Millions of Americans are their own boss, which means that millions of Americans need to be proactive with their retirement savings.
One-in-ten workers are self-employed, according to a 2015 Pew Research Center report, and another 20 percent work for the self-employed (although only a quarter of these businesses employ other workers).
Where you work overwhelmingly determines your ability to amass sufficient retirement savings. The more workers a company has, the more likely they are to offer any sort of retirement plan, according to a 2015 Social Security Administration report. Nearly nine-in-ten firms with more than 100 workers had a retirement plan, compared to just one quarter with fewer than 10 employees.
This exacerbates the nation’s slow-moving retirement crisis — about half of current workers are at risk of a lower standard of living when they hit 65.
But how should the self-employed save? One option to consider is a SEP IRA.
What is a SEP IRA?
A SEP IRA, short for a simplified employee pension individual retirement account, resembles an IRA account for the self-employed, but with some extra perks.
You can contribute $5,500 (or $6,500 for quinquagenarians) in a traditional tax-deferred IRA. In a SEP IRA? The lesser of $55,000 in 2018 or 25 percent of your compensation, up to $275,000. The 10 percent of Americans who are their own boss take that 25 percent from net self-employment income. To be fair, that includes your SEP IRA contributions, so it’s really closer to a fifth of your gross business income.
You’re subject to the same penalties for early withdrawals as other IRA, so don’t touch the funds until you hit age 59-and-a-half, and you must take distributions by the age of 70-and-a-half. Withdrawals are subject to individual tax rates. IRS data show that SEP-IRAs are the least popular IRAs.
If you have a side hustle, you can contribute to your regular job’s 401(k) plan and also maintain a separate SEP IRA. Those interested in tax diversification, likewise, can still contribute to a Roth IRA.
The good news
This is a no-brainer for anyone who has their own business, and doesn’t have any qualifying employees.
“For the self-employed individual, it’s really an easy and cost-effective way to save a decent-sized chunk of money into a retirement plan,” says Baird director of advanced planning Tim Steffen.
Compared to a 401(k) plan there are fewer regulatory hoops to jump through, and it’s pretty simple to set up. Fill out a file IRS form 5305-SEP, you’ll notice on the upper right-hand corner that you don’t even need to mail it to the IRS, and go to a low-cost broker, such as Vanguard or Fidelity, to sign up.
If you earned $80,000 in business profits, you could save nearly $15,000 a year into a SEP-IRA. The earnings grow tax-deferred, and are eventually taxed as individual income when you withdrawal.
The bad news
Life stops getting easy once you take on employees.
Whatever percentage you allocate for yourself, you must also allocate to qualifying workers. (That’s people over the age of 21, earning more than $600 and worked in your business three of the past five years.) That will limit how much you can save for your own retirement.
Since a SEP IRA is an employer contribution, rather than employee, you may want to look into another retirement plan that allows you a bit more flexibility, such as a SIMPLE IRA.
SEP IRAs also don’t allow for the increased catch-up limits you see in IRAs and 401(k)s – although the max is already pretty high – and there is no Roth alternative.
What should you do
If you’re earning income on your own — whether you’re a freelancer, gig worker or entrepreneur —you should strongly consider funding a SEP-IRA. If nothing else, you’ll have more flexibility saving for retirement than you would otherwise.
Choosing a SEP-IRA doesn’t rule out other retirement savings, especially a Roth IRA, assuming you qualify. You contribute after-tax money with a Roth IRA, and pay no taxes when you take the money out after the age of 59-and-a-half.
Workers just starting out in their careers, earning relatively low incomes, can lock-in a low tax rate now and avoid a higher one as they near retirement.
Remember, though, all of these accounts are merely that, accounts. You still need to make investment decisions with your funds. And no matter how you save, investors should be biased towards low-cost, diversified index mutual and exchange-traded funds.