Today’s United States workforce is increasingly nontraditional, with more professionals freelancing, owning businesses and working as independent contractors. According to Small Business Administration (SBA) data, 81 percent of small businesses have no employees beyond the business owner. With self-employment growing more popular and commonplace, retirement issues are looming large for more people in these situations. However, a Roth individual retirement account (IRA) may be an excellent solution for self-employed individuals seeking a potent retirement strategy. We’ll explain more about Roth IRAs and what self-employed people need to know about this type of retirement account.
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What is a Roth IRA?
A Roth IRA is a type of retirement account that allows individuals to contribute after-tax dollars. The money grows tax-free and account holders can access funds in their account once they turn 59.5 without paying any taxes on their distributions.
Roth IRAs are particularly helpful for people who expect to pay a fairly high tax rate after they retire, including many self-employed individuals and small business owners who might cash out of their companies later in life.
However, not everyone is allowed to use a Roth IRA. Your modified adjusted gross income must be under specific limits, which vary from year to year and are based on your tax filing status.
Did You Know?
Some of the ways traditional and Roth IRAs differ include when you pay taxes on your retirement account and whether you can take early withdrawals.
Benefits and drawbacks of a Roth IRA
With traditional retirement savings plans, people can deduct contributions from their taxes but must pay taxes on withdrawals. In contrast, Roth plans require you to contribute after-tax money but allow you to deduct withdrawals you make in retirement.
Before deciding on a retirement account, consider the benefits and drawbacks of a Roth IRA.
Benefits of Roth IRAs
Roth IRAs bring the following benefits, which may be of particular interest to self-employed individuals and business owners:
- Lower out-of-pocket costs in retirement: Many retired people are on fixed incomes and must minimize their expenses. A Roth IRA can help minimize expenditures because you’ve already paid taxes on the money and won’t have to do so when you make withdrawals.
- Tax-free growth: If you make good investments and your money grows in your Roth IRA, you’ll pay less in taxes than you would with a traditional IRA, which is taxed on the full amount at the time of withdrawal.
- More flexibility to access money before retirement: There are no penalties or taxes due when you withdraw money from a Roth IRA — a helpful perk if you need money for an emergency before retirement.
- No minimum distribution requirements: Unlike other retirement accounts, Roth IRAs have no required minimum distributions during your lifetime. If you don’t need the money, you can leave it to your heirs.
- Lower tax rate on contributions: If your tax bracket increases in retirement, you don’t have to worry about paying more taxes on the money in your Roth IRA. Your contributions have already been taxed at a lower rate.
Drawbacks of Roth IRAs
While Roth IRAs offer tax-free growth and tax-free distributions, they also have several drawbacks, including the following:
- Contributions are not tax deductible: You will miss out on the reduction of your taxes in the years you make contributions. If you are in a higher tax bracket, this will impact your overall tax liability more.
- Income threshold: You can only contribute to a Roth IRA if your income is under a specific threshold. In 2024, single filers with incomes of $161,000 or more cannot contribute to a Roth IRA and the amount you can contribute is reduced for single filers earning between $146,000 and $161,000.
- Roth IRA contribution limits are not considered separately from other IRAs: Roth IRAs have contribution limits ($7,000 for people under 50 and $8,000 for people 50 and older), so you’ll likely want to supplement your Roth IRA with other retirement accounts to have enough money in retirement. However, the contribution limits apply to all IRAs in the aggregate, not just your Roth IRA.
Tip
Self-employed individuals should also research Simplified Employee Pension (SEP) IRAs and other self-employed retirement plans designed with their unique needs in mind.
4 things to know if you want to open a Roth IRA
If you’re seriously considering opening a Roth IRA, keep the following in mind.
1. A brokerage company must hold your Roth IRA account.
Both well-known and smaller brokerage houses offer Roth IRAs as options. Here are some tips for selecting a brokerage company to hold your Roth IRA:
- Look for a brokerage company with excellent customer service that doesn’t charge account fees.
- For enhanced convenience, consider choosing a brokerage company that can handle Roth IRAs, SEP IRAs and other types of IRAs and retirement accounts you want to start.
- It’s particularly important for self-employed individuals to seek out a brokerage house with advisors. For example, Merrill Lynch employs advisors who can help plan your retirement strategy.
- If cost is a concern, consider a discount brokerage with a good reputation. For example, E-Trade provides excellent phone support and advice for choosing investments.
- Consider hiring an independent investment advisor or financial planner to help you clarify your goals and set up your plan.
Bottom Line
The best employee retirement plan providers offer ample plan options, reasonable costs, low investment fees and solid advice and customer support. Check out our review of Vanguard and our Fidelity Investments review to get started.
2. When it comes to investing for retirement, you should 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 exchange-traded funds (ETFs). The classic approach is a mixture of stock and bond funds, with the proportion of bond funds rising as you age.
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 percent a year. Remember, any gains are growing tax-free; that’s one of the best things about a Roth IRA.
FYI
Be aware that contribution limits for tax-qualified accounts like IRAs are not considered separately. If you contribute money to a Roth IRA, you can't contribute the maximum to other types of retirement accounts.
3. You’re better off making automatic, periodic contributions.
Unlike traditional employers, self-employed professionals don’t have the crutch of automated deductions and escalations. It’s best to set up monthly automatic deductions from your bank account to your Roth IRA. Small, regular contributions over time can help your returns.
4. It’s essential to look at all your retirement accounts at once to ensure you’re diversified.
When it comes to retirement funds for solopreneurs and other self-employed individuals, it’s crucial to note that you are solely responsible for ensuring that your retirement counts are diversified into stock and bond funds — perhaps international stock and bond funds, too.
Why is it crucial to look at all your plans at once? If you’re 90 percent in stock mutual funds in your SEP plan, which has $100,000 and 90 percent 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.
Roth IRA FAQs
The most significant difference between SEP and Roth IRAs is that SEPs have much higher contribution limits. In 2024, a SEP IRA allows you to deposit 25 percent of your income, up to $69,000 annually.Unlike Roths, SEPs are taxed as regular income during retirement. However, you can make pretax contributions to a SEP. Essentially, a SEP allows the taxes you owe on it to be deferred until retirement. With a Roth, you pay taxes on the income upfront.In 2024, you can contribute $7,000 to a Roth after making your SEP contribution ($8,000 if you are 50 or older). However, you also must fall under the income limit for Roths. If you are married, you must make less than $240,000.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. Detailed rules are available on the IRS website.
A 401(k) is another option for self-employed workers saving for retirement. With small business 401(k) plans, you can salary-defer up to $23,000. If you are over 50, you can add another $7,500. You can also deposit up to 25 percent of your net earnings for self-employment, up to a total of $69,000, including salary-deferred payments.
It depends on your situation. For example, if you earn too much money to open a Roth IRA and want to contribute as much money as possible, a 401(k) is the better choice. However, if you prefer having the option to access your funds before retirement or think you may want to keep the money in the account after you turn 72, a Roth IRA might be the way to go. Some entrepreneurs opt to have both a Roth IRA and a 401(k) to diversify their retirement plans.
Assuming you make the maximum annual contribution and the maximum amount remains $7,000 each year for the next 10 years, you will have over $100,000 with an 8.77 percent annual growth rate. This will change if the annual growth rate changes, if the maximum annual contribution limit changes or if you skip or reduce your contribution in any year or years.
Once you make the first contribution to your Roth IRA, you must wait five years before being able to withdraw your earnings tax-free. The five-year period begins on January 1 of the year you made your initial contribution.
Dock Treece contributed to this article.
