Retirement savings for the suddenly self-employed

The COVID-19 pandemic has upended countless lives. For some older workers, the economic fallout from the pandemic has resulted in unanticipated job losses, shortening their careers. For others, healthcare concerns about the virus have triggered voluntary early retirement.

Some of these newly unemployed older workers have recast themselves as entrepreneurs. In that situation, setting up a retirement plan can offer significant tax-saving opportunities.

A new report from the Center for Retirement Research at Boston College examines the impact of late-career nontraditional work on retirement security.

“These results provide further evidence that working longer is financially beneficial to those who are healthy enough to do so,” the report concluded. “Workers who do not feel capable of maintaining their career job, or who desire more flexibility and autonomy, can take heart that even a nontraditional job can bring them closer to their retirement goals.”

 “We’ve seen many individuals finding themselves self-employed after spending years as a W-2 employee,” said Martin Abo, managing member of Abo and Co., a certified public accounting firm in Mt. Laurel, New Jersey. “Often such roles can result in significant taxable income.”

Some well-timed financial planning can result in substantial tax savings. The primary strategy for reducing taxable self-employment income is contributing to a retirement plan, such as a Simplified Employee Pension IRA or a solo 401(k). The right option depends on whether the client is totally self-employed or operating a side gig in addition to another job. Timing is also key.

It's easy to set up a SEP IRA and make contributions. The maximum contribution can be calculated when that year’s tax return is prepared and the contribution needs to be made prior to the tax filing deadlines, including extensions. That means a SEP IRA can be opened and funded after year-end.

For 2020, the maximum deductible contribution that can be made to a SEP IRA on behalf of the self-employed owner is the lesser of 20% of his or her self-employment income (after subtracting half of the self-employment tax) or $57,000. In 2021, the limit increases to $58,000.

“A significant feature of the SEP IRA is the ability to contribute to both the SEP IRA and an employer-sponsored 401(k) plan,” Abo explained.

If you have self-employment income while also working as an employee of a company with a 401(k) plan, you can contribute up to $57,000 to the SEP IRA on top of the $19,500 401(k) employee contribution for 2020. That adds up to $76,500 plus a $6,500 401(k) catch-up contribution for those age 50 or older.

“Highly compensated employees who receive employer contributions to their 401(k) can effectively double the total annual limit for contributions to their tax-deferred retirement accounts by utilizing a SEP IRA,” Abo said.

The other retirement plan option for self-employed individuals is a solo 401(k). It effectively replaces a traditional 401(k) and the account needs to be opened by Dec. 31.

A self-employed individual can make both employee and employer contributions to a solo 401(k) plan. For 2020, the employee portion is limited to $19,500 plus a catch-up contribution of $6,500 for those age 50 or older. The employer’s contribution is limited to the lesser of 20% of net self-employment income or $57,000. The $57,000 cap applies to the combined total of employee elective deferrals and employer contributions.

The employee contribution must be made during the calendar year, so 2020 elective deferrals must be made by Dec. 31. The employer contribution can be made once the net income has been calculated and finalized during preparation of the tax returns, typically the following March or April. Unlike the SEP IRA, which requires only one contribution, the solo 401(k) requires at least two contributions to maximize tax-saving opportunities.

A solo 401(k) plan is probably not a good choice for someone who operates a side gig in addition to traditional employment because contributions to an employer-sponsored 401(k) plan reduce the ability to contribute to a solo 401(k). For example, if an individual works for an employer and maxes out his or her contributions to that company’s 401(k) plan, he or she could not contribute to a solo 401(k) plan.

“Opening and contributing to one type of plan doesn’t preclude future use of the other,” Abo noted. “It may be beneficial to contribute to one plan in one year and the other in the next.”

For example, if an individual who would benefit from maxing out a solo 401(k) neglects to open an account or contribute the employee portion by Dec. 31, he or she could open and max out a SEP IRA before filing that year's tax return. Later, the individual could get back on track and fully maximize the solo 401(k) for the current and future years.

For advisers conducting year-end reviews with clients, it’s a great time to ask them about any self-employment activity and apprise them of possible tax-saving opportunities.