Solopreneur Retirement: Pay Yourself First
Whether you call yourself a solopreneur, self-employed, or freelancer, you’re most likely a hard-working individual with the best boss ever – You! However, as sole-decision makers, solopreneurs often suffer from a lack of objective feedback. This can be especially damaging when it comes to taking care of our basic personal needs.
Managing all aspects of a business, from marketing to operations, requires even the most disciplined among us to push beyond our limitations. The point is, it’s easy to ignore our own welfare. When you are your business, you have to wear many hats. But why do we so often forget to wear the most important one – our HR hat? Seriously, who is going to take care of our business if we, ourselves, are not taken care of? This topic is especially critical when we consider the future we are entering.
The Gig Economy is a Different Future
Today, 36% of American workers are gig economy workers. By 2020, that figure is expected to increase to 40%. This includes both completely independent workers and contingent workers, that is, those who work for a company but without benefits. In the gig economy there are no benefits, no guarantees of minimum wage, no guarantees of a steady paycheck, no company sponsored retirement savings plans or saving into social security. And this is a reality that solopreneurs must come to terms with and manage, on top of everything else.
If this is the future reality we face, what can we do to make sure we are planning for our individual future while growing our business in the gig economy?
Paying Yourself Means More than Simply Reinvesting in your Business
In the gig economy, if you don’t invest in your own retirement, who will? Even if you are betting on your business to succeed, you have to hedge. Risk mitigation is what keeps events from becoming ruinous. Remember that you are not your company. If your business fails, you will still need to be healthy and solvent as you seek your next adventure.
We know that it can be confusing to figure out the different retirement account options available to solopreneurs. With Solo 401(k), Roth Solo 401(k),SEP IRA, Roth IRA, Self-Directed IRA and Health Savings Accounts, how do you know what is right for you? This is why we have put together this The Solopreneur Retirement Funds Series.
Part 1 – The Solo 401(k) and the Roth Solo 401(k)
What is a Solo(k)?
A Solo(k), also known as a Self Employed 401(k) or an Individual 401(k) or i401K, is a plan for business owners (with no employees) and their spouses. When you have a Solo(k), you get to play two roles: that of the employer and that of the employee. Bonus: this means that you get to make contributions through both of those roles.
- You as the Employer: You are the employer and can contribute up to 25% of your net self-employment income, up to a maximum of $55,000, which is your business income minus half your self-employment tax. These pre-tax contributions* lower your taxable income and help cut your tax bill.
- You as the Employee: You are the employee and are allowed to contribute pre-taxed* earned income up to the annual contribution limit. For 2018, you can contribute up to $18,500 as an employee even if $18,500 represents 100% of your self-employed earnings for the year! (If you’re over 50, you get an additional $6,000 added to your contribution limits for a total of $24,500.)
*Pre-tax contributions and their earnings will be taxed as regular income when they are withdrawn in retirement. If you want to avoid being taxed when withdrawing contributions and their earnings, you might want to consider adding a Roth Solo(k).
What is a Roth Solo(k)?
Another option is the Roth Solo 401(k). While Roth contributions are taxed, you will not be taxed on the contributions or their earnings when you withdraw them after the age of 59 ½. Note: this assumes you have had the account open for at least 5 years.
So, while Roth contributions don’t give you a tax break now, you can withdraw the money (and the gain on that money) tax-free in retirement. Depending upon whether or not you think you will be in a higher or lower tax bracket by that age, this can give you quite a break at the end of the road.
You can only contribute up to $18,500 of employee contributions annually to the Roth Solo(k). Like the Solo(k), you get an additional $6,000 added to your contribution limits for a total of $24,500 if you you are over 50.
There is no employer contribution with the Roth Solo(k).
Questions to Ask When Setting up a Solo(k)
To set up a Solo 401(k), you need to complete an application to open an account with a financial institution. Solo(k)s are offered by the largest retail brokers, including Vanguard, Schwab and Fidelity. You’ll definitely want to shop around a bit and compare plans at different institutions. Here are some important questions you’ll want to ask while shopping for your Solo 401(k):
1) What investment options should I choose?
Once you open the account, you then need to pick the investments in the account. Make sure that your plan provider offers total stock market index funds that are low cost (low expense ratio), have no sales loads and have commission free trades into these funds.
Top Reasons For Choosing Passively Managed Index Funds
If you hire someone to manage your investments for you, that person tries to beat the market by picking and choosing investments. He or she performs an in-depth analysis of many investments in an attempt to outperform the market index, like the S&P 500.
Hiring someone to actively manage your funds takes a big cut out of your return. There’s the expense ratio, which is a recurring fee the fund deducts from your account. There are sales loads, which you pay when your manager buys your funds. There can be commissions and a myriad of other fees that investors just aren’t aware of when they hire an advisor to pick their funds or invest in actively managed funds.
For the 15-year period of April 1, 2001 through March 31, 2016, only 29% of actively-managed U.S. large company funds were able to beat the S&P 500 Index. – The Balance
You would hope that, after all of these fees are deducted, the performance of your funds would beat the market, right? Unfortunately, the opposite is often true. Actively managed funds rarely beat the market over time, and they are more costly. But what if there were some simple and cheap way to passively own a small piece of the entire stock market instead of paying someone to try and “guess” which stocks might beat the market? Well, there is. They are called index funds.
