When you’re self-employed, finding a way to save for retirement and reduce your taxes can be a challenge. While you benefit from the freedom of running your own business, you also get stuck with the heavy burden of quarterly estimated taxes, tax planning, and setting up your own retirement plan. Here are six ways you can boost your retirement savings while simultaneously reducing the amount of federal taxes you must pay.
1. Stay on Top of Tax Policy Changes
Whether or not you love what you do, taxes will always be a part of your life. Saving on taxes today is a good way to have more money later. Keep in mind that tax rates and policies change from year to year. If you live in a city or state with income taxes, there will be additional policies to track. If you don’t have an accountant handling your self-employment taxes, be sure to choose a comprehensive software package. The tax software packages are updated each year to reflect tax policy changes. If you try to do your taxes yourself, you might end up missing out on key deductions and credits that could make a big difference in your taxable income or your federal tax obligations.
2. Establish an IRA
There are two types of individual retirement accounts (IRAs) to consider. If you have a small sum of money to save each year, this is the way to go. You can use an IRA along with another type of retirement plan. For tax year 2021, you can contribute $6,000 to an IRA if you’re 49 years old or younger. If you’re 50 years of age or older, you may contribute up to $7,000 in one of these plans.
Not all self-employed people will qualify for a Roth IRA. It’s designed for people with lower incomes. If you’re a high-earning self-employed person, you may be ineligible for a Roth IRA.
Traditional IRAs offer more leniency when it comes to income. However, if you’re filing federal income taxes as a married couple filing jointly, your access to a traditional IRA could be limited if your spouse can access a retirement plan through their employer.
SEP IRA (Simplified Employee Pension Plan)
Small business owners, including sole proprietors, often choose a SEP IRA. The maximum contribution for 2021 is $58,000. The amount you can actually contribute is a maximum of 25% of your self-employment income. For example, if you earn $100,000 in 2021 through self-employment, you can contribute $25,000 to your SEP IRA. These plans require minimal paperwork. The contribution deadline is October 15 for the following year. For the tax year 2020, you have until October 15, 2021, to make your contribution.
3. Individual or Solo 401(k)
A solo 401(k), which is also referred to as an individual 401(k), is a top option for self-employed people for retirement investments. The maximum contribution is $19,500 for 2021. If you’re over the age of 50, you can do an additional $6,500 catch-up contribution. The employee contribution can be up to 100% of your earnings. If you set up your business such that you’re an employee and earn a salary from it, this is a good choice. The business can make a profit-sharing contribution of an additional 25% of your earnings if you’re set up this way. An individual or solo IRA can be set up as a Roth or traditional IRA.
4. Defined-Benefit Plan
Defined benefit plans lower your current taxes and create a personal pension. They’re complicated to set up, and many financial advisors don’t have the proper tax knowledge to do this. These plans are often combined with 401(k) investments. A defined benefit plan paired with a 401(k) is an optimal arrangement for self-employed individuals with high incomes.
An annuity is like a contract with an annual payout. It’s a tax-deferred way to save money for your retirement. If you’ve already maximized your IRA and other options for retirement savings and tax reductions, consider annuities. There is no contribution limit on how much you can put into an annuity account each year. Some annuity accounts have guaranteed annual benefits. This means that after 10 years, the management company will add funds to your account if the value of the investments took a hit on the market. Keep in mind that tax-deferred annuities aren’t FDIC-insured, and the broker will charge a fee based on your contributions.
6. SIMPLE IRA
Another option for self-employed individuals to save for retirement and reduce their current tax burden is a savings incentive match plan for employees, which is also called a SIMPLE IRA. You must have your business set up such that you are an employee of it in order to take advantage of a SIMPLE IRA. With this retirement plan, you make pre-tax contributions of up to $13,500 per year. If you’re 50 or older, you can contribute up to $16,500 per year. Your business can add an additional 3% of your earnings.