Part 1: Why you don’t need a self-employed retirement plan

The majority of soloprenuers don’t need an official retirement plan for their businesses. Why? A self-employed retirement plan may unnecessarily complicate your life, for many reasons.

Written Nov 21, 2008, read 971 times since then.

This may sound heretical coming from a financial planner, but I believe that the majority of soloprenuers don't need an official retirement plan for their businesses. It's not that I don't believe in saving; it's more an issue of choice, convenience and using provisions that actually apply to a soloprenuer. My objections include:

Start up businesses have tight cash flow. Soloprenuers rarely maintain a 100% long-term savings focus when concerned about current expenses and acquiring more clients. A healthy cash reserve is key for small business owners, so even if you have the money to fully fund a retirement plan, you're probably not going to. Many would probably prefer to re-invest into the business's infrastructure.

Some plans have odd contribution provisions. With a SEP IRA, if you ever got an employee, they couldn't contribute to the plan because SEPs are funded solely by employer contributions. Personally, I would resent funding someone else's retirement when they have no "skin in the game."

Some limit long-term usage. The self-employed "Solo" 401(k)s aren't meant for anyone except the soloprenuer and a spouse-employee. That may be fine for a lot of people who know they'll never have any other people in their businesses, but what about those who aspire to eventually employ other people not related to them? You'd have to stop contributing to the solo 401(k) and then start another kind of plan that your employees could contribute to. Doable yes, but I am all for keeping things simple.

Others are just plain confusing. SIMPLE IRAs require employers to match employee contributions. You must either match employee contributions up to 3% of compensation; (that can be reduced to 1% in any two out of five years); or contribute 2% of each employee's compensation, up to $4,600. Most people who don't speak financial-ese say, "Huh?"

In theory, I don't object to matching employee contributions, but I resent being told what I can and cannot do. I'd rather pay the extra administrative fee and have a full-out 401(k), where I can choose those provisions myself. But then we're not talking small business anymore!

The chief advantage of self-employed retirement plans is the ability to sock away more money. In the early years of self-employment, this isn't something that a lot of soloprenuers are able to take advantage of. For those of you who ARE at that point, you may want to check out a very good chart of small business retirement plan options here.

Start ups don't reap the plan tax advantages. Most soloprenuers aren't going to contribute to a pre-tax plan at a level that would significantly reduce their taxes. The solo self-employed mainly reduce their taxable income through their Schedule C deductions, not their retirement plan deduction. For someone in the 25% tax bracket, a $5,000 pre-tax plan contribution would reduce taxes by about 8% (note: this is VERY general, everyone's actual savings would be different).

What to do? The good news is that many start up soloprenuers' after-expenses income qualifies them to save into a Roth IRA (or a Traditional IRA). An individual making less than $99,000 is eligible to make a full contribution to a Roth. For marrieds the number is less than $156,000. If you're making more than that you still might be eligible, but the amount you are allowed to contribute is phased out. A Roth IRA will provide tax advantages in the future, instead of in the present.

So, in the interest of cash management, plan simplicity and future tax advantages, clearly I advocate saving into a Roth IRA. It may not be glamorous, but it gets the job done. Stay tuned for my next article where I discuss in more detail the advantages of saving into a Roth IRA.

Learn more about the author, Mindy Crary, MBA .

Posted by Darol Tuttle, Tacoma, Washington | Nov 24, 2008

I so agree. I have a SEP. What a pain! It goes against conventional wisdom, but I am starting to re-think a lot of the advice I have given small businesses to include business entity planning, etc. I see many small businesses spending big fees to file as a S Corporation. As a litigator, I often am able to hold the owners liable anyway because they didn't follow the rules, which didn't make sense for them in the first place. We should do a workshop on this! The theme could be: "What your lawyer and CFP won't tell you." Just a thought.

Seattle Kirkland Tacoma Elder Care Attorney
Posted by Mindy Crary, MBA , Seattle, Washington | Nov 24, 2008

Awesome! I agree, there should be a way that we can make everyone's lives simpler in the process of earning a living :o)
Posted by Gary V. Anderson, Bainbridge Island, Washington | Nov 25, 2008

Good article. You may have over-simplified the solo 401k plan idea. Most plans are written so that employees under 21 and /or less than 1,000 hours worked annually do not qualify. So a self-employed person could have employees. Most plans are written so they allow moving to a multi-employee plan when that is necessary.

Also, solo 401k plans are most valuable for the trustee to trustee transfer of other 401k's and IRA accounts for checkbook control. Now that is what I call simplifying my business life.
Posted by Mindy Crary, MBA , Seattle, Washington | Nov 25, 2008

Yes, you'd be correct that part-time employees don't qualify, which is true of most all plans, so you're correct in that the soloprenuer could have part-time employees without affecting the solo 401(k); I was referring to a scenario where an owner was hiring full-time employees and wanted to offer a plan to them. So, that owner would still need to change the plan like I said. I'm glad to hear you say it can be as easy as you mentions, thanks for your comments!
Posted by Susan Peters, Seattle, Washington | Nov 25, 2008

I like your philosophy. Most of the financial planners I've come across seem to be oblivious to the immediate needs of sole proprietors. This makes it seem doable.
Posted by Laura Totten, Seattle, Washington | Nov 25, 2008

Thank you for sharing and clarifying this. It's quite daunting trying to figure out the best use of my money regarding retirement plans, and it's refreshing to hear your side of the story.
Posted by Chris Gemmill, Seattle, Washington | Nov 30, 2008

In terms of getting things off the ground, I think this is a nice article Mindy. As a "general rule of thumb" I would agree that Roth IRAs can be a great starting point for retirement savings for most people without a matched retirement plan to which they can make contributions. One thing that concerns me here is a possible misinterpretation of the statement: "The majority of soloprenuers don’t need an official retirement plan for their businesses." To the extent that an annual retirement plan contribution of $5,000 or less will suffice for a certain individual, or when cash flow constraints limit one's ability to make a contribution in excess of $5,000, this might be the best place for many to start. Otherwise there are a lot of variables and SEPs, SIMPLEs, 401(k)s, et al, might be very beneficial for a soloprenuer – especially (but not necessarily limited to) once they wonder what to do with that 5,001st dollar…

I think it's important that everyone understand that the host of savings vehicles available is simply a basket of tools. No tool is inherently good or bad and using the most appropriate tool (or combination of tools) for the job at any given time will typically yield the best results.
Posted by Mindy Crary, MBA , Seattle, Washington | Nov 30, 2008

You right . . . so, you're not saying I was misleading so much as saying that I didn't really cover what to do next, which is right, b/c I think there's a lot of material out there for the people who can save more and get more tax breaks (see the paragraph with the link). Those people get to come to you and have you help them figure it out!

The intent of my article was to make sure people getting started weren't getting confused with all of the options, and instead, could focus in their efforts on a simple, viable first option.
Posted by Chris Gemmill, Seattle, Washington | Nov 30, 2008

And the first paragraph of your next article clarifies perfectly! (I should'a read them in conjunction with each other...)