Rise of self-employment
In the 21st century, we are witnessing the global rise of self-employment and entrepreneurship. Thanks to modern technologies and online platforms, it’s becoming increasingly easier to work remotely. A McKinsey survey reports that up to 20%-30% of the working-age population (162 million people) in the United States and Europe are engaged in various forms of independent work.
During the COVID-19 pandemic, we have witnessed governments struggle tremendously with lockdown measures, negatively impacting the national economy. Altogether, all sectors of the economy have been negatively affected except the self-employment sector that has managed to grow.
Although there are various definitions of self-employment, a self-employed person refers to an individual who does not work for a particular employer or a company that pays them consistent salaries or wages. On the contrary, a self-employed individual profits from an independent pursuit of economic activity by contracting directly with clients.
Usually, the clients will not withhold taxes; therefore, this becomes the responsibility of the self-employed person.
Thus, a self-employed individual must file an annual tax return and pay an estimated quarterly tax, as well as pay a self-employment tax of 15.3%. Self-employment tax (SE tax) is a Social Security and Medicare tax, where the self-employed will pay the employer and the employee portion of the taxes. Those who make less than an annual net profit of $400 are exempt from paying taxes on that income.
The Internal Revenue Service (IRS) recognizes main types of self-employed workers:
- Independent contractors
- Sole proprietors of businesses
- Individuals engaged in partnerships
- Part-time business owner
Independent contractors are individuals or businesses that are hired solely to do specific jobs. Independent contractors do not receive benefits or workers’ compensation because they are not full-time employees. The most common occupations of the individual contractors are medical doctors, lawyers, actors, journalists, freelance workers, and accountants who are in business for themselves.
Sole proprietors, also known as sole traders, are the only owners of unincorporated businesses that pay personal income tax on profits earned. A sole proprietorship is becoming increasingly popular as it’s the most accessible type of business to establish and dismantle due to a lack of government regulation.
Partnerships are formal arrangements involving two or more self-employed people who operate and manage a business together and share profits.
A part-time business owner doesn’t have to carry on regular full-time business activities to be considered self-employed; they may as well have a part-time business in addition to their regular job.
It’s never too early to start planning for retirement. Generally, it’s better to invest more aggressively when you’re young and slowly progress to more conservative types of investments as you approach retirement age.
When you do begin diverting a portion of your earnings into a tax-advantaged retirement savings plan, your wealth will subsequently grow to help you achieve a financially secure future. Remember that you can max out your benefits and achieve the retirements you desire only by learning your retirement plan options and choosing the right one for you.
Make sure to determine the actual amount of money you will need to retire and consider several contributing factors such as health care costs, inflation, and your life expectancy. Plan your annual retirement income; ideally, replace about 70-90% of your yearly earnings (pre-retirement income) through savings, social security, and pensions.
You probably have other saving goals, expenses and debts, that may be tempting to forget about your retirement savings. However, make sure other current financial goals aren’t stopping you from saving regularly for retirement.
There are several retirement plan options available to choose from for self-employed individuals. For example, you may consider investing in a Roth IRA or traditional IRA if you are interested in options with smaller annual contribution limits than most other retirement plans. Also, there are plenty of alternatives available, such as the SEP IRA, the solo 401 k, and the SIMPLE IRA.
With retirement accounts, you will have access to a range of investments, such as mutual funds, stocks, and bonds. You can make a regular income stream with dividend stocks and construct a bond ladder that will help you manage interest rate risks with steady cash flow.
In this article, we will cover main retirement plan choices for self-employed individuals and other crucial details concerning this subject:
- Pros and cons of self-employment
- Traditional IRA
- Roth IRA
- Solo 401 k
- SEP IRA
- SIMPLE IRA
- Defined benefit plan
- Keogh Plan
- Health Savings Account
- Gain financial independence with Infinite Banking
There are many pros of self-employment:
- Flexible schedule. You can choose your work hours and take time off when you need it, which will allow you to spend more time with your family.
- Cut the costs of transportation to an office and save time by working in the most comfortable environment – your home.
- You get to choose your business projects.
- You can claim tax-deductible business expenses that may include business equipment, meals, business trips, and more.
However, there are a few downsides of self-employment, including:
- Irregular income and late payments. As a self-employed, the number of businesses and clients that come your way will vary from month to month, and so will the clients’ willingness to pay for the work you’ve done, which will make your monthly earnings unsteady.
