One of the benefits of earning income outside of a day job while not significantly increasing my expenses has been the ability to fully invest in a 401(k) plan. Assuming one can trust the chances of the stock market (and the financial industry) to produce impressive results over the long term, the 401(k) is the vehicle most people will use to provide some stability in retirement. With a 401(k), employees can defer a good portion of their taxes until the future. Even if tax rates are higher thirty years from now, today’s younger investors will be in a better position to afford those taxes later on, assuming they continue saving in their 401(k).
Self-employed individuals can’t invest in an employer-sponsored 401(k). One of the first retirement investment changes I put into effect when I had enough self-employment income was to invest using a SEP-IRA. The acronym stands for Simplified Employee Pension Individual Retirement Account, and it functions like an IRA. Self-employed individuals (whether they own a corporation or a sole proprietorship) can contribute to the SEP-IRA on behalf of the company. The maximum annual contribution for the employer portion of the SEP-IRA depends on the type of business and whether the employee is also the owner. Sole proprietorships or unincorporated businesses are limited to 20% of the employee’s income before the self-employment tax deduction is applied to the income, but incorporated businesses can contribute up to 25% of net income. Both calculations are further limited to $49,000 for 2010 income. The worksheet in this IRS form [pdf] is helpful.
For small businesses and self-employed individuals, the SIMPLE IRA could be a good replacement for an employer-sponsored 401(k). The benefit for the employee is deferring income until retirement, and the benefit for the employer is receiving a tax deduction for the employer’s matching contribution. Of course, if you are the employee and the employer, you get to benefit on both sides of the coin. The employer must match up to 3% of each employee’s pay or pay a required (non-matching) contribution of 2% of each employee’s pay, and the employee is limited to $11,500 each year for 2010 and 2011, and employees aged 50 years or older can contribute an extra $2,500.
The Individual 401(k), also called the Solo 401(k), is probably the best plan for self-employed individuals, whether a sole proprietor or a corporation, who want to defer income until retirement. Sole proprietors can contribute up to $49,000 each year in an Individual 401(k) account (or $54,500 if age 50 or older) including an employee contribution and an employer contribution. Corporations also qualify for an Individual 401(k). Employees of corporations, even if the corporation has only one employee, can contribute only $16,500 in 2010 (or $22,000 if age 50 or older). The corporation, however, can contribute 25% of the employee’s W-2 income.
I expect this plan will be the best for me as I replace my employer-sponsored 401(k) with something more robust than my SEP-IRA. I will be able to contribute a greater percentage of my business income. Brokerages like Vanguard offer Individual 401(k) plans.
I’m voluntarily giving up my salary and benefits in favor of more time. Until I’m sure I can use that time to make up the income and benefits lost, I’m going to have to cut back on my expenses a bit in an attempt to keep progressing financially at the same speed I would have otherwise. It’s similar to my situation ten years ago, when I didn’t have much income and I needed to watch every penny for a while. I want to make sure I can continue contributing to retirement, saving money for the short term, and meet all of my expenses, and the immediate loss of significant income and benefits makes that more difficult.
I am not as stressed about my financial condition as I was when I first started focusing on my personal situation with money, but losing my day job income is a little like being robbed. The salary I have been counting on for nine years, even though it’s a smaller portion of my total income, will no longer be finding its way to my bank account through direct deposit. In the short-term, I want to make up for that income, and the quickest way to do so is by cutting back expenses, while working hard on my business is the longer-term solution to making up for lost ground.
Updated June 24, 2016 and originally published December 10, 2010.