Most Americans work as employees and can save for retirement through a combination of their own personal IRAs and any retirement plan their employer happens to provide. But if you're self-employed, you have many more options for your retirement savings, and depending on which one you choose, you might be able to put quite a bit more money into tax-favored accounts.
The advantages of being self-employed
These days, typical American workers have access to two main retirement-savings options. Anyone with earned income can open an IRA, funding it with up to $5,500 this year, or $6,500 if you're 50 or older. In addition, many employers offer 401(k) plans, which let you set aside as much as $17,500 from your paycheck into an employer-sponsored retirement plan account -- $23,000 for those 50 years old and up. Combine those amounts, and many employees aren't able to find enough money to save in order to hit the limit.
Self-employed individuals have the same access to IRAs as employees. But if you're self-employed, you have the capacity to do far more with your retirement savings. By acting both as employer and employee, you can put retirement plans in place that have much higher limits and give you greater flexibility in structuring your retirement investments.
3 smart choices for self-employed retirement plans
The downside of being self-employed is that no one's going to take care of putting a retirement plan in place for you. That burden is all on you, but fortunately, there are several relatively easy-to-implement choices available.
First and arguably simplest is the aptly named SIMPLE IRA, more formally known as the Savings Incentive Match Plan for Employees. You can put 100% of your earnings up to $12,000 in a SIMPLE IRA this year, with an extra $2,500 for those 50 or older. Then, acting as the employer, you can then add a matching contribution equal to whatever you set aside, subject to a limit of 3% of your net self-employment earnings. The big advantage of SIMPLE IRAs is that they're relatively easy to set up, as many financial institutions are equipped to open SIMPLE IRA accounts, and they don't require a lot of additional paperwork or reporting requirements.
The second option is the simplified employee pension, or SEP. With the SEP, you're able to set aside up to 20% of your net self-employment earnings. That means that if your business has only modest income, you might not be able to save as much using a SEP as you could with a SIMPLE IRA. But the maximum dollar limits are much higher, at $51,000 for 2013. So once your net earnings get above the $120,000 level, the SEP gives you the chance to set aside a greater amount on a tax-deferred basis. Like SIMPLE IRAs, SEPs allow you to set up accounts at most banks or financial institutions without a great deal of paperwork.
The third option is to set up your own self-employed 401(k). Sometimes known as solo 401(k)s, these plans give you the best of both worlds: the ability to make the same employee contributions as regular workers, while also having the right to contribute as much as 20% more of your net earnings in the form of employer contributions. You're still subject to the same $51,000 limit, except that those 50 or older can set aside up to $56,500 if your net earnings are high enough to meet the 20% requirement.
Of these options, the self-employed 401(k) is the most burdensome from a reporting standpoint. To establish a solo 401(k), you have to fill out paperwork to establish a formal retirement plan, with ongoing requirements to make updates when retirement-plan laws change. Moreover, once your retirement plan assets exceed $250,000, you'll have to file annual information returns with the IRS. However, several financial institutions offer self-employed 401(k) plans and will help you create and set up your account correctly.
Get big savings now
Whichever way you decide to go with your retirement plan, be sure to take maximum advantage of the generous tax breaks available to the self-employed. Given the high taxes you have to pay as a self-employed professional, anything you can do to cut your tax bill can make a huge difference in your long-term financial success.
Once you open a self-employed retirement account, you have to invest your money well. The best investing approach is to choose great companies and stick with them for the long term. The Motley Fool's free report "3 Stocks That Will Help You Retire Rich" names stocks that could help you build long-term wealth and retire well, along with some winning wealth-building strategies that every investor should be aware of. Click here now to keep reading.
The article Self-Employed? How You Can Save More for Retirement originally appeared on Fool.com.Fool contributor Dan Caplinger has no position in any stocks mentioned. You can follow him on Twitter @DanCaplinger. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.