Retirement Savings For Solo Entrepreneurs

 

Hey, what's up, everyone! Henry here from Disruptive Money Management, and today we're back with an episode on retirement savings for self-employed individuals. In recent years, an ever-increasing number of individuals have been migrating to becoming self-employed or otherwise known as independent contractors.

In actuality, looking back through the years, this was not uncommon. Still, it wasn't until the news media started shining the light on self-employed entrepreneurs that it became more relevant. My Apple News and Google News feed are frequently showing the latest articles on solo entrepreneurship. 

One thing that has become more apparent in recent years is the migration of millennials working for themselves rather than working for someone else. Let me ask you this, think about your situation, and I was hoping you could think about your family and friends and separate them by age. The older generation, those most often associated with the baby boomers, has historically always worked for a company. Traditionally, it was not uncommon for that generation to come out of college and join a company that offers a predetermined work schedule, set benefits, and very little flexibility. It was not uncommon for that generation to work for the same company or perhaps switch companies just a few times over their careers.

Entrepreneurship and self-employed gig workers are on the rise with the advent of technology and many major corporations such as Uber, Lyft, and Amazon outsourcing their work to independent contractors.

Entrepreneurship and self-employed gig workers are on the rise with the advent of technology and many major corporations such as Uber, Lyft, and Amazon outsourcing their work to independent contractors.

In contrast, the millennial generation has operated much differently. Yes, there is still a large number of this population that has gone off to work for major companies. Still, there is an ever-increasing number of Millenials operating a side business or have migrated full time to becoming a solo entrepreneur.

I think that this shift from building a career of working for someone else to creating something for yourself was born out of both necessity and, of course, modern technology.

Starting with necessity, the millennial generation has been working with the cards stacked against them. Now, I'm not saying baby boomers had it easier because that's not true. Every generation undergoes different hardships relative to that time, but millennials coming out of college today are tremendously burdened with massive student debt obligations. In one of my last episodes, I talked about the student debt crisis, surpassing $1.5 trillion. Millennials coming out of college hold an average of $50,000 in student debt.

Suppose you also factor in that majority of the major companies where millennials are attracted to are in a very high cost of living cities where housing is exceptionally unaffordable and day to day living expenses are much higher. In that case, it becomes readily apparent that the cards are stacked against them.

Going back to the baby boomers starting their careers in the 40s, 50s, and 60s, the work environment was drastically different. Most significant companies had the added benefit of the pension plan, which meant you dedicated your life to a company, clock in, and clocking out with the ultimate reward of a guaranteed retirement income that would supplement your Social Security.

The corporate world, what was once the pinnacle of many individual’s careers, is now seen more as a stepping stone for Millennials as they search for companies, organizations, or even entrepreneurism to fulfill professional passions and ideologies. …

The corporate world, what was once the pinnacle of many individual’s careers, is now seen more as a stepping stone for Millennials as they search for companies, organizations, or even entrepreneurism to fulfill professional passions and ideologies. As corporations shifted out of pensions, the desire to commit decades of work has slowly evaporated.

Well, with pensions having become all but eliminated and retirement savings being obligated to the responsibility of today's modern workforce, there isn't that long and lengthy tie to an employer like it was in the past.

Technological and societal factors have also played a considerable part in this shift towards entrepreneurism. Even up until the early 2000s, the primary means of communication has been either directly in-person or via phone. If you needed an important document signed, it most likely had to be either overnighted or sent by fax. Today's landscape is the complete opposite of that, with technology now allowing us to communicate in real-time across continents. When I look at how I conduct my business, I can easily communicate with clients across the country using video conferencing solutions and emails. The advancement in technology meant we are no longer tied to a specific geographic area, which opens up working with more individuals across the country who finds value and alignment in our core beliefs and services. 

