Retirement can be a scary concept to most people, as humans we crave purpose and having a job satisfies that in us. Although the major contributor to stress around retirement isn’t so much the lack of purpose, as it is the lack of funds. Ensuring you put enough money aside to survive the 20+ years you may live after retirement can be hard, especially when you’re a contractor.
The importance of functional retirement plans isn’t lost on the average contractor, who doesn’t receive the same support from employers that the majority of working Americans do. Unlike their employed counterparts, independent contractors are often forced to find their own ways to prepare for retirement, often utilizing solo 401k plans to achieve this. Without guidance from an in-house HR representative, this can be a feat in itself.
Here is a look at the solo 401k benefits compared with the other retirement plans available to independent contractors.
Unlike retirement plans for employees, there are only 4 retirement plans for independent contractors. They are the Solo 401k plans, Simplified Employee Pension (SEP) IRA, Simple IRA, and Keogh Plan. Depending on how much you earn, and how much effort you want to put into setting them up, some are more suitable than others. For the sake of the average independent contractor or self-employed person, we will be considering the first three plans, and not the complicated Keogh plan.
Officially known as a one-participant 401k, these plans are reserved for sole proprietors with no employees other than a spouse working for the business. Solo 401k plans emulate the standard 401k plans that most employees have, with the major difference being that you can contribute as both the employee and the employer.
This gives you a much higher contribution limit than other similar plans, at $58,000 per year for those younger than 50 years old, and $64,000 if older. If your spouse works for you they can also contribute up to the same amount, which can then be matched by you. This is one of the major Solo 401k benefits which makes it that much more attractive than other plans.
A common concern with the Solo 401k is the difficulty of setting it up, and restrictions on what investments can be made within the plan. As these plans need to be set up with a Financial Institution, the individual needs only to shop around to find reputable firms that offer low-cost plans with a great deal of flexibility.
This is a variation of the traditional IRA, and is considered one of the easiest retirement accounts to set up and operate, making it great for sole proprietors. It also allows for one or more employees, making it more suitable if you have plans of hiring employees in the future. Unlike the Solo 401k, only the employer can make contributions to the SEP IRA.
Contributions are capped at 25% of your net earnings, which is defined as your annual profit minus half of your self-employment taxes, and limited to a maximum of $58,000 in 2021. A SEP IRA is much easier than a Solo 401k to set up, and can be done so online through various brokerages.
When compared with the Solo 401k benefits, it is an attractive option, although as contributions are based on a percentage of your profit you will need to earn more to actually take advantage of the larger contribution cap.
The Simple IRA follows the same investment, distribution, and rollover rules as the traditional or SEP IRA, except with lower contribution thresholds. Unlike other plans, you can put all of your net earnings from self-employment into the plan, up to a maximum of $13,500 in 2021, plus an additional $3,000 if you’re 50 or older.
Employees can contribute along with employers in the same annual amounts, although as the employer you’re required to contribute dollar for dollar up to 3% of each participating employee’s income to the plan each year. Otherwise, you must make a fixed 2% contribution to every eligible employee’s income regardless of whether they contribute or not. This plan also typically has early withdrawal penalties of up to 25% in the first two years, so you should be 100% sure you’re going with this plan in the long run.
Setting up a Simple IRA is similar to setting up a SEP IRA, although the Financial Institutions may charge administration and participation fees, and the paperwork to set it up is considered more complicated than that of a SEP IRA.