When you’re a corporate employee, you have a company-matched 401K and maybe even a fully funded pension plan (if you’re lucky). When you’re self-employed, saving for retirement falls 100% squarely on your shoulders. Furthermore, unless you want to still be working when you’re old and gray, it’s a good idea to start saving sooner rather than later.
The good news is, the government makes it easy, and tax free, for you to build up your own personal retirement account. In this post we discussed in detail the options specifically related to those who are self employed. Below, we highlight two of the most common retirement plans in which people participate.
401K & Individual Retirement Accounts
A 401K is a special type of retirement fund set up and administered through an employer. Some companies offer to match a percentage of every dollar you contribute, making this a nice, pre-tax benefit. But if you are self-employed, there is a variant called a Solo/Individual 401K (available only to self-employed persons with no employees) that pretty much allows you to do most of the things you can with an employer offered 401K.
Traditional IRAs, or Individual Retirement Accounts, are set up with the help of a bank or financial planner, and are also non-taxable. That means that if you’re paying 30% of your net income to the IRS (not uncommon for self-employed folks) you can save 30 cents on every dollar you contribute to an IRA. Note that a traditional IRA contrasts with the newer Roth IRA. The Roth IRA uses after-tax dollars, meaning that contributions are not deductible. However, upon reaching retirement age, both the principal and your gains can be withdrawn tax-free.
Contribution Limits & Other Considerations
There’s a limit to how much you can invest in a retirement account. For 401Ks, the maximum you can stash away pre-tax is $17,500 ($23,000 if you’re 50 or older). For IRAs, it’s $5,500 ($6,500 if you’re age 50 or older).
Before you start stashing money away, though, remember that this tax savings does come with a price: You can’t touch the money you invest until you’re 65, or you end up paying not only the income tax, but penalties as well. In addition, you will have to pay income tax on that money when you retire (except Roth IRA withdrawals).
A Sound Investment?
In addition to helping you prepare for retirement, there’s another benefit of a retirement savings account; the potential to earn a substantial rate of return. Since you have the flexibility to divide your contributions among various investments, you can potentially earn substantially higher returns than the current 0.5% rate of interest that your savings account is giving you.
Of course, there’s no guarantee that any investment will earn money. Just talk to anyone who was close to retirement age when the economy took a downturn in 2008. Many people saw their 401ks and IRAs dwindle away significantly.
Yet, as a mechanism to save on your income tax, as well as saving for retirement, an IRA or 401K plan could be worth considering. They’re easy to set up, have few costs involved, plus they give you the freedom to invest your money in higher earning investments while still enjoying tax breaks.