Long-Term Saving Strategies for the Self-Employed

Correction appended, Feb. 7, 2017

When Kathleen Keating worked for IBM, she didn’t think much about her retirement plan. She signed up for the company’s 401(k) and left it at that.

But at age 40, she decided to leave the corporate world and become her own boss. That meant coming up with her own retirement savings plan as well.

What she found over the next nine years was surprising. Working for herself allowed the Boston-area public-relations professional to set aside thousands of dollars more per year for retirement, reducing her income tax bill substantially while giving her more options about when and how to invest.

“I have so much more flexibility,” she says. “When you’re working for someone else, you’re locked in to their retirement plans and you have to deal with HR and all the paperwork.”

Financial advisers say retirement plans for self-employed Americans have become more popular in recent years thanks to a 2001 tax law that allows them to put more money away than most people who work for someone else. But to make it work, they have to be diligent about setting up the accounts and putting money in regularly.

The difference can be substantial. Most workers with a traditional 401(k) can set aside a maximum of $18,000 this year, or up to $24,000 if they are over age 50. By comparison, a self-employed worker can set up a type of investment account called a SEP-IRA and put away up to 20% of their net income, up to a maximum of $54,000, this year.

Self-employed workers willing to do a little more paperwork can also set up what is called a solo or individual 401(k), which allows them to put the typical $18,000 salary deferral in as well, dramatically increasing the amount they can set aside in a year.

They can also contribute money on their own schedule. Workers with a traditional 401(k) at a medium- to large-size corporation typically need to sign up at the beginning of the year to have money taken out of each paycheck. Changing the contribution amount can take a few pay cycles, making it harder to catch up at the end of the year if you weren’t putting away enough earlier.

But contributions to SEP-IRAs and individual 401(k)s can be made in lump sums at any time. For self-employed workers who can see big swings in how much they’re making each month, that makes it easier to put a chunk of money in when it’s a good month and hold off when times are tight. And if they want, they can wait until they’re doing their taxes to add another chunk to reduce their taxable income.

David Rae is a self-employed financial planner in West Hollywood who works with a lot of people in the entertainment industry who don’t have regular jobs or access to a traditional 401(k). He set up a SEP-IRA shortly after starting his business and recommends that his clients do the same, to give themselves the option to set aside money when they have it.

“If you happen to have a good month, you can write a big check,” he says.

The potential market for self-employed retirement plans is huge. According to a report from the Pew Research Center, 14.6 million Americans were self-employed in 2014, representing about 10% of the national workforce. (Another 29.4 million, or about 20% of the workforce, were hired by self-employed Americans.)

Susan Diehl, president of PenServ Plan Services, a consulting firm that works with employers and financial institutions on retirement plans, says individual 401(k) plans have become “the hottest thing since sliced bread” in recent years because of how much self-employed workers can save.

She gives the example of a consultant over age 50 making $50,000 a year. With a SEP-IRA, that person could set aside up to 20% of their net income, or $10,000. With a solo 401(k), that person could put in another $24,000, for a total of $34,000–or more than two-thirds of their income. That would dramatically reduce income tax while also saving much more for retirement than a traditional worker could.

And some older workers may need to save more. A national survey commissioned by Experian in 2016 found that 71% of Americans felt they did not have enough retirement savings.

For Keating, who has maxed out her contributions most years since starting her business, working for herself has helped her catch up to her retirement goals and forced her to take a more active role in securing her financial future.

“I think if I was on somebody else’s payroll, I don’t know if I would be as diligent about having these conversations,” she says. “I 100% feel it’s all on me.”

Note: Before deciding on either account, talk with a tax accountant or a financial planner about which would work best for you.

Correction: The original version of this story misstated the percentage of income that a self-employed worker can set aside in a SEP-IRA. The maximum contribution rate is effectively 20%.