Saving for Retirement as a Solo Business Owner

Congratulations! You decided to leave your 9-to-5 job to open your one woman shop. But, unlike a corporate job, solopreneurship doesn’t include a formal orientation with Human Resources. (Which were pretty boring anyway, right?)

So today, I’m going to answer your questions about solopreneur retirement options — because being on your own means shouldering the weight of setting up your retirement options. Even so, it doesn’t have to be draining. To make it more enticing? Take my view and think of it in terms of your “financial independence.”

The best definition I’ve read of financial independence comes from Matt Becker of Mom and Dad Money (he’s also a fee-only financial planner). He defines financial independence as “The freedom to make decisions based on what makes you happy instead of what makes you money.”

When you’re financially independent, you can choose to spend more time with your family, travel, or volunteer. You can choose when to work, and how you work. Unlike your 9-to-5, it’s all up to you. But unlike your 9-to-5, you’ve got some decisions to make. Let’s begin.

What do I do with an old 401(k) or 403(b)?

One of the first questions I get from solo business owners, or anyone who’s changed jobs for that matter, is what to do with their old 401(k) or other company-sponsored retirement plan. As tempting as it may be to cash out and use the funds to grow your new business, I wouldn’t go that route. Yes, investing in your business is a good idea, but there are additional taxes and penalties for tapping into your 401(k) before age 59½. An early distribution will generally be subject to both ordinary income taxes and a 10% early withdrawal penalty. Plus, you lose future tax-advantaged growth.

You have three good options when it comes to your old 401(k), 403(b), or other company-sponsored retirement plan: do nothing, roll the funds over to a Traditional IRA, or roll the funds into a solo retirement account. Let’s explore those options:

1. Do nothing and keep the funds in your prior employer’s retirement plan

  • Pros: This is the easiest option, but if your account balance is less than $5,000, you might be forced into taking action. Additionally, you may have access to certain investments (think institutional funds with potentially lower expenses) that might not be available outside of this retirement account.
  • Cons: You’re limited to the investment options chosen by your employer. Additionally, you’ll be unable to make additional contributions. If you can still make contributions, they’ll be restricted.

2. Roll the funds over to a Traditional IRA

  • Pros: You typically have access to a wider range of investment options, including mutual funds and ETFs (exchange-traded funds) as well as individual stocks, CDs (certificates of deposit), and bonds. Additional contributions are allowed and you have the option to move assets to a future employer’s plan. In addition, if you already have a Traditional IRA, all of your retirement assets will be in one place.
  • Cons: You can’t take a loan, but I wouldn’t recommend a 401(k) loan even if you had the ability to take it. Also, certain 401(k) investments may not be available.

3. Roll the funds into a solo retirement account like a solo 401(k) or SEP IRA

  • Pros: You can make contributions — and employer contributions are considered business expenses. Loans may be allowed.
  • Cons: Potentially limited investment options. This isn’t so much of a con, but a consideration. Depending on your solo retirement account type and size, you’ll need to file forms with the IRS.
    • Another consideration to make note of: If you rollover to a SEP IRA and hire employees in the future, you’ll have to contribute to the SEP IRA on their behalf if you also contribute for yourself.

Whichever route you take, pay attention to the fees and expenses associated with your old and new retirement accounts. Sometimes it makes sense to keep your money in your old retirement plan if the fees and expenses are much lower than a new retirement account.

Additionally, if you plan on rolling over your old retirement plan into another plan, make sure the new plan is set up first. Consider requesting a direct rollover, right to your financial institution. This is also referred to as a trustee-to-trustee rollover, and it can help ensure that you don’t miss any deadlines.

Where should I save if I’m starting from scratch?

