More and more people are entering the world of entrepreneurship. Being self-employed is appealing to many, offering freedom and control of your own future, as well as unlimited income potential. But it also has its challenges, one of which is retirement planning.
In this guide, you’ll find out how to prepare for retirement as a self-employed individual.
Retirement Planning for the Self-Employed – How is it Different?
People who work for a company or in the public sector usually have the benefit of company-matched 401Ks or pension plans, making saving for retirement automatic. Self-employed people, on the other hand, have to be proactive and create their own retirement plans. They also have to be disciplined enough to allocate some of their income to savings vehicles.
Planning and saving need to start early and should be based on your specific retirement goals, such as your ideal retirement age and your retirement lifestyle goals.
Understanding Retirement Plan Options for the Self-Employed
Several different types of retirement account options are available for self-employed people.
Traditional or Roth IRAs
Individual retirement accounts (IRAs) are the simplest retirement savings option. Traditional IRAs are funded with pre-tax income and grow tax-deferred until retirement. Contributions to the IRA are tax deductible in most cases, up to specified limits, which for tax year 2023 are $6,500 annually for people under 50 and $7,500 for people over 50. Some exceptions to the deductibility rules do apply, so you’ll need to check your eligibility.
IRA contributions cannot be distributed without a penalty until age 59 1/2. When withdrawals are made after that age, they become taxable income. Distributions taken before age 59 ½ are subject to income tax plus a 10% penalty.
IRA contributions can be invested in most types of investment vehicles, including stocks, bonds, and mutual funds. There are a few exceptions, which include collectibles and life insurance policies.
A Roth IRA has similar rules, but contributions are not tax deductible. However, the earnings of the IRA are tax-free and distributions taken after age 59 ½ are also tax-free.
If you’re self-employed and have no employees, you can contribute to a solo 401K, both as an employer and as an employee. Contributions are tax deductible and grow tax-deferred until retirement, and then withdrawals are taxed.
Contribution limits are much higher than with IRAs: $66,000 annually for those under 50 for tax year 2023, and an additional $7,500 for those over 50.
Of those totals, $22,500 can be contributed as an employee, and 25% of your net income can be contributed as an employer up to the $66,000 total contribution limit.
A simplified employee pension (SEP) IRA can be established by an employer or a self-employed person. If you don’t have employees, you can make tax deductible contributions to the SEP IRA, and contribution limits are higher than those of traditional IRAs. If you have employees, you can make contributions on their behalf into individual SEP IRAs, and those contributions are also tax deductible.
Contributions made on behalf of employees are discretionary, so you can change the contribution amounts at any time, as long as your contribute equally for all eligible employees.
Contributions are limited to the lesser of 25% of income or $66,000.
A Savings Incentive Match Plan for Employees (SIMPLE) IRA allows both employee and employer contributions. As the business owner, you can make your own contributions both as an employer and an employee. The employee contribution limit is $15,500 and the employer contribution limit is 2% of your net earnings
A succession plan is a plan for what happens when you retire, die, or become disabled. It should also be part of your retirement plan. When you retire, you may want to sell the business outright, or you may want to hand over the reins to a family member or a key employee. You need to have clear documentation about how and when this will happen, as well as a plan to transition the person or persons into their new role.
A succession plan can contain a provision in which you, as the business founder, continue to receive residual income from the business, which is why it’s an important part of your retirement plan.
Creating a succession plan involves several steps.
First of all, you’ll need to determine when you’ll transfer the business to your successor. Presumably, you have a target retirement age, so you’ll need to determine your retirement date. You also should have a contingency plan for what will happen to the business if you die or become disabled before that date, or what happens if you decide to retire early.
Choose Your Successor
Choosing your successor may be a difficult decision, particularly if you have multiple family members involved in the business or who are interested in taking over the business. However, your decision should be a practical one. You’ll need to choose a person or persons who are qualified to manage the business so that the business has a better chance of survival after you retire. This will also protect the residual income that you plan to take from the business.
You can choose to transfer ownership to multiple family members or key employees, but you’ll need to determine how that ownership will be divided. You should also determine what the key roles of each person will be. For example, perhaps one person is most qualified to handle the finances of the business, while another is more skilled at operations.
You can create an organizational structure for your business that will make these future roles very clear.
Document Your Processes
Your successor or successors are going to need to know how you’ve made the business successful, so basically, you should draw up a blueprint for managing the business. You need to document your operational processes, your key personnel, your marketing strategy, your financial processes, and your human resources processes.
