Now Is the Time to Contribute to a Self-Employed 401k
By: Debbie Patskowski
Tags: Money Management, Money, Small Business, Investing, Business

Now Is the Time to Contribute to a Self-Employed 401k

Photo by Micheile Henderson

If you’re self-employed, you already have a lot to worry about besides retirement planning. You fulfill every role in your company from the executive suite to the cleaning crew. Absolutely nothing gets done unless you do it yourself. Most of these roles probably aren’t your specialty either, and tackling them can seem daunting. Since you still need time to do actual work, vital components of your business, like retirement planning, can get pushed to the side. Planning for your future doesn’t have to be complicated or time-consuming, though. If you were self-employed in 2020, now is the perfect time to open a self-employed 401k. Your future self will thank you.

What is a SEP 401k?

As the name implies, a self-employed (SEP) 401k is similar to other 401k retirement savings plans. Plan participants make pre-tax contributions which then grow tax-deferred until retirement. If you’ve ever contributed to an employer-sponsored 401k plan, this should sound familiar.

What makes a SEP 401k such a powerful financial vehicle is your ability to make contributions as both the employee and employer. The difference between how much you can contribute to SEP 401k versus a traditional 401k can be huge, and it’s worth taking advantage of. In 2020 you can contribute up to $19,500 to your SEP 401k as an employee as long as you earned at least that much from your business. Yes, you can save up to 100% of your income. If you’re over the age of 50, you can save an additional $6,000 in catch-up contributions.

This alone makes a SEP 401k attractive, and that’s just part of its savings potential. The rest comes in the form of an employer contribution. Remember how I said that if you’re self-employed you’re both the employee and employer? As the employer, you can contribute even more — up to 25% of your compensation for the year (after business expenses) or a maximum of $57,000 in 2020. All of this adds up to quickly grow your retirement savings.

Obviously being able to save 100% of earnings is great if you can afford it, but it’s worth it even if you can’t save the maximum allowed. The money inside your SEP 401k will continue to grow depending on how you choose to invest it. You will have different but comparable options (money markets, mutual funds, bonds, etc.) available to you depending on which investment firm you choose to open your account with.

Why should I care about tax-deferred investments anyway?

Funding your account with pre-tax dollars gives you that much more money to work with. For example, let’s say you contributed $1,000 to a SEP 401k at age 40. Assuming a modest 7% return, that money would grow to $3,870 by the time you reached age 60. If instead you paid 22% in taxes on that money before you invested it, your initial contribution would drop to $780 and by age 60, your account would be worth only $3,020, or about $850 less. Tax-deferred does not mean tax-free, though. You still have to pay taxes on the money you withdraw from a tax-deferred account like a SEP 401k, but ideally you will be in a lower tax bracket during your retirement years. Until then, your money continues to grow. It’s like having another employee in the household, working for you around the clock.

Warren Buffett is rumored to have pondered the value of a $300,000 haircut when he was 10 years old. He wasn’t thinking about getting some luxe new do; he was thinking about the time value of money, and the same applies to tax-deferred investment accounts. Not paying taxes on your money today gives it the chance to compound and grow for years to come.

Do I qualify for a SEP 401k?

To qualify for a SEP 401k, you must be self-employed. Before I opened my SEP 401k, I first applied for an employer identification number (EIN) with the IRS and registered my business as a sole proprietorship in the state where I live. The EIN was free, and I pay $5 a year to keep my business name registered. I was surprised how easy it was to start my own business.

If you don’t have a sole proprietorship, you may still qualify. Other eligible business types are partnerships, corporations, and S corporations — as long as you don’t have any employees other than yourself and your spouse. If you’re planning on growing your business in the future, this probably isn’t the right option for you. If you’re not sure if you qualify, contact a representative at an investment firm that administers these types of plans. You can make contributions for 2020 if you open the plan before the end of the year.

Sounds great, but isn’t there a lot of paperwork involved?

A SEP 401k is easy to set up and administer. Once the plan is established and funded, you will need to make up to two contributions for each year: one as the employee and the other as the employer. The employee contribution is fairly straightforward. For the employer contribution, you will need to know both how much your business earned for the year and how much it had in expenses. If your SEP 401k is worth more than $250,000, you will also need to fill out a Form 5500 with the IRS.

Are there other retirement plan options for self-employed business owners?

If a SEP 401k isn’t a good fit for you, there are other options to fund your retirement as a self-employed business owner. An individual retirement account (IRA) also allows you to save for the future, but there are stricter limits on the contributions. Fortunately, you can contribute to both an IRA and SEP 401k in the same year if you qualify for both. IRA’s come in different flavors including a simplified employee pension (SEP) IRA. A SEP-IRA let’s you contribute pre-tax dollars up to 25% of your compensation for the year. It’s similar to the employer contribution of a SEP 401k.

As with any major financial decisions, you should consult with your financial advisor first. They can guide you toward the retirement plan that is best for you and help you decide how to invest your money once you’ve opened an account. This is the perfect time to make your retirement goals a priority!