Maybe you’re not coming from a former employer with a company-sponsored retirement plan. No problem — there’s no better time to start investing (and saving) than now! Here are a few options for you, solo biz owner:

1. Traditional or Roth IRA

One way an individual with earned income can start saving for retirement is by contributing to a Traditional or Roth IRA. Individuals have until April 15, 2017 to make a contribution for the 2016 tax year. For 2016, individuals can contribute up to $5,500 ($6,500 if you’re age 50 or older) or their taxable compensation for the year, if their compensation was less than this dollar limit. However, a Roth IRA contribution might be limited based on tax filing status and income.

Roth IRAs are great because you can withdraw your money tax-free when you’re in retirement. Contributing to a traditional IRA, on the other hand, earns you an income tax deduction. However, that deduction may be limited if you or your spouse is covered by a retirement plan at work and your income exceeds certain levels. Review the IRS guidelines for more details.

Also, if you’re a new business owner, you may find yourself in a lower tax bracket than when you were at your corporate job. (Not for long, I hope!) That means it might be a good time to convert an old 401(k) or traditional IRA into a Roth, where you can capture lower taxes today and withdraw that money tax-free when you’re in retirement.

If you have more money to contribute to retirement than $5,500 ($6,500 if you’re age 50 or older), then you may want to invest in one of the following retirement accounts.

2. The Solo 401(k)

The Solo 401(k) is a traditional 401(k) plan covering a business owner with no employees, or that person and his or her spouse. A business owner can make the following contributions:

  • Elective deferrals of up to 100% of earned income up to a maximum annual contribution of $18,000 in 2016, or $24,000 in 2016 if age 50 or over; plus
  • Employer non-elective contributions up to 25% of compensation, with total contributions not to exceed $53,000 for 2016.

Note that these elective deferral limits apply per person, not per plan. So if you’re also participating in another employer’s 401(k), say if you’re starting your business while still employed at a corporate job and making 401(k) contributions to take advantage of an employer match, these will count against the limit for employee contributions to an individual 401(k) or IRA.

Also: A Solo 401(k) plan is generally required to file an annual report on Form 5500-SF if it has $250,000 or more in assets at the end of the year. A solo 401(k) with fewer assets may be exempt from the annual filing requirement. If you choose to go this route, your solo 401(k) must be set up by December 31st and funded by your tax return due date in order for contributions to apply for that year.

3. Simplified Employee Pension Plan (SEP IRA)

A SEP IRA is like a traditional IRA, but it is funded solely by employer contributions. A business owner sets up an IRA for each qualifying employee and can contribute up to 25% of each employee’s pay (and 25% of net self-employment income). Annual contributions are limited to the smaller of $53,000 or 25% of compensation for 2016. There are no “catch-up” contributions like the solo 401(k).

The SEP IRA is a great option for those who do not qualify for a solo 401(k), or who have employees and are looking for a retirement plan for their company. Business owners just need to file a form with the IRS (Form 5305-SEP) and open a SEP IRA at a bank or financial institution

How to choose your retirement account as a solo business owner

Which tax-advantaged retirement plan should you use? That depends on the nature and size of your business. (Do you plan on hiring employees in the future?) Additionally, you need to consider your tax filing status, age, and participation in other retirement plans. Since some plans require more administrative and fiduciary responsibilities, you may want to chose one retirement plan over another due to simplicity.

Pay yourself first!

Finally, in order to reach your financial goals, start by paying yourself first. This is important even if you aren’t a business owner! You can achieve this by setting up automatic transfers to your savings, retirement, and/or investment accounts. As an entrepreneur, your income may vary, so allocate your savings based on percentages instead of dollar amounts. For example, make it a goal to set aside 5% of every client payment. This will automatically help you save more dollars when your income is higher and keep you from overextending yourself during leaner months.

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Cathy Derus, CPA founded Brightwater Financial to help you feel confident about your finances so you can get back to doing what you love. From small business accounting to taxes and financial planning, Cathy will help you grow your business and plan for a brighter future. Get your free guide: “Five Struggles Female Entrepreneurs Face with Their Finances…and How to Beat Them.”

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