Self-employment is on the rise, and today’s small-business owners have more assets to invest, and therefore protect, than ever. In fact, small business’ annual revenue increased by 32 percent from 2011 to 2014, and investable assets rose by 35 percent, according to a recent Guardian Life study.
However, the same survey found that only about half of small-business owners feel well-prepared for retirement. Similarly, a recent TD Ameritrade study found that 40 percent of self-employed people only save occasionally, when they feel they can afford to, and that 28 percent aren’t saving at all.
Still, only 19 percent of those respondents expect to fund their retirements through ongoing business profits, and just 14 percent predict that selling their businesses will provide the bulk of their nest egg. Despite the difficulties of balancing business expenses and retirement savings, a majority of small business owners plan to live mainly on the investments they make before they quit working.
Fortunately, whether they’re playing catch-up or maintaining long histories of consistent savings, the self-employed enjoy a great deal of flexibility in retirement planning. Though they also bear greater responsibility than the traditionally employed, consistency and sound advice will allow them to grow sizable portfolios, minimize their tax liabilities and continue to enjoy the wealth they’ve built—all while still growing their businesses.
Tax-Deferred Accounts for the Self-Employed
“Any business owner needs to understand the total pool of retirement account options available to them, and usually they enlist the help of a financial advisor to find out,” said Greg Lessard, Aspen Leaf Partners Founder and President. The plans open to small business owners are similar to those for employees, but well-rounded advisors need to be able to explain their nuances and help clients pick the ones that suit their incomes and goals.
For many business owners, the best option is the Simplified Employee Pension (SEP) IRA. “It’s one of the easiest to set up, and you can contribute 20 to 25 percent of your income,” said Caleb Huftalin, advisor at Catalyst Wealth Management. In contrast to a traditional IRA, which allows for up to $5,500 in tax-deductible contributions, the SEP IRA allows owners to contribute the lesser of 25 percent or $53,000 as of 2015, according to the IRS.
For high earners, however, a 401k plan may be a better bet. “If someone’s income is under $200,000, the SEP IRA is probably sufficient, but once you get above that percentage or you want to contribute more, you’ve got to go the 401k route,” said Huftalin. “One of the most under-utilized plans is the solo 401k, but it’s great for businesses that have a big year or an income far above the SEP limits.” While the traditional 401k only allows for $18,000 in tax-qualified contributions per year, the one-participant, or “solo” 401k allows for an additional 25 percent of net self-employed earnings. The total contribution is still limited to $53,000, but the combination of the initial $18,000 and 25 percent of earnings allows for greater overall savings than a SEP IRA with the same income.
Finally, there’s the Savings Incentive Match Plan for Employees of Small Employers (SIMPLE) IRA, often the best bet for lower income earners. The plan has no percentage-based limit, and owners can contribute up to $12,500 in 2015. Although that far exceeds the $5,500 limit for traditional and Roth IRAs, the SIMPLE IRA also requires small business owners to match their employees’ contributions at three percent or contribute a flat two percent of their salaries, even for employees who contribute nothing themselves. Ultimately, self-employed savers with one or more employees will have to weigh the plan’s high limits against those employees’ paychecks and saving habits.
Despite the popularity of tax-deferred retirement plans for both traditionally and self-employed savers, some advisors like to steer clear. “You can pay taxes on a small amount of principal or a great deal of return,” said Bruce Elfenbein, Seeman Holtz senior advisor. “For regular people who don’t have time to study the market and don’t want to gamble, it’s tough to beat an overfunded life insurance policy.” According to Elfenbein, a properly structured policy can produce tax-free returns in the neighborhood of eight percent – a particularly attractive option for business owners who don’t have a great deal of extra money to contribute, but who are able to start early and save consistently.
Roth contributions are also a great for creating tax-free retirement income, but small business owners may not want to rely on the Roth IRA, which is still capped at $5,500. On the other hand, the Solo 401k allows for Roth contributions up to the salary deferral limit of $18,000. The “employer” contributions—25 percent of self-employment earnings—must still be made tax-deferred, though.
Creating a Plan
Whether a client is catching up or contributing to long-standing retirement accounts, the first step their advisors should take is to look at their current assets. “A self-employed business owner who wants to get organized should look at their existing retirement plans first,” said Lessard. They may have 401ks from old jobs, annuities or taxable investments they’ve earmarked for retirement, and some of that money may be able to be rolled over into other products that make more sense for their current goals and incomes.
After reviewing current assets, they should then look to self-employed retirement accounts with the help of a financial advisor or tax planner. “There are enough differences between the Solo 401k, SEP IRA and SIMPLE IRA, among other plans, that they warrant a conversation with an expert,” Lessard added. “Most business owner clients don’t have the time or inclination to read IRS documents about which plans are best for them.”
Social Security should also be factored into their portfolios, though ideal strategies don’t differ much between traditionally and self-employed clients. If anything, business owners’ attempts to minimize tax liability may just require that they save more of their own money to offset the resultant reduction in Social Security payouts. “Social Security is only going to pay out so much,” said Elfenbein. “If I have a chance to maximize a contribution to retirement with something like life insurance, that’ll give me a better return than I’d ever get on Social Security.”
While small business owners’ investment options may differ, however, their saving and spending habits should not. “No matter how someone earns their dollar, they should always focus on the things they can control: reducing investment expenses, diversifying portfolios, minimizing taxes and being disciplined. Market trends, picking winning stocks and market timing should generally be avoided,” said Lessard.