- No employee benefits and health insurance. Forget about paid holidays, vacations, or sick leaves; when you can’t work, you won’t get paid.
- Self-employment taxes. Self-employed individuals pay taxes themselves.
There isn’t a one size fits all type of retirement plan; in fact, every retirement plan has its advantages, and it’s up to you to decide which one is going to suit your retirement goals. In the rest of the article, we will explain these retirement plans in detail to help you better understand this complex topic.
A traditional IRA is an individual retirement account that allows you to make pretax contributions, reduce your tax burden by filing tax deductions, and encourage you to save for future retirement. Thus, a traditional IRA helps your investments to grow tax deferred and provides you financial security when you retire. Anyone who earns taxable income can open a traditional IRA.
Tax deferred growth means you will not owe capital gains taxes on the investment returns, dividends, or interest in the account. In contrast, you’ll owe regular income tax on some of your gains and earnings when you make withdrawals from your traditional individual retirement account in retirement.
As previously mentioned, contributions to traditional IRAs are mostly tax deductible. For example, if you contribute $6,000 to your IRA, you can claim that amount as a tax deduction on your annual income tax return, and the IRS won’t apply taxes to those earnings. In 2020 and 2021, you could contribute up to $6,000 per year into a Traditional IRA. For those older than 50, you may contribute an additional $1,000 up to $7,000 per year.
Unlike a traditional IRA, where your contributions may be tax deductible, a Roth IRA has no tax breaks up-front. Once your money has been taxed, it will go into the Roth IRA afterward. The benefit of using Roth IRA is that when you start making withdrawals in retirement, they will be tax-free.
Furthermore, you can contribute to both a traditional and Roth IRA in the same tax year as long as you don’t exceed an annual contribution limit ($6,000 in 2020 or 2021, or $7,000 if you’re 50 or older). According to some financial advisors, it may be beneficial to diversify your retirement account types. The best part of Roth IRA is that it allows you to withdraw money when in need, before your retirement. Thus, Roth IRA can act as an emergency fund.
The Roth IRA rules have set contribution limits based on filing status and total income. If the individual’s earnings are above the contribution limits, they aren’t eligible to open a Roth IRA. The annual contribution limit in 2021 is $140,000 for individuals and $208,000 for married couples filing jointly.
You can set up these individual retirement plans with a bank or other financial institution, life insurance company, mutual fund, or stockbroker. Roth and traditional IRA are suitable for individuals looking to save a modest amount of money.
The solo 401 k plan is slightly different from a standard, employer-offered 401k plan, where you make contributions pre tax. In a solo 401 k plan, you can make withdrawals after age 59 and a half without paying withdrawal penalties and pay taxes when you take the money out.
However, there are some rules to contribute a solo 401 k, such as not being allowed to contribute if you have employees, making a 401 k plan ideal for small business owners and self-employed with no employees. Luckily, if applicable, you can hire your spouse and contribute to the plan together. In this instance, your spouse can contribute up to the standard employee 401 k contribution limit. There are no income limits and age restrictions to apply for a solo 401 k plan.
On top of that, you can add the employer contributions up to an additional $58,000 total in 2021 or $61,000 in 2022. If eligible, people aged 50 or older may even get catch up contributions to their 401 k accounts. You can easily open a solo 401 k account by online brokers with your employer identification number. Don’t forget you’ll have to file paperwork with the IRS once you get past $250,000 in your 401 k account.
A Simplified Employee Pension plan (SEP) permits employers to contribute to traditional IRAs set up for employees. Simplified Employee Pension plans offer a significant income source at retirement, allowing employers to set money aside in retirement accounts for their employees and themselves.
One of the SEP IRA advantages is a low administrative burden, as SEP IRAs require less paperwork and no annual reports to the IRS. Also, you aren’t obliged to contribute every year.
SEP IRA has no start-up and operating costs, unlike conventional retirement plans. A simplified Employee Pension plan is ideal for small business owners with few or no employees, as it allows contributions of up to 25 percent of each employee’s pay.
You must set your SEP IRA for each eligible employee, ideally by qualified financial institutions like banks or insurance companies. The maximum contribution an employer can make to an employee’s SEP IRA cannot exceed the lesser of 25 percent of the employee compensation or less than $61,000 for 2022.
