This article is for the people who are thinking about self employment or are wondering about the retirement saving options for the self employed. The first part is about how much you can save and the second is about my experience with Vanguard.
Individual 401k – a great option for soloprenuers
2013 was the first full year that I was self employed and I did well enough to continue saving for full retirement. Before I left my corporate job, I calculated that we would need about $500/month from my online business to make ends meet without dipping into saving. If I make anything more than that, I can contribute a tax advantaged retirement account to reduce our tax liability. Taxes take such a big bite out of your income and you should try to reduce your tax as much as possible.
Here are the main options for the self employed.
- SEP IRA. The employer (self) can contribute up to 25% of your income to this account. The cap was $51,000 in 2013 and $52,000 for 2014.
- SIMPLE IRA. The employee (self) can contribute up to $12,000 in 2013. The employer (self) can match up to 3% of the employee’s compensation.
- Individual 401k aka solo 401k. This one is only for solopreneurs with no employee (or just the spouse.) The employee (self) can contribute up to $17,500, the standard 401(k) limit. In addition, the employer (self) can contribute up to 25% of the earned income. The total limit is $51,000 in 2013 and $52,000 in 2014. You can add another $5,500 if you’re at least 50.
In 2013, I made about $33,000 and I’m keen to avoid tax as much as possible. If we can reduce our tax liability enough, we can get into the 15% tax bracket and won’t have to pay tax on our dividend income. I plugged $33,000 into the calculator at solo401kcalculator.com and here is the result. The individual 401k enabled me to save more than the other accounts so I went with that.
At first, this seems a little off to me. For the individual 401k, I thought I should be able to contribute $17,500 plus 25% of $33,000. Well, I should have known it wouldn’t be that simple when it comes to the IRS. Here is what I got from irs.gov.
When figuring the contribution, compensation is your “earned income,” which is defined as net earnings from self-employment after deducting both:
- one-half of your self-employment tax, and
- contributions for yourself.
You need to sit down with one of those crazy 21-step worksheets to figure out your maximum contribution.
Anyway, I already plugged my number into TurboTax and the result is the same. So for 2013, I will contribute $17,500 + $6,000 to make it $23,500. BTW, if you are self employed and have some contractors working for you, then you need to do part of your taxes in early January because you need to send out the 1099-MISC. Yes, it’s tax time already. Yuck!
I decided to go with Vanguard for my individual 401k. Vanguard is a great company and I like their index investing approach for my 401k.
I called Vanguard and set up an appointment with the small business service division. Later on, I talked to Vanguard’s representative for about 30 minutes. He went over what Vanguard is all about and their investing philosophy. They wanted to make sure we are the right fit for each other. For my i401k account, I will be buying and holding index funds, so it’s a good fit. If you trade often, then Vanguard probably isn’t the right choice for you.
Here are some details.
- Cost – $20 per year for each Vanguard fund held in the i401k account.
- Investment choices – More than 100 Vanguard mutual funds. I found out later that I couldn’t invest in Admiral Shares in the i401k account. Admiral Shares have lower expense ratio than the investor shares so they are less costly.
- Roth option – Vanguard is one of the few companies to offer Roth 401k.
- No Loan – You can’t borrow from your i401k account at Vanguard. This isn’t a big deal to me because I don’t plan to do this anyway.
- Fee waiver – If you have more than $50,000 with Vanguard, then they will waive the $20/year fee.
- IRS – You will have to file form 5500 with the IRS if the i401k plan asset is over $250,000. See the IRS’ instruction for form 5500.
The representative told me that this account probably isn’t the right place to build a complete portfolio because of the per fund fee. I agree and targeted only one midcap index fund in this i401k account. I didn’t have much midcap investment in my other accounts so this would be a good place for it. I use Personal Capital to keep track of our asset allocation and I added the new Vanguard account there. It’s quite helpful to see all your asset classes mapped out.
I like Vanguard’s customer service and would recommend them. There was a little problem with the account application paperwork and they helped me straighten out everything. I