You’ll also want to highlight your keys to success. What has helped you most in growing your business to this point?
Create a Transition Plan
The first step in creating a transition plan is evaluating the skills and experience of your successors, to understand any training that you’ll need to do. This training can occur during a transitional period in which you’re still present in the business, and working side by side with your successors to give them hands-on training and experience.
You’ll need to establish terms for this transition period in terms of responsibilities and compensation. This transition plan should be clearly defined in writing. You’ll also need to establish how long this transition period will last.
Create a step-by-step plan for this period. You may want to have all your successors involved at the same time, or you may want to transition them one by one so that you can give them more of your time.
The point is you need to document exactly how you’re going to prepare these people to take over your business.
Create an Ownership Transfer Agreement
You’ll need to create a formal agreement regarding the transfer, which you should do with the help of an attorney. The agreement should specify the financial terms of the agreement, including your residual income amount, and the timeline of the transfer.
It will also need to specify any formal procedures that will need to occur, including transferring the ownership of the business entity (such as an LLC), and how items like business insurance, contracts, leases, and any other agreements will be transferred.
Your attorney can help you to determine all the terms and provisions that the agreement should contain.
Determining Your Retirement Needs
As mentioned, your retirement plan should be based on your goals for retirement. How much you save will be based on those goals and how much you’ll need to retire to meet those goals. Calculating your necessary savings plan includes making investment growth projections and factoring in things like inflation and life expectancy.
If you plan to sell your business when you retire or pass it to successors, those will also need to be factored in.
It’s a complicated process to calculate your savings needs and is best done with the help of a financial advisor.
Strategies for Boosting Retirement Savings
First of all, you have to be disciplined about saving and maximizing your contributions as much as you can. You also need to be disciplined about your spending and live within your means so that you’re saving as much as possible.
Your retirement account investment vehicles should be diverse and should be balanced at different stages of your life based on your age and risk tolerance. Again, your financial advisor is your best bet to build a portfolio that will help you to achieve your goals.
You also are, obviously, not limited to retirement savings accounts. You can have other investment accounts that can grow for you over time. You can also make investments in other vehicles like real estate. Building a portfolio of rental properties over time can give you supplemental income when you retire.
Boosting Retirement Income
When you get to the retirement point in your life, hopefully, you’ll have enough income from your business and your retirement accounts to support the retirement lifestyle you’re looking for, but often retirees seek ways to boost their income.
Also, as an entrepreneur, you may not be comfortable without something productive to do, which is why many retiring self-employed people these days are starting a new small business as a side hustle. In fact, one study showed that 40% of baby boomers have started a side hustle.
One idea is to start a consulting business to put your years of business experience to work. Management consulting, in particular, is in high demand, so with your credentials you could probably find many local small business owners who need your services. Focus on whatever your skills are, though, so if you feel that your strength is in operations, do operations consulting.
Any type of consulting could bring in a healthy extra income, and you can work on your own time.
Another idea is freelancing using a skill that you’ve acquired. Perhaps you became an expert at digital marketing during your time as an entrepreneur, so you could perform digital marketing services as a side hustle. Or maybe you developed great writing skills and could combine them with your business experience to be a freelance business writer.
If you want more passive income, you could create online courses. Many websites allow you to create your own course curriculum and upload it, and then students pay to access your courses. Once you have your curriculum developed, you don’t have to do much but answer student questions.
One more idea is to start a part-time bookkeeping business if that’s a skill you’ve acquired. You can probably bring in a few hundred dollars a week, even by just working a few hours.
If you’re more of a get out of the house type, you could consider investing in distressed properties to rehab and resell. This is a great option, especially if you have handy skills. It’s something you could do periodically when you just need a project, or you could do it on a regular basis. House flipping can bring in quite a profit if you do it right.
Rely on Professionals
Planning for retirement, whether you’re self-employed or not, is not a do-it-yourself project. A financial planner is essential to creating a comprehensive financial and retirement plan, and a plan to meet your shorter-term financial goals. You should look for a financial planner that also has experience in succession planning so that they can help you through that process.
An attorney is also a necessity when creating your succession plan and documents.
The most important thing for you to take from this article is that the time to start retirement planning is now. It may seem as though retirement is a long way away, but to achieve your retirement goals, you have to have a long-term plan. You also have to teach yourself to be disciplined about saving and follow the advice of your financial planner. If you take the right steps, you can spend your retirement years exactly how you choose.