How to pick a retirement plan

If you don’t want to work forever, you need to start setting aside money for retirement. The government makes that easier by providing generous tax deductions for saving. The bad news is that when you’re self-employed, U.S. tax law provides such a dizzying array of retirement account choices that it’s easy to get lost in the jargon.

Retirement plan choices

Do you want an IRA, a Roth, a 401(k), a Simple or a SEP, for instance? Each is a little different, with different limits on how much you can contribute. You also can choose whether to take your tax breaks now or to take them later, when you actually retire. Lost? No worries. Here’s our quick and easy guide.

Part-time hustlers, with a day-job: Take the 401(k)

If you have a traditional job in addition to a side hustle, there’s a good chance that you will be offered a retirement plan at your day job. Ninety-percent of the time, that’s going to be your best option. The reason is “matching.”

What’s matching? It’s when your employer agrees to add a set amount to your account for each dollar you contribute. Big employers typically provide matching contributions ranging from 25 cents to a $1 for every $1 workers contribute.

There are some limits. For instance, most employers only match contributions to 6% of pay. Still, matching contributions are free money. And because they’re placed in a retirement plan, you are not taxed on receiving this free money. In fact, if your employer has a “traditional” (vs. Roth) 401(k), the money you contribute to the plan is also tax-free. The government acts as if you never earned it.

The math

So, let’s say you contribute $500 a month to the 401(k). That reduces your taxable income by $6,000 ($500 times 12 months) and saves you $1,500 in federal income taxes (25% of that $6,000). If your employer matches, 50 cents on the dollar, you get $3,000 in additional free money.

You also can start your own 401(k) plan with your self-employment income, of course. But, if you don’t contribute to the employer plan, you usually don’t get the matching.

Poor now/rich later: Choose the Roth

Let’s say you’re young and poor, paying almost no income tax at all, but you’re a great little saver. Then you might want to look at a “Roth” IRA or 401(k). The difference between a Roth and a traditional IRA or 401(k) is that you get no up-front tax benefits with the Roth, but the government promises not to tax you on the money coming out of the account at retirement.

If you’re a good saver, you’re likely to be in a higher tax bracket when you’re old than you are now. That means this account is likely to save you the most tax money over your lifetime. The catch: You don’t get any of the tax breaks now.

Limited income/No employer plan: Open an IRA 

The benefit of an IRA (Individual Retirement Account) is that they’re simple to start and everybody – banks, brokers, mutual fund companies — offers them. If you are not covered by any other company plan, you can contribute up to $6,000 per year — or $7,000 if you are over the age of 50 —  and all of your contributions are deductible. The other benefit of the IRA? You can get a 2019 tax deduction for contributing to one, even if you didn’t make the contribution until 2020. You just have to make the contribution before the April 15th tax deadline.

Why is this helpful? Let’s say you complete your tax return and realize that you’re going to owe a bunch of tax because you forgot to make estimated payments on your self-employment income. You can reduce the bill by contributing to the IRA and claiming that contribution for the previous year.

In other words, if you’re filling out your 2019 return in, say, March of 2020 and realize you underpaid, you can quickly contribute to the IRA in early 2020 and take that deduction on your 2019 return.

The catch: If you or your spouse are covered under an employer plan, you can only fully deduct IRA contributions if your income is less than $196,000 (when single) or $206,000 (when married, filing jointly). After that, your deductions are limited until they’re phased out completely. 

High-income/big saver: Choose a SEP IRA or solo-401(k)

They’re not quite as simple as a traditional IRA, but SEP IRAs and Solo 401(k) plans can allow you to contribute far more to your retirement plan. Indeed, the maximum contribution amounts for 2019 add to $56,000 per person in 2019 and $57,000 in 2020.

The bad news?

Unless you’re a math whiz with plenty of time on your hands to go through arcane tax rules, you’ll need a tax preparer to calculate your allowable contribution each year. The good news is that if you’re earning this kind of dough, you ought to have a good tax preparer anyway.

Your preparer should also be able to explain which type of account is better for you. The SEP allows post-tax-year contributions, just like a traditional IRA. However, the solo 401(k) has some attractive features, such as the ability to borrow from the account.

When you have employees: Consider a SIMPLE

If your business grows to the point that you need to hire additional employees and you want to provide them with a retirement account, the best bet is likely to be a Simple plan. SIMPLE, which stands for Saving Incentive Match Plan for Employees, have the same contribution limits as IRAs. However, they also allow for employer contributions — and, in fact, encourage employer contributions.

The plans are easy to set up, but if you’re at this stage in business, you really ought to seek out good tax advice because starting a Simple plan may hinder your own retirement savings options.