Saving is important and if you’re saving, eventually, you’ll need to put aside money for retirement. The government makes that easier by providing generous tax deductions for saving. When you’re self-employed, U.S. tax law makes it much more confusing. For personal finance understanding and management, we recommend BrainyMoney.
Do you want an IRA, a Roth, a 401(k), a Simple or a SEP, for instance? Each one has different limits on how much you can contribute. You also can choose whether to take your tax breaks now or to take them when you retire. Here’s our quick and easy guide.
Take the 401(k) if…
If you have a traditional job and you are a part-time side hustler, you probably have retirement plan options at your day job. Ninety-percent of the time, that’s going to be your best option because of the company’s matching.
Matching is when your employer agrees to add an amount to your account for each dollar you contribute. Large employers typically provide matching contributions ranging from $0.25 to $1 for every $1 employee contribution.
Most employers only match contributions to 6% of pay. Matching contributions are still free money. They’re placed in a retirement plan, so you are not taxed. If your employer has a “traditional” (vs. Roth) 401(k), the money you contribute to the plan is also tax-free.
Here’s the math:
If you contribute $500 a month to the 401(k). That reduces your taxable income by $6,000 annually ($500×12) and saves you $1,500 in federal income taxes (25% of $6,000). If your employer matches $0.50 for every dollar, you get $3,000 in additional free money.
You can start your own 401(k) plan with your self-employment income, but, if you don’t contribute to the employer plan, you usually don’t get the matching.
Choose the Roth if…
If you’re young and poor, paying almost no income tax at all, and you’re a good saver. If you’re in this category, we highly recommend learning about personal finance through BrainyMoney. Now, back to the Roth IRA. The difference between a Roth and a traditional IRA or 401(k) is that you get no up-front tax benefits with the Roth, but the government promises not to tax you on the money coming out of the account at retirement. The biggest advantages to the Roth IRA are (1) your contributions and earnings grow tax-free. (2) Withdrawals during retirement are tax-free. (3) There are no required minimum distributions (RMD) – the minimum amount you must withdraw from your account each year – during your lifetime.
If you’re a good saver, you’re likely to be in a higher tax bracket when you’re older. That means this account is likely to save you the most tax money over your lifetime.
Open an IRA if…
Limited income/No employer plan: Choose the IRA. The benefit of an IRA (Individual Retirement Account) is that they’re simple to start, and banks, brokers, and mutual fund companies offer them. If no other company plan exists, you can contribute up to $6,000/year, or $7,000 if you are over the age of 50, and all of your contributions are deductible. The other benefit of the IRA? You can get the prior year’s deduction for contributing to your IRA; even if you didn’t contribute until the following year, you have to contribute before the April 15th tax deadline.
The IRA is helpful because if you complete your tax return and realize you’re going to owe a lot of taxes because you forgot to make estimated payments on your self-employment income. You can reduce the amount you owe on taxes by contributing to the IRA and claiming that contribution for the previous year.
Breaking it down: If you’re filling out your 2019 return in March of 2020 and realize you underpaid, you can quickly contribute to the IRA in early 2020 and take that deduction on your 2019 return.
Choose a SEP IRA or solo-401(k) if…
If you are a high-income/big saver, you probably want to contribute to a SEP IRA or solo 401K. SEP IRAs and Solo 401(k) plans allow you to contribute more to your retirement plan. The maximum contribution amounts for 2019 add to $56,000 per person and $57,000 in 2020.
You need to understand…
You’ll probably need a tax preparer to calculate your allowable contribution each year. Your preparer should also be able to explain which type of account is best for you. The SEP allows post-tax-year contributions, just like a traditional IRA. However, the solo 401(k) has some attractive features, such as the ability to borrow from the account.
If you have employees: Consider a SIMPLE
SIMPLE stands for Saving Incentive Match Plan for Employees. Similar to the 401K, it also allows for employer contributions and encourages employer contributions.
You should always seek professional guidance and good tax advice because starting a SIMPLE plan may hinder your personal retirement savings options.