Throughout this quarter’s blog series, we’ll be discussing different types of retirement plans that self-employed workers commonly use. There’s no shortage of options. Being self-employed, you’re tasked with wading in the pool of alphabet soup to try to understand the difference between a SEP IRA, Solo 401(k), SIMPLE IRA, and others, including Traditional and Roth IRAs. What are the rules? Which is best? Which should be avoided? We’ll try to give you the information you need to make that decision. But like many financial decisions, deciding on a retirement plan for your small business is complex, and it’s a good idea to involve a financial planner and tax advisor in that decision.
In this article, we’re going to discuss the simplest and easiest type of retirement account to consider. It must be a SIMPLE IRA, right? Nope. Despite the name, a SIMPLE IRA isn’t quite so simple (I’m a father of two now, so please forgive the awful humor). The easiest type of retirement account to open, administer, and contribute to is just a plain old Traditional IRA. As a bonus, and because the two accounts are so closely related, we’ll also be discussing the Roth IRA in this article. To be clear, you don’t actually need to be self-employed to contribute to a Traditional IRA or Roth IRA. It’s not really designed to specifically benefit self-employed workers. But Traditional and Roth IRAs are one of the most common types of retirement accounts, so they’re worth discussing in this series.
Contribution Rules for Traditional and Roth IRAs
First off, let’s understand the rules around putting new money into a Traditional IRA or Roth IRA.
- For either one, you can contribute a maximum of $6,000 per year in 2022. If you’re aged 50 or older, you can put in an additional $1,000. The limit is an aggregate limit, meaning you can contribute $6,000 combined between the two — not $6,000 in each.
- You can only contribute an amount up to you or your spouse’s earned income. If neither you nor your spouse has earned income, you can’t make a contribution.
- If you make too much money, you can’t contribute directly to a Roth IRA. For 2022, single filers who make less than $129,000 can make a full contribution. Single filers who make $144,000 or more can’t make a contribution at all. If you earn between $129,00 and $144,000, you can make a partial contribution. For married taxpayers filing jointly, the lower limit is $204,000 and the upper limit is $214,000. Download this chart for the specifics. If you’re above the income limits, discuss the feasibility of a backdoor Roth IRA contribution with your financial advisor.
- For Traditional IRAs, there are no income limits to being able to put money into a Traditional IRA. You could make $1,000,000 in a given year and still put money into a Traditional IRA that year. But there are other rules that we discuss later regarding whether that contribution is deductible.
Tax treatment of a Roth IRA
When you contribute to a Roth IRA, that contribution doesn’t affect your taxes. In fact, the contribution doesn’t even show up on your tax return. The big tax advantage of Roth IRA contributions is that they grow tax-free. For example, let’s say you contribute $6,000 to a Roth IRA at age 30, you contribute nothing more after that, and you earn a hypothetical 8% rate of return each year. That $6,000 would be worth $88,712.07 at age 65. That’s a lot of tax-free growth! The thing to remember here is that while Roth IRAs don’t lower your taxes now, they do help your tax situation in the future.
Tax treatment of a Traditional IRA
The tax treatment of a Traditional IRA is a little more complex. For people who can deduct the contribution, that’s a big tax benefit. So, let’s think about whether the contribution is deductible. For most workers, it really comes down to how much you make. If you earn too much, you can’t deduct the contribution even though you could make the contribution. Whether you and your spouse have a group retirement plan available at a different employer also matters. But to answer the question more specifically, I’m actually just going to direct you to this flowchart. It’s much easier to follow than a paragraph or two of text.
If the contribution to the IRA was deductible, that money grows tax-deferred. When you take out the money later in life, the entire withdrawal is taxed as ordinary income. If you couldn’t deduct the contribution, it’s a bit different. The growth on top of the contribution amount (the basis) will grow tax-deferred, and when you make a withdrawal, that growth is taxed as ordinary income. The withdrawal of the basis is tax-free. If you have basis in an IRA, the rules around taxability upon withdrawal are pretty complex and beyond the scope of this article. But know that a portion of your withdrawal is considered growth (taxed as ordinary income), and a portion is considered basis (not taxed).
The basic rules of both Roth IRAs and Traditional IRAs state that you need to be at least 59.5 years old to make a withdrawal while fully realizing the tax benefits and avoiding penalties. However, there are so many caveats and exceptions. Discussing the rules and exceptions related to withdrawals is about where the scope of this article ends. Instead of focusing on the granularity of withdrawal rules, we’re really trying to help you decide what type of retirement account is most appropriate for you as a self-employed individual. Assuming this is a long-term retirement savings vehicle that you won’t use until your 60s, the rules around distributions — while important to consider — are less of a factor when compared to contribution rules and tax benefits.
What Are the Pros and Cons of Traditional and Roth IRAs?
Is a Traditional IRA or Roth IRA a good choice for you? How do they compare to each other? How do they compare to other types of retirement accounts? Generally speaking, Traditional IRAs and Roth IRAs are appealing in terms of their simplicity (although, you might argue they’re not quite simple with all of the rules that we discussed, not to mention the rules we didn’t discuss). They’re widely available from countless different financial institutions. They don’t require much administration, and they’re usually cheap. Typically you can select just about any type of investment within the account. Both provide tax benefits. For folks who can get money into a Roth IRA either by direct contributions or by conversions, the tax-free growth can make a major impact during retirement. Alternatively, Traditional IRAs can provide current tax benefits along with tax-deferred growth.
Limitations for High Earners
With that said, often times our clients run in to problems with using Traditional IRAs and Roth IRAs as the primary way they save for retirement because they are high earners. High earners often make too much money to get much of a tax benefit from Traditional IRAs because they can’t deduct the contributions. Further, they often make too much money to contribute directly to a Roth IRA. This can be remedied by a backdoor Roth IRA. However, for folks who already have a material Traditional IRA balance, a backdoor Roth IRA usually doesn’t make sense for reasons related to conversion rules.
The other issue that self-employed high earners encounter with using Traditional IRAs and Roth IRAs as the primary means for saving for retirement is that the contribution limits are simply too low. If your household income is, say, $300,000, saving $7,000 for each spouse via a backdoor Roth IRA contribution just ain’t gonna cut it if you’re trying to replace your income during retirement with your IRA contributions. You need the higher contribution limits that come from other types of retirement accounts.
We’ll cover some of the other retirement accounts for self-employed workers in upcoming blog posts in this series. If you want personalized advice on the decision and you aren’t already a client, please contact us to discuss what it might look like to work together. Otherwise, stay tuned to read about other options for retirement savings accounts.