The societal trends of communicating in real-time and pushing ourselves out there aren't new. Many of you have been doing it personally for at least two decades now via Facebook and now-defunct MySpace. The millennial generation that has grown up with MySpace and Facebook have subconsciously been branding themselves as individuals by their posts and uploads for many years. It was only the next step of taking that personal upload and translating it to professional productivity that has been recently in these past ten years.  

With a better grasp on modern technology, Millennials are gravitating towards taking their knowledge and interests to the mainstream audience in ways that previous generations could not; thus capitalizing on opportunities never presented before.

With a better grasp on modern technology, Millennials are gravitating towards taking their knowledge and interests to the mainstream audience in ways that previous generations could not; thus capitalizing on opportunities never presented before.

So, where does that lead us? Well, suppose you combine a tough financial hand, technological advancements, and an inherent societal factor that allows us to communicate about ourselves and our skills. In that case, you have the perfect storm for individuals to dip their toes into solo entrepreneurship. 

If you are a solo entrepreneur, regardless of whether you're doing it part-time or have made it a full-time commitment, I not only applaud you, but I also want to congratulate you on having created something. The creation of something that you uniquely possess based on your skills and ideas is the most crucial aspect of you and something that can never be taken away. And to be able to translate that into an income stream where you do what you love and are the master of is the most extraordinary form of independence that a person can have. 

But as you shift from a corporate livelihood to an entrepreneurial mindset, the financial tools you incorporate into your lives must also adapt to the new norm. Being with a company has its merits and ease when it comes to retirement planning because we all know that if a company offers a 401k and especially one with a match, you need to participate. You participate every year until you're comfortably saving enough to be on track for retirement.

Whether you're part-time or full-time, the shift to entrepreneurship does not necessarily mean you have to lose out on the path to retirement. Being self-employed allows you to invest for retirement with a broader selection of investment selections.

I'm going to start with the SEP IRA just because it was the first to arrive for solo entrepreneurs. The SEP IRA was predominantly created for small business owners who did not have employees or had very low employees. Although I don't find the SEP IRA to be of any significance in today's time now that we have access to the Solo 401(k), I'm going to briefly go over the concept behind just to put things into perspective. 

As a side note, I do not recommend SEP IRAs for small business owners with employees any longer. The SEP IRA for business owners with employees requires contributions for the employees. From my experience, small business owners who want a company-sponsored solution generally want the employees to contribute their own money, which is not an available option for SEP IRAs. SEP IRAs are all employer contributions. SEP IRAs have been recommended for small business owners in the past, and even to this day, some financial advisors still utilize it because most people think that 401k plans are expensive. If you were to go back to pre-2015, establishing a 401(k) plan can be costly. Still, start-up cost has dramatically decreased since then, which makes the price a minimal comparison. 

As a solo entrepreneur, you can make pre-tax contributions to a SEP IRA, and the contributions invested would grow tax-deferred. Upon obtaining age 59-1/2, you can withdraw from the SEP IRA as an ordinary income. The SEP IRA is very similar to a Traditional IRA in this sense. The way the contributions and withdrawals work is the same. The primary difference and why SEP IRAs were used for solo entrepreneurs is because the contribution limit is significantly higher than a Traditional IRA. The SEP IRA allows you to contribute 25% of your compensation up to the IRS limit of $57,000 for 2020. 

So right off the bat, we see that there is a pretty high limit. $57,000 a year for a solo entrepreneur is a lot of money to socket away for retirement. From an individual standpoint, this far exceeds what you can typically contribute to an employer's 401(k) plan because that limit is only $19,500. So again, if you're a W-2 employee with a 401(k) at work, you can only contribute up to $19,500, whereas if you have self-employed income, you can contribute up to 25% of your self-employed income or $57,000-whichever is the lesser.

That's where there is the catch. The $57,000 maximum is the upper limit on the SEP IRA, but your contributions are calculated on 25% of the self-employed income. So for easy math, if your self-employed income is $50,000, that means 25% of that is $12,500, which is the max you can contribute to the SEP IRA. If your self-employed income is $100,000, then your contribution limit is $25,000. To fully fund the SEP IRA, your self employed compensation must exceed $228,000 due to the 25% rule.