The downside of SEP IRAs for business owners is making employee contributions equal to the ones you make for yourself, yet not equal in dollar amount, but as a percentage of earnings, which may be costly. Remember that all SEP contributions must go to traditional IRAs.
A Savings Incentive Match Plan for Employees (SIMPLE IRA) is a retirement plan suitable for business owners (with up to 100 employees) and self-employed individuals. SIMPLE IRAs are simple as they have low maintenance and start-up costs and require minimal paperwork, just annual disclosures to employees and an initial plan document.
The SIMPLE IRA has some similarities to a traditional IRA, as it’s also on a tax deferred basis and has the exact withdrawal requirements. Employers must add matching contributions to the employee’s SIMPLE IRA account; they can either match contributions up to 3% of employee compensation or contribute up to 2% percent of a worker’s salary up to the annual compensation limit of $290,000 (2021).
The maximum contribution limit is $13,500, with a $3,000 catch-up contribution for those aged 50 or older, up to a total of $16,500. The amount of money an employee can save with a SIMPLE IRA is lower than with a Traditional 401 k plan, where workers under 50 can save as much as $19,500 and an additional $6,500 if they’re 50-plus.
It’s important to mention a 401 k version of a SIMPLE IRA, which allows users to take loans from their accounts, but it’s more expensive to start up and requires more administration.
Defined benefit plans or pension plans are becoming increasingly rare. With a defined benefit plan, employees will receive a pre-set fixed benefit when they retire.
A defined benefit plan may be the best option for a self-employed person with a high income, solid cash flow, no employees, and a goal to contribute more than $60,000 per year to a retirement account income. With a defined benefit plan, your retirement savings will be guaranteed, reliable, and won’t depend on market growth and investment returns.
Contributions may be up to a maximum of $294,500 when combined with a 401 k plan. A defined benefit plan should be set up with a certified public accountant and an actuary. They will set the contribution amount based on your age and compensation history.
On the downside, defined benefit plans are more expensive, have high setup and annual fees, and require funding regularly a certain amount per year, so business owners tend to opt for other available retirement plans. Once the employer’s contribution amount is set, the employer must make the annual contribution minimum as planned. If you must change the original amount, the IRS may impose excise taxes with interest charged.
A Keogh plan is a tax-deferred retirement plan for self-employed people or unincorporated businesses, partnerships, and sole proprietorships. The IRS recognizes Keogh plans as qualified retirement plans that come in two types: defined-benefit and defined-contribution plans. Defined-contribution plans include profit-sharing plans and money purchase plans. The Keogh plan is most popular among high earners.
Contributions are generally tax-deductible up to a certain percentage of annual income, which the IRS may change from year to year. Most Keogh plans are defined-contribution plans. If you are an independent contractor, the Keogh plan is not an available option for you.
Keogh plans are generally more complex than the SEP IRA plans. It falls under the Employee Retirement Income Security Act guidelines, a federal law that sets specific standards for employer-sponsored retirement and health plans.
To establish a Keogh for yourself and your business, you must submit a complete plan document to the government. In most cases. It may be more convenient to get a certified financial planner or an accountant to prepare and submit your Keogh plan.
Health savings accounts are there to pay for your out-of-pocket medical costs, but they may work as outstanding tax-advantaged retirement savings accounts as well. Using your health savings account for future medical expenses is a better strategy than using retirement accounts. You can contribute to a health savings account via payroll deductions or from your funds, in which case they are tax-deductible, even if you don’t itemize them. When you make contributions from your funds, they’re made on a pre tax basis, which will reduce your federal and state income tax liability.
As a result, your health savings account balance grows tax-free, as well as any interest, capital gains, or dividends you earn. A Health savings account is the most tax-preferred account available with tax advantages similar to a traditional 401 k plan or IRA, making it a resourceful way to save for retirement, and it’s budget-friendly as premiums are low.
If you keep receipts for unreimbursed medical expenses, you can get tax-free funds from your Health savings account even years after you made the expenses.
There are plenty of self employed retirement plans available, but be sure to take all pros and cons into consideration, as well as your self employment income, particular tax benefit, and your unique saving goals.
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Sadly, Americans are still way behind when it comes to retirement planning. According to the US Government Accountability Office, in 2019, almost half of households headed by someone 55 or older had no retirement savings at all. As a result, many people won’t have enough money to live comfortably during retirement and will have to depend solely on Social Security to pay for their living costs.
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