An index fund tries to mimic the returns of an index it follows (such as the S&P 500) by purchasing all (or almost all) of the holdings in the index. Thus, they are referred to as “passively managed” and are therefore cheaper to buy. Instead of paying someone to try and pick a winner that beats the market for you, you are actually just buying the whole market.
Another benefit of index funds is that they are tax efficient. Index funds have extremely low turnover while actively-managed funds often have high turnover ratios. Higher turnover = higher taxes. When funds have more buying and selling activity (aka turnover), some securities will probably sell at a higher price than they were purchased. That means you’ll be paying capital gains taxes more frequently.
So, to recap. Index funds offer:
- Low cost
- Broad diversification
- Tax efficiency
- Set and forget simplicity (no day trading required)
- Superior performance
These index funds have broad coverage and very low expense ratios:
|Broker||Fund Name||Symbol||Initial minimum investment||Companies Included||Expense Ratio||Loads or Trade Commission***|
|Vanguard||Total Stock Market Index ETF||VTI||none||3,680||0.04%||None|
|Vanguard||Total Stock Market Fund||VTSMX||$3,000||3,680||0.14%||None|
|Vanguard||Total Stock Market Index Fund Admiral Shares||VTSAX||$10,000||3,680||0.04%||None|
|Schwab||Schwab Total Stock Market Index Fund||SWTSX||$1||2,728||0.03%||None|
|Fidelity||Fidelity® ZERO Total Market Index Fund||FZROX||$500*||2,530||0%**||None|
* Initial minimum investments into retirement accounts such as the Fidelity Simplified Employee Pension-IRA, Keogh, Self-Employed 401(k), and Non-Fidelity Prototype Retirement accounts are $500 or higher.
**NEW index fund from Fidelity – with zero expense ratio. They are the first to get rid of the expense ratio for their total market index.
*** No loads or trading fees when you purchase from the fund’s platform. For example, if you choose a Fidelity Total Market index fund and trade through your account at Fidelity, you will not be charged a commission. However, if you trade that same Fidelity index fund through an account at Schwab, you will be charged a trade fee. Tip: open an account with the broker that has the funds you want.
Why We Like Vanguard (No, we aren’t paid to say this.)
We like Vanguard because their Total Stock Market Index fund has the most companies (about 3,600). That’s almost every publicly traded company in the U.S. They also have some of the lowest expense ratios (0.04%) and no trading fees. That means you can invest every single month without paying commissions. Also, Vanguard pioneered the index investing movement and operates their business at cost. Vanguard has no outside owners. If you own a Vanguard fund, you own part of Vanguard. We think this keeps the incentives in the right place.
Bonus (this applies to any broker): you can split your contributions between total stock market funds and an investment strategy YOU believe in. For us, that would be sustainable investing.
2) Loans: Can you take loans from the plan?
Federal law allows workers to borrow up to 50% of their account balance, up to a maximum of $50,000. But be very careful with loans from retirement accounts. Some 401(k) plans ban contribution for six months after a loan. Also, remember that you will be paying both the loan payment and the interest on that loan with post-tax dollars. Finally, a loan from your 401(k) takes your earnings out of the market. While loans can be helpful during times of crisis, make sure you understand the rules regarding them.
3) Rollovers: Are they allowed into and out of the plan?
You may find yourself in a position later where you are working for an employer again. In this case, you may want to roll your Solo 401(k) into your employer’s Traditional 401(k) in order to take advantage of employer matching if their plan allows it. You may also want to roll an existing 401(k) into a Solo 401(k), or roll your Solo 401(k) into an IRA or visa-versa. For these reasons, find out if your plan can be structured to accept rollovers.
4) Does the plan offer a Roth option?
As mentioned above, a Roth option accepts taxed employee contributions. This means that you can invest all or part of the $18,500 and you will not be taxed on the contributions or their earnings if you withdraw them after the age of 59 ½ (and if you have had the account open for 5 years.)
Note: Employee contributions must be made by the end of the calendar year but you can make Employer contributions until the tax-filing deadline.
Tip: Be sure to open your Solo 401(k) account before December 31st, 2018 to be able to make employee contributions and lower your taxes for the tax year 2018.
Last Tip: Rules about Withdrawing funds from a Solo 401(k)
- If you make withdrawals before you are 59½ they may be subject to a 10% early withdrawal penalty in addition to any applicable taxes. This is a big deal. Don’t withdraw your funds early. If you have to, take out a loan and pay the interest back to yourself before liquidating the account.
- You must take required minimum distributions from Solo 401(k)s starting at age 70½.
- You can roll your Solo 401(k) assets into IRAs or an employer’s 401(k) (if it is allowed by that employer’s 401(k).
Tune in next week for the next issue of The Solopreneur Retirement Funds Series where we will continue our discussion on more Solopreneur Retirement Funds options such as SEP, SEP IRAs, Roth IRAs, Self-Directed IRAs, and HSAs (Health Savings Accounts.)
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