Being self-employed comes with its own perks, including greater control over your career, the potential for more flexibility in your schedule and, above all, no annoying boss to answer to. One downside of working for yourself, however, is not being able to take advantage of an employer's 401(k) or similar retirement plan. Instead, the responsibility of building wealth for the future rests squarely on your shoulders. Taking care to avoid the following stumbling blocks can help your retirement years to be as bright as possible. (For more, see Retirement Planning Basics.) Here are three common retirement-planning mistakes that self-employed savers should avoid making.
1. Choosing the Wrong Retirement PlanSelf-employed savers have several options for planning their retirement. In addition to an IRA, traditional or Roth, you can also choose from the following:
All three options offer a tax-deferred way to invest, and contributions are tax-deductible, but they're not identical. Choosing the wrong plan can limit how much you can save. (For more, see: Retirement Plans for the Self-Employed.) Check with a financial advisor to make sure you've picked the right type.
2. Calculating Contributions IncorrectlyWhile each plan has a maximum contribution limit, there are some guidelines to keep in mind when calculating how much you put into your plan. Specifically, you need to make sure you're using your net business income, less the deduction for half of what you pay in self-employment tax.
Consider a sole proprietor who has a SEP IRA and grosses $100,000 annually but reports a net income of $75,000. If said proprietor were using gross income, he or she might assume the ability to contribute $25,000 to the plan, but that is incorrect. Assuming a deduction for half of the proprietor's self-employment tax, totaling $5,300, self-employment income would be approximately $69,700. Based on the 25% rule, the most he or she would be able to contribute to a SEP would be $17,425.
Contributing more than the allowed limit to a self-employed retirement plan is problematic because it can trigger an excise tax penalty. Currently, the penalty is 10% of the amount over your individual contribution limit. Going back to our previous example, if our hypothetical sole proprietor had mistakenly contributed $25,000 to a SEP instead of the $17,425 allowed by net income, he or she would owe the 10% tax on the difference. That illustrates how important it is to do the math correctly when figuring up what you can contribute to your retirement plan. (For more, see How to Correct Ineligible (Excess) IRA Contributions.)
3. Tapping Savings PrematurelySaving for retirement is a long-term goal, and the money you're setting aside is meant to grow over time. Pulling your savings out before you reach retirement age shrinks your nest egg in more ways than one: You're not earning any returns on what you withdraw and you may face tax penalties if the IRS classifies it as an early distribution.
Generally, the penalty for taking an early withdrawal from any of these plans before age 59½ is 10% unless you qualify for an exception. What's more, you'll also pay regular income tax on the distribution. While some solo 401(k) plans allow loans, these can become taxable distributions if not paid back on time. Unless you have absolutely no other of cash, you're better off leaving your retirement plan alone.
The Bottom LineThe rules for retirement planning are a little different when you're self-employed, and it pays to educate yourself as much as possible about your savings options. If you're choosing a plan without first researching the contribution limits and tax advantages, it's possible that you could shortchange your retirement in the long run.