Another option for solo entrepreneurs that is more attractive and better suited for modern times is the Solo 401(k). The Solo 401(k) works similarly to a traditional 401(k), but it is established for business owners without employees other than their spouse. So right off the bat, this is an excellent solution for:

  •  independent freelancers such as graphic designers, software engineers, and consultants 

  • independent realtors without an assistant or employees

  • personal trainers

  • YouTube content creators,

The possibility of what you can do to set up a Solo 401(k) is practically endless. If your income or any part of your income is derived from a source other than a traditional W-2 employee model, you can access the Solo 401(k).

I prefer and always recommend the Solo 401(k) over the SEP IRA because the contribution limits are much easier to manage. For 2020 you can contribute up to a maximum of $57,000 to a Solo 401(k), which puts it equal to the SEP IRA. However, part of the 401(k) is split between employee and employer contributions. For 2020, you can elect to contribute up to $19,500 if you're under age 50 towards the Solo 401(k) as the employee of your own business. If you're over age 50, you have a $6,000 catch-up provision.

Additionally, you can also contribute up to 20% of your net self-income as the employer. The net income is minus one-half of your deduction for self-employment tax.

Now, right off the bat, in terms of maximizing contributions, the Solo 401(k) is easier for those earning less than $228,000. I'll go into the math in a second, but there are also other benefits to the Solo 401(k) that I'll get into.

For someone earning $100,000 in self-employed income, the maximum that you can defer into a SEP IRA for yourself is $25,000 because the calculation is 25% of your self-employed income. If you were using a Solo 401(k) instead and under age 50, you could contribute a maximum of $38,087. That's because you're contributing $19,500 for 2020 as an employee as well an additional 20% of net self-income, which equates to another $18,587.

The difference of $13,087 is why the Solo 401(k) is more advantageous than a SEP IRA for solo entrepreneurs. In addition to that, the Solo 401(k) can also be structured with a Roth component, so if you have the want to contribute more than $6,000, which is standard for a Roth IRA if you're under age 50, then you can pair a Roth component to the Solo 401(k). Effectively, you'll create the ability to divide your employee contribution of $19,500 into tax-free or tax-deferred growth.

The Solo 401(K) also provides you with the option of taking loans from your retirement plan, very similar to what is offered in a corporate retirement plan. The SEP IRA does not allow that. Now, I'm an advocate that retirement money should be set aside for just retirement. Still, with the Solo 401(k), you have the added advantage that if something drastic happens to you financially, you know you have the option of borrowing from that account if you need to. That type of flexibility and having both the tax-free and tax-deductible components make Solo 401(k) superior to the SEP IRA.

Retirement savings may seem meager and difficult without the added benefits of a company’s sponsored match but putting retirement savings off for too long can be costly due to the power of compound interest.

Retirement savings may seem meager and difficult without the added benefits of a company’s sponsored match but putting retirement savings off for too long can be costly due to the power of compound interest.

Saving for retirement is critical, especially with the retirement crisis our country is facing. Suppose you're a solo entrepreneur or have a side business from your 9 to 5. In that case, I implore you to look further than the Individual Retirement Accounts and have a more in-depth conversation regarding the Solo 401(k). The flexibility of the account, the lower threshold for contribution amounts, and the ability to pair with a Roth component make this a must-have retirement tool for self-employed individuals. 

And that's it for today, my friends. I hope you enjoyed this piece. Please share with your friends and family who are self-employed or have a side hustle. I do extensive work with self-employed individuals trying to maximize their tax deductions and save for retirement, so if you have any questions, please reach out to me. Additionally, I'll be releasing a piece in the upcoming weeks on the defined benefit plan and how it pairs with a Solo 401(k).

Until next time, stay healthy, stay safe, and I wish you all a productive week.