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How the Self-Employed Can Make Roth IRA Contributions

business.com editorial staff
business.com editorial staff

If you're self-employed, a Roth IRA is probably one of the essential retirement saving tools you need in your arsenal.

  • 40% of American workers have nontraditional jobs.
  • You can contribute $6,000 to a Roth IRA if you're under the age of 50. If you're 50 or older, you can contribute up to $7,000.
  • SEPs allow you to contribute 25% of income up to $57,000 

More than 40% of the U.S. workforce comprises people in nontraditional jobs: They are freelancers, business owners and independent contractors, often cobbling together a paycheck from several sources. 

If you're self-employed, a Roth IRA is probably one of the essential retirement saving tools you need in your arsenal. It's hard enough for traditionally employed people to save for retirement and harder still for the self-employed.

In a nutshell, Roth IRAs are particularly good for people who expect to be paying a fairly high tax rate when they are retired. That includes a lot of self-employed people, like small business owners who might cash out of their companies later in life.

Traditional plans for retirement savings allow people to deduct contributions from their taxes, but require them to pay taxes on withdrawals. Roth plans require you to contribute after-tax money, but enable you to deduct withdrawals you make in retirement. 

One side note: If you are considering a Roth IRA, you want to also look at a SEP IRA or one of several other kinds of retirement plans specifically designed for self-employed people. 

What is the difference between a Roth and SEP IRA?

The biggest difference between a SEP and Roth IRA is the SEP has much higher contribution limits. A SEP allows you to deposit 25% of your income, up to $57,000 a year in 2020.

SEPs are taxed as regular income during retirement, unlike Roths. However, you can make pretax contributions to a SEP. Essentially, SEPs allow taxes owed to be deferred until retirement. With a Roth, you pay taxes on the income upfront.

This year, you can contribute $6,000 to Roth after you've made your SEP contribution. However, you also have to fall under the income limit for Roths. If you are married, you must make less than $183,000.

The ability to contribute to both a SEP and a Roth is a boon to the self-employed that makes it a little bit easier to save. The rules are detailed on the IRS website.

4 things to know if you want to open a Roth IRA

1. You need a brokerage company to hold the account for you.

Look for one with good customer service and no fees on the account. Any one of the big brokerage houses, Fidelity, Vanguard, or Schwab, offer Roth IRAs, as do smaller brokerages. Look for a brokerage that offers to hold the account for you without charging a fee. You might also find it convenient to keep your Roth IRA at the same company that offers a SEP or other kinds of IRAs.

Because you're self-employed, look for a brokerage house that employs advisors, like Merrill Lynch, or a discount brokerage like E-Trade that offers good phone support and advice on picking investments. You can also hire an independent investment advisor or financial planner.

2. When it comes to investing for retirement, keep it simple and cheap.

One of the easiest options is a high-quality target date fund, which will automatically match your investment mix to your age as the years go by. You can also ask your brokerage to buy a selection of mutual funds or ETFs. The classic approach is a mixture of stock and bond funds, with the proportion of bond funds rising as you age.

Keep in mind that one of the factors you can best control is fees. Look for low fees on whatever investment you pick. You should be able to find low-fee, broad-based funds for your Roth IRA for an expense ratio of less than 0.25% a year. Remember, any gains are growing tax-free; that's one of the best things about a Roth IRA.

3. You're better off making automatic, periodic contributions.

Because you're self-employed, you don't have the crutch of automated deductions and escalations, which people who work for traditional employers do. Set up monthly automatic deductions from your bank account to your Roth IRA. Investment research shows that small, regular contributions over time can help your returns.

4. It's important to look at all of your retirement accounts at once to make sure that you are diversified.

If you're self-employed and don't have a financial advisor, the only person doing this is going to be you. So make sure you've diversified into stock and bond funds, and perhaps international stock and bond funds too.

Why is it crucial to look at all your plans at once? If you're 90% in stock mutual funds in your SEP plan, which has $100,000, and 90% in bond funds in your Roth, which is only $25,000, you aren't properly diversified between stocks and bonds. Look at your total and then decide how you want to invest.

You can read more about Roth IRAs here. The rise in self-employment is one of the factors behind the decline in workplace retirement coverage.

Another retirement-savings option: A 401(k) plan

A 401(k) is another option for saving for retirement. You can salary defer up to $19,500 into a 401(k). If you are over 50, you can add an additional $6,500. You can deposit up to 25% of your net earnings for self-employment as well, up to a total of $57,000. This includes salary-deferred payments.

About 30% of U.S. workers are not in jobs where employers offer retirement savings plans. Changes in the workplace are placing the burden on you to save for retirement, but the tax code gives you the tools you need to succeed. Start now. 

Image Credit: Utah778 / Getty Images
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