When you work for a company, it’s typical to be able to contribute to the 401(k) plan your employer provides. Some employers will also match your contributions. You may also have the option of receiving a pension. When you work for yourself, this element of structure for your retirement plan with employer-driven 401(k)s or pensions is lost. One survey reveals that 70% of Americans who are self-employed do not regularly contribute to a retirement plan or fund. Almost 25% of self-employed workers report not actively saving for retirement at all. What can you do, especially as a small business owner, to prepare for your retirement? The following are some best practices you can follow to help make sure you are on track for the retirement you want.
HOW MUCH SHOULD I PLAN TO SAVE?
Most people have no idea how much they will really need for the duration of their retirement. There are many variables such as life expectancy, current and future income, and what kind of lifestyle you’ll want to have in retirement. While experts have declared at least $1 million as the target, the amount will vary for each person. Here are some ways you can plan for these variables in your own life as you come up with the best strategy to meet your needs.
PLANNING FOR THE LENGTH OF YOUR RETIREMENT
While no one likes to think about when their life may end, considering how long you will need to live off your retirement funds is part of the process to make sure you will have enough to be comfortable. The average retirement age in the US is 65 for men and 63 for women. This varies depending on the cost of living in each state (higher cost of living means working longer). On average, retirement will last 20 years. If you work past 65, this may end up being less years. You could also live into your 90s and need to plan for up to 30 years. Consider your family history and any serious health issues you have that may affect your life expectancy or play into added healthcare costs during retirement. As you get closer to retirement, your health may change and you’ll want to revisit your plan.
Financial professionals agree that the 5-year period before you retire is usually the most critical time to be finalizing the details of your plan. Of course, you will want to be paying into a plan and making investments long before this 5-year countdown. However, this will be the prime time to evaluate where you’re at and make any big changes like downsizing on your house to reduce maintenance and property taxes or finally committing to your world travel plans and the accompanying expenses.
RULES OF THUMB FOR DECIDING HOW MUCH WHEN SAVING FOR RETIREMENT
So, how much money will you need to live off of each year during your retirement? NerdWallet suggests the following way to get precise numbers rather than just in the ballpark. Take a look at your current spending habits and expenses and identifying which costs will remain the same in retirement, what new costs may appear (i.e. health expenses), and what costs will disappear during retirement (i.e. mortgage, child’s college tuition). To accomplish this, bust out your current personal budget and add a column to project expenses for retirement. Include future expenses for activities you have planned for retirement that you are not currently spending for like travel or hobbies. Divide the number of your annual projected retirement budget by your pre-retirement salary. This will generate your income replacement ratio. As a general rule of thumb, you’ll want to shoot for a replacement ratio of 70-80% to maintain your lifestyle. For example, if you make $70,000 a year before retirement and your retirement projections are $50,000 a year ($49,000 is the national average), that is a ratio of about 71%. The level of gross income you’ll need will fall as your taxable income shrinks at retirement and you won’t be worrying about saving for retirement anymore—you’ll now begin living off your savings.
Some other standard rules of thumb can help you decide how much to save if you aren’t close enough to retiring to accurately outline specific expenses. One is the 4% rule. This means that you will only withdraw 4% of your retirement savings each year. If you have a $1 million dollar portfolio, this will amount to $40,000 every year.
Another method is the multiply-by-25 rule. Take your projected annual spending in retirement and multiply it by 25 for the 25 years you will allegedly live in retirement. If you think you will need $35,000 a year, this will be a total savings of $875,000. One financial advisor suggests practicing living off of the annual gross income you expect to use during retirement when you are a couple years away to make sure $35,000 a year will really give you the life you want. Budgeting during retirement will be just as important as before you retired to make sure you can maintain your standard of living and don’t run out of money.
But how do you ensure that you will have this 6 or 7 figure nest egg by the time you retire?
HOW DO I MANAGE SAVING FOR RETIREMENT?
First of all, it’s never too early to start saving. The earlier you begin, the less you will have to do each year to make sure you hit your target with saving for retirement. As a self-employed person, there are still many options to help you build the portfolio you want. How much you want to save will determine which account is best for you so follow the guidance above to estimate your retirement expenses and then pick the vehicle that will get you there.
