A Retirement Savings Rule the Self-Employed Should Be Using

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I don’t profess to have all the answers, but my woman’s intuition is usually right (and has been since I was 13).  I’ve slowly but surely learned to live by the “80-10-10 rule” - this is a principle I made up, but one I wish someone had taught me when I was younger.  The basics are this: “learn to live on no more than 80% of your income, save at least 10% for your future self, and give 10% away to causes and communities that matter to you”.  

Believe me, I know it can be difficult to remind yourself of the importance of regular and timely deposits into your future retirement savings (it was especially difficult for me to remember that while in the shoe department at Neiman’s… miss you Neiman’s).  

Trust me when I say (particularly to the women in the audience!): stash that 10% away each year and every year, because it will provide you so much freedom and choice in the future, especially when the chips are down in life.

Btw, “the 80-10-10 rule” isn’t inflexible.  If you’re young, up to your eyeballs in student debt, and earning an entry level salary, maybe you can’t part ways with 10% of your income for charitable causes.  Maybe your 10% back to the community is you donating the equivalent of that monetary value in the form of your time and expertise.  For example, you could volunteer with Junior Achievement and teach the next generation!

Anyway, back to retirement savings and paying your future self… Here is a high-level overview of how retirement savings works now that you’re self-employed.

1. There are two main types of contributions: pre-tax and post-tax.  Most plans are pre-tax contributions.

  • Pre-tax contributions reduce your tax bill when you put the money into your retirement plan, it grows tax-free while in the plan, and then when you take distributions at retirement age the full amount is taxable at that time.
  • Post-tax contributions are put into the plan without current year tax reductions… but… they grow tax free and give you a bigger bang for your buck when you retire as the money comes out tax-free too.

2. Retirement as a sole proprietorship/single-member LLC - what are my options?

Option 1: SEP IRA

  • The contribution limits for a SEP IRA are 25% of your net self-employment earnings, capped at $58,000 maximum contributions for the year.  
  • Contributions must be paid into the plan by the date you file your personal tax return - so April 15th of the following year.
  • These plans are some of the cheapest and easiest to administer, and are good if you’re looking to make contributions but may be short on cash during the year.

Option 2: Solo 401k

  • The annual Solo 401k contribution consists of a salary deferral contribution and a profit sharing contribution. The total allowable contribution adds these two parts together to get to the maximum Solo 401k contribution limit.
  • Although the term salary deferral is used, a sole proprietorship, partnership or an LLC taxed as a sole proprietorship do not provide a W-2 salary to the business owner.  For businesses of this type, the salary deferral contribution is based on net adjusted business profit.  In 2021,the limit is 100% of net adjusted business profits income up to the maximum of $19,500
  • A profit sharing contribution can be made up to 20% of net adjusted business profits.
  • A sole proprietor works as an independent contractor with $50,000 of net income in 2021. In this example, the sole proprietor could contribute $19,500 of salary deferrals plus $9,294 profit sharing contribution for $28,794 total Solo 401k contributions.
  • You have until you file your tax return to make the contributions.

Option 3: Roth/Traditional IRA

  • If cash is really tight, then another option is a Roth and/or Traditional IRA.  The max amount you can put in is $6,000 for the year.
  • The Roth contributions are made post-tax, but they grow tax free giving you more growth towards your retirement.  The traditional contributions are made pre-tax, giving you real-time tax savings.
  • These must be paid into the plan by the date you file your personal tax returns - so April 15th of the following year.

3. Retirement as a single-owner S Corporation - what are my options?

Option 1: SEP IRA

  • The contribution limits for a SEP IRA as an S Corp are 25% of your W-2 wages, capped at $58,000 maximum contributions for the year.
  • For example, if you put $50,000 through payroll as your reasonable salary (and remember, all these non-cash benefits count towards the W-2 amount), you can contribute up to $12,500 to your SEP tax-free.
  • Contributions must be paid into the plan by the date you file your S Corp tax return - so March 15th of the following year.
  • These plans are the cheapest and easiest to administer, and are good if you’re looking to make contributions but may be short on cash.

Option 2: Solo 401k

  • Like a 401k you may have had at a previous corporate job, these plans have both employee and employer contributions (you just happen to be both the employee and employer).  The employee portion can be 100% of W-2 wages up to $19,500 for the year.  The employer portion is limited to 25% of your W-2 wages, and the total aggregate employee and employer contributions cannot exceed $58,000.
  • Using the above example, you pay yourself $50,000 in wages on your W-2 - you can contribute $19,500 as the employee and $12,500 as the employer for a total of $32,000.  Also, the employee portion can be a post-tax Roth 401k contribution if you can afford to make post-tax contributions, which produce higher growth towards retirement.
  • While the employer portion isn’t due until the March 15th S Corp tax return deadline, the employee portion must be paid in before the close of the calendar year on December 31st.  Both portions should be reflected in your W-2 as tax-free retirement contributions.
  • These plans are a little more costly to open, but many high street banks and investment firms offer affordable ones for small businesses.  These plans are good for those with liquidity and looking to beef up their retirement savings.

Option 3: Roth/Traditional IRA

  • This option is also available to S Corp owners if they are short on cash, but still want to contribute something.  

4. Any other considerations?

  • Save what you can, when you can!

Written by:

Bethany Swartwood
Head of Tax & Business Law, Mylance

I specialize in helping businesses-of-one and start-ups achieve financial and tax compliance while saving them tens of thousands of dollars each year.

Schedule a free tax consultation with our CPA