Column Archive Money Magazine Ask the Expert by Walter Updegrave
Late-start, self-employed - what's the retirement plan?
There are a host of tax-advantaged ways to save when you're your own boss.
NEW YORK (Money) -- I'm a 50-year-old self-employed man with no children who makes about $60,000 a year after taxes and has $20,000 in an IRA, $100,000 in home equity and $30,000 in debts. What is the fastest way for me build up my retirement fund? - Kevin B., Albany, New York
The same way as anyone else - sock away as much money as you possibly can. But since you're self-employed, you do have two advantages.
First, you have access to more tax-advantaged ways to save than regular salaried Joes.
Second, these tools allow you to put a lot more money away.
SOLO 401(k) For example, if you really, really want to rev up your savings effort, you might consider starting a Solo 401(k), which also sometimes goes by the name Self-employed 401(k) or Uni-k. The big attraction to this type of account is that it offers the opportunity for double-barreled savings. That's because you get to contribute to your Solo 401(k) as both an employer-owner and as an employee.
Here's an example. Let's say your self-employment income from your business totals $50,000 a year after all expenses and income taxes. Under the rules governing Solo 401(k)s and similar plans, you would able to salt away 20 percent of those net self-employment earnings to your plan. So right there, we're talking about a $10,000 annual addition to your retirement fund.
Not bad, but there's more.
Because you are also essentially your own employee, you can also make a 401(k) contribution just the same as any other worker covered by a 401(k) plan. In fact, you can contribute 100 percent of your self-employment income up to a maximum of $15,000, the current limit set by law. And anyone 50 or older - which includes you - can throw in as much as another $5,000 in catch-up contributions. (Both the $15,000 and $5,000 limits increase with inflation.) So that brings your contribution as an employee to $20,000.
Add that to your $10,000 contribution as an employer-owner, and that means you can sock away as much as $30,000 a year.
Now, if you're earning only $50,000, you're probably not going to be able to put away $30,000 and still live (although someone with a working spouse might be able to manage it, or something close). But you can still pump up your retirement accounts by contributing less than the max.
Of course, if your self-employed career thrives and you being earning much more, the maximum amount you can save goes up too. If your net self-employment earnings grow to, say, $100,000, then you could contribute 20% of that as the employer-owner, or $20,000, plus the $15,000 employee contribution, plus the $5,000 catch-up, for a grand total of $40,000.
SEP-IRA Another way to go is to open a SEP-IRA, another type of retirement account available to small business owners and the self-employed. Like a Solo 401(k), a SEP-IRA allows you to contribute up to 20% of your net self-employment income, or $10,000 if your net self-employment earnings are $50,000. But you can't make those employee contributions of up to $15,000 with the SEP-IRA, nor can you take advantage of the $5,000 catch-up.
So why would anyone do a SEP-IRA rather than a Solo 401(k)? Well, it takes a bit more paperwork to set up the Solo 401(k) and you may have to file more tax-related forms than with a SEP-IRA. So if you can't afford to take full advantage of the Solo 401(k)'s hefty savings limits, it might be easier just to do the SEP-IRA.
I should add that since Solo 401(k)s and SEP-IRAs are creatures of the federal government, there are a whole host of rules and regulations that govern them beyond what I've gone into here. See more on how these accounts work, the dollar ceilings on how much you can contribute to them and a comparison of the two plans.
By the way, if you do a Solo 401(k) or a SEP-IRA, you can also do a traditional deductible IRA or a Roth IRA, assuming you meet the income eligibility rules.
And if you don't meet the income requirements, you can always invest in a nondeductible IRA (although, as I've said in an earlier column, I think you're probably better off opening a regular taxable account with tax-managed funds, index funds or ETFs than a nondeductible IRA.)
CUT DEBT Clearly, there's certainly no shortage of tax-advantaged savings opportunities out there for self-employed people like you. The key is to rein in your spending so you can fund them as much as you can.
In your case, there's something else you'll want to do to get in better financial shape for more retirement: pare down that $30,000 of debt.
I don't know what sort of loans you have. But if it's not home mortgage or home equity debt, you might want to consider opening a home equity line of credit and paying off your borrowings with a draw against the credit line. That transaction won't erase your debt, but it will likely make your interest payments tax-deductible, which will lower your after-tax interest rate.
But while paying down your debt is important, I don't think it should take precedence over building up your retirement savings. In fact, even in instances where it might make more sense from a strictly financial point of view to pay off debt first and then start saving, I don't think that's a good strategy for the real world.
The reason is that after a year or two or diligently paying off debt, people sometimes backslide and fall off their repayment schedule and even start borrowing again. Before they know it, they're back in debt and still have no savings.
So my advice is to fund your retirement accounts as much as you can and set a reasonable schedule for repaying your loans. Once you've got your retirement kitty fattened up a bit and you're regularly pouring money in, you can then think about devoting more income to paying off your debt more quickly.
But your first order of business is to start salting away those bucks for retirement, whether it's in a Solo 401(k), a SEP-IRA or even a traditional or Roth IRA. The earlier you start doing that, the bigger the nest egg you'll have to support you when you retire.
Social Security: When's the right time
Ask Walter a question: Click here or e-mail us at email@example.com.