Saving when you are self-employed

Self-employment removes the automatic retirement plan and replaces it with options that are considerably more generous, if anyone sets them up.

The options

SEP IRA. Simple to establish and administer, funded entirely by employer contributions, with a limit expressed as a percentage of compensation up to an annual maximum.

The complication is that if you have employees, you must generally contribute the same percentage for them, which makes it expensive for a business with staff.

Solo 401(k). Available to a business with no employees other than a spouse.

The advantage over a SEP is structural: you contribute both as employee and as employer, which allows a larger total at lower income levels.

Many providers also offer a Roth option within these plans, and some permit loans.

Administrative requirements are slightly higher, including a filing obligation once assets exceed a threshold.

SIMPLE IRA. Designed for small businesses with employees, with lower limits and a mandatory employer contribution.

Defined benefit plans. For high-income self-employed people, particularly later in a career, these can permit very large deductible contributions.

They involve actuarial work, ongoing funding obligations and real administrative cost, and they suit a specific situation: high and stable income, few or no employees, and a desire to shelter substantial amounts over a limited number of years.

Choosing between them

For a sole operator with no employees, the solo plan generally permits the largest contribution at any given income level, because of the two-part structure.

A SEP is simpler and can be established after year end, which makes it useful for someone who did not plan ahead.

Solo plans generally must be established before the end of the year, with some flexibility introduced by recent legislation, which is worth confirming rather than assuming.

The particular challenges

Irregular income. The core difficulty. Contributions require cash at the point they are made, and self-employed income arrives unevenly.

The practical approach is to set aside a percentage of every payment received into a separate account, and contribute from that at year end.

Treating it as a bill rather than as a residual is the mechanism that works.

Self-employment tax. Covering both halves of the payroll tax contribution, which is a substantial cost that employed people do not see.

No default. Automatic enrolment has substantially increased retirement saving among employees. Nothing equivalent exists for the self-employed, and participation rates are correspondingly lower.

Health insurance, which must be purchased individually and which is a significant cost affecting how much is available to save.

Self-employed health insurance premiums are generally deductible, which helps.

The order of priority

A reasonable sequence for someone with limited capacity.

An emergency reserve first, larger than an employee would need given income volatility — six to twelve months is commonly suggested.

Then a health savings account if eligible, given its tax treatment.

Then the retirement plan, contributing at least enough to bring taxable income into a comfortable bracket.

Then additional retirement contributions up to the limit, then taxable investing.

The retirement question specific to business owners

Many self-employed people plan to fund retirement by selling the business.

This is worth examining sceptically. A large proportion of small businesses do not sell, or sell for considerably less than the owner expected, particularly where the business depends heavily on the owner personally.

A business whose value is the owner's relationships and expertise is difficult to transfer.

Which argues for building retirement assets outside the business rather than treating the business as the plan, however confident the owner is.

Where a sale is genuinely intended, preparing for it years in advance — documented processes, a management team, clean financial records, reduced owner dependence — is what makes it saleable.

The practical first step

Most self-employed people who are not saving cite complexity rather than affordability.

Opening a SEP IRA at a low-cost provider takes under an hour and can be funded at any level. Starting with a small amount and increasing it is considerably better than continuing to research the optimal structure.

General information only, not financial or tax advice. Limits and deadlines change annually — consult a qualified tax professional about your own situation.