribute wearing your employer hat. You can contribute up to 25% of your net earnings (defined as your annual profit less half of your self-employment taxes), up to a maximum of $56,000 in 2019. The plan also offers flexibility to vary contributions, make them in a lump sum at the end of the year, or skip them altogether. There is no annual funding requirement.

Its simplicity and flexibility make the plan most desirable for one-person businesses. But there's a catch if you have people working for you. Although you do not have to contribute to the plan each year, when you do contribute, you will need to contribute for all of your eligible employees—up to 25% of their compensation, limited to $280,000 annually.

While SEP IRAs are simple, they are not necessarily the most effective means of saving for retirement. "You can contribute more to a SEP IRA than a Solo 401(k), excluding the profit-sharing, but you must make enough money since it’s based on the percentage of profits,” says Joseph Anderson, CFP®, president of Pure Financial Advisors, Inc, based in San Diego, Calif.

Setting It Up

The account is simpler to set up than a Solo 401(k). You can easily open a SEP IRA online, at brokerages like TD Ameritrade or Fidelity Investments.

Officially known as the Savings Incentive Match Plan for Employees, a SIMPLE IRA is kind of a cross between an IRA and a 401(k) plan. Although available for sole proprietors, it works best for small businesses: companies with 100 or fewer employees that might find other sorts of plans too expensive.

How It Works

The SIMPLE IRA follows the same investment, rollover and distribution rules as a traditional IRA or SEP IRA, except for its lower contribution thresholds. You can put all your net earnings from self-employment in the plan, up to a maximum $13,000 in 2019, plus an additional $3,000 if you are 50 or older.

With the SIMPLE, employees can contribute along with employers, in the same annual amounts. As the employer, however, you are required to contribute dollar-for-dollar up to 3% of each participating employee’s income to the plan each year or a fixed 2% contribution to every eligible employee’s income (whether he or she contributes or not).

So, like a 401(k) plan, the SIMPLE IRA is funded by tax‑deductible employer contributions and pre-tax employee contributions. In a way, the obligation of the employer is less—because employees make contributions—but there is that mandated matching. And the amount you the employer can contribute for yourself is subject to the same contribution limit as the employees.

Also, early withdrawal penalties are particularly heavy: 25% within the first two years of the plan.

Setting It Up

Like other IRAs, these accounts or plans must be opened with a financial institution, and that institution will have rules as to what sorts of investments can be bought under the plan and may charge fees for plan administration and participation. The process is similar to a SEP IRA, but the paperwork load is a little heavier.

The Keogh plan or HR 10 plan (more commonly referred to today as a qualified or profit-sharing plan) is arguably the most complex of the plans intended for self-employed workers, but it is also the option that allows for the most potential retirement savings.

How It Works

Keogh plans usually can take the form of a defined contribution plan, in which a fixed sum or percentage is contributed every pay period. In 2019, these plans cap total contributions in a year at $70,000. Another option, though, allows them to be structured as defined benefit plans. In 2019, the maximum annual benefit was set at $225,000 or 100% of the employee's compensation, whichever is lower.

A business must be unincorporated and set up as a sole proprietorship, limited liability company (LLC), or partnership to use a Keogh. Although all contributions are made on a pre-tax basis, there can be a vesting requirement.

As you might imagine, these plans are mainly beneficial to high earners, especially the defined-benefit version, which allows greater contributions than any other plan. A Keogh is best-suited for firms with a single high-earning boss or two, and several lower-earning employees—as in the case of a medical or legal practice.

Setting It Up

Keogh Plans have federal filing requirements, and the paperwork and complexity often means that professional help (be it from an accountant, investment advisor or financial institution) is necessary. Your options for custodians may be more limited than with other retirement plans—you'll probably need a brick-and-mortar institution, vs. an online-only service. Charles Schwab is one brokerage that offers and services these sort of plans.

As a freelancer, you might well have to pay for your own health insurance, and the deductibles for individual medical plans tend to be high. If that's your situation, consider opening a Health Savings Account (HSA). Though created for medical expenses, rather than one's golden years, a Health Savings Account often can function as a de facto retirement account.

These accounts are funded with pre-tax dollars, and the money within them grows tax-deferred—as with an IRA or 401(k). While the funds are meant to be withdrawn for out-of-pocket medical costs, they don't have to be—you can let them accumulate year after year. Once you reach age 65, you can withdraw them for any reason. If it's a medical one (either current or to reimburse yourself for old costs), it's still tax-free; if it's a non-medical expense, you will owe income tax, at your current rate.

To open an HSA, you have to be covered by a high-deductible health insurance plan (HDHP). For 2019, the IRS defines a high deductible as $1,350 per individual; $2,700 per family. Not all plans allow for HSAs. If yours does, you're allowed to contribute up to $3,450 for an individual plan; $6,900 for a family plan in 2019. People over 50 are allowed a $1,000 catch-up contribution.

If none of the above plans seem a good fit, you can start your own individual IRA. Roth and traditional IRAs are available to anyone with employment income, and that includes freelancers. Roth IRAs let you contribute after-tax dollars, while traditional IRAs let you contribute pretax dollars. The maximum annual contribution is $6,000 or $7,000 (if you are age 50 or older) in 2019 or your total earned income, whichever is less. 

Most freelancers work for someone else before striking out on their own. If you had a retirement plan such as a 401(k), 403(b), or 457(b) with a former employer, the best way to manage the accumulated savings is often to transfer them to a rollover IRA or alternatively, a One-Participant 401(k).

Rolling over allows you can choose how to invest the money, rather than being limited by the choices in an employee plan. Plus, the transferred sum can act as a jump-start to saving in your new entrepreneurial career.

Make no mistake: You need to start saving for retirement as soon as you start earning income, even if you can’t afford much at the beginning. But the sooner you start, the more you'll accumulate, thanks to the miracle of compounding.

Let's say you save $40 per month and invest that money at 4.65%, which is what the Vanguard Total Bond Market Index Fund has earned over the past 10 years. Using an online savings calculator, an initial amount of $40, plus $40 per month for 30 years adds up to $31,550. Raise the interest rate to 8.79%, the average yield of the Vanguard Total Stock Market Index Fund over the last 10 years, and the number rises to more than $70,000.

As your savings build, you may want to get the help of a financial advisor to determine the best way to apportion your funds. Some companies even offer free or low-cost retirement planning advice to clients. Robo-advisors like Betterment and Wealthfront provide automated planning and portfolio building as a low-cost alternative to human financial advisors.

Creating a retirement strategy is extra-important when you are a freelancer because there’s no one looking out for your retirement but you. That's why your mantra should be: Pay yourself first.

Many people think of retirement money as the money they put away if there is any cash left at the end of the month or year. “That’s paying yourself last,” says David Blaylock, CFP, and former senior financial planner at LearnVest Planning Services. "Paying yourself first means saving before you do anything else. Try and set aside a certain portion of your income the day you get paid before you spend any discretionary money."