As an employee, your choices pretty boil down to a traditional individual retirement account (IRA), a nondeductible Roth IRA, and an employer-sponsored 401(k) plan. But there are income and contribution limits for both traditional and Roth IRA accounts, especially (for the traditional IRA) if you or your spouse are covered by a workplace 401(k) plan But self-employed one-person businesses have an embarrassment of riches when it comes to retirement plans. Of course, you’ll need the cash to sock away, but once you get it there are many places to put it.
1. SIMPLE IRAs. These plans allow owners or employees of small businesses to contribute to traditional IRAs. They
are, in a way, 401(k)s Lite, because they are easier and less costly to set up, although employers are required to
make a 3% match for employee contributions. The rules are the same as traditional IRAs for salary deductions, taxdeferred accrual over the years, and distributions, but in 2020 the maximum contribution for participants over 50
will be $16,500, far less than a 401(k). There are much better alternatives for the self-employed, in my view.
2. SEP IRAs. The SEP, which stands for Simplified Employee Pension, lets business owners make IRA contributions
for their employees and themselves. But many sole proprietors who don’t have employees use them. The same
rules on contributions, accruals, and withdrawals that apply for traditional IRAs also apply to SEPs.
But the big difference is in the amount you can contribute each year. According to the Internal Revenue Service, in
2020, SEP IRA contributions to either employees or the self-employed cannot exceed the lesser of 25% of annual
compensation (up to $285,000) or $57,000—in effect, $57,000.
One potential drawback: If you have employees, all must get the same percentage contribution, and there are no
over-50 catchup contributions. But whatever the ultimate number, $57,000 is a lot of money to sock away—if you
can afford to.
3. Solo 401(k). This is my favorite—I have one myself—because it’s almost ideally suited for sole proprietors.
Amazingly, you can contribute to a solo 401(k) as an employee and an employer. As an employee, the IRS says, you
can contribute the same amount you could to a corporate 401(k)—$19,500, or $26,000 if you’re over 50.
In addition, you can make an employer contribution based on, yet again, a ridiculously complicated formula only
Congress or the IRS could have dreamed up. Basically, you take your net earnings from self-employment, subtract
the deductible portion of your self-employed tax from your 1040 form and the amount of your own retirement
plan contribution to get your “plan compensation.” (“This is a circular calculation,” the IRS writes. No kidding.)
The limit on that total is, again, the same $285,000 maximum for the SEP-IRA, but you can stash away more. Not
only can you put in the same maximum $57,000 you can with a SEP-IRA; if you’re over 50, in 2020 you can add a
catch-up contribution of $6,500, too, for a grand total of $63,500.