When choosing a retirement plan, consider the tax benefits and interest options for each plan. Interest can be your best friend when building your funds over time. In this section we will cover traditional and Roth IRAs, solo 401(k) plans, how you can set up these accounts, and what to expect from Social Security in the coming years.
TRADITIONAL AND ROTH IRA ACCOUNTS
IRA stands for individual retirement account. Both traditional and Roth IRAs are great for individuals , especially if you are just beginning to save and are planning on putting less than $6,000 a year into your account, as this is the annual cap for IRAs. If you’re over 50 years old, you can contribute an additional $1,000 to “catch up.” For a traditional IRA, your contributions are tax-deductible. While they are not immediately deductible for contributions to a Roth IRA, there is no tax upon withdrawing funds once you enter retirement. This being the case, opening a Roth IRA can be a great idea when you are in the early days of your business. When your tax rate becomes higher in retirement, your withdrawals will be tax-free. Roth IRAs also have an income limit. Different brokers have different modified adjusted gross income (MAGI) limits ranging from $122,000 to $137,000 for single people. The limit is higher for couples.
The difference in timing for your tax advantages is the main distinction between a traditional and Roth IRA. The best part of either of these accounts is the compound interest you accrue over time just by contributing to them and letting your account managers handle the investing (many institutions will have investment options for you to choose from). Without investing into an account that generates compound interest over time, it may be difficult to meet your retirement targets.
SOLO 401(k) ACCOUNT
To meet the requirements for a solo 401(k), you cannot be an employer of other employees unless your spouse is the employee, in which case they can contribute to your account as well. However, as a business owner, you fall under both roles of the employer and the employee and so can make contributions from both standpoints yourself. To qualify, you also must be able to prove that you have earned income. This is a good option for small business owners with no employees. One major benefit of solo 401(k)s is that you can contribute more funds annually to it than to an IRA. In 2019, the cap was $56,000 with an extra $6,000 as the “catch up” contributions for people over 50. The tax advantage of a solo 401(k) is that your contributions are not taxed. Withdrawals after age 59 and a half are taxed. This plan is better suited to self-employed individuals who are trying to save a lot of money for retirement. It is possible to open a Roth 401(k) with tax benefits that operate more like a Roth IRA.
OPENING AN ACCOUNT
Both IRA accounts and solo 401(k) accounts can be set-up through brokers, investment management companies, or exclusively online institutions. Most of these institutions will not charge you fees to open an account through brokers may take a small commission. These account managers will help invest your contributions so that they will grow over time and also make sure the appropriate tax advantages are applied.
In regards to Social Security (SS), it would be unwise to plan to rely on these benefits in your retirement. In previous years, monthly SS checks have varied throughout the country from $1,000 to $2,000. In addition to this low amount, the Social Security Administration estimates that funds will be exhausted by 2035. If you are in your 50s or younger, this means that it is unlikely you will get the full benefits of social security. Be prepared with a diversified savings portfolio so you don’t end up trying to live on less than $20,000 a year.
HELPING EMPLOYEES WITH SAVING FOR RETIREMENT
As a small business owner, it is likely you now have or will eventually have employees other than a spouse. If you are wanting to provide your employees with retirement plan options, additional types of IRA accounts that are good for this are a Simplified Employee Pension (SEP) IRA if you only have a few employees and a Savings Incentive Match Plan for Employees (SIMPLE) IRA for larger businesses with up to 100 employees.
For an SEP IRA, only the employer contributes and they can contribute up to 25% of the employee’s pay. They must pay into every eligible employee’s fund equally. SEP IRAs have flexibility in their contribution levels so this is a good option for companies with uncertain cash flows throughout the year. SIMPLE IRAs are contributed to by both the employee and the employer. Employees can choose to take money from their paycheck and contribute it to their IRA. Whatever they contribute will be matched by the employer up to 3% of an employee’s annual compensation. Employees can choose which investment funds they want to associate their account with, depending on the offerings of the financial institution where the employer keeps the SIMPLE IRA account.
As a self-employed business owner, it’s up to you to create your plan for saving for retirement. There are lots of good methods and account options to help you figure out the best plan for your goals and current financial situation. Be strategic and remember: if you haven’t already started investing in your future, there’s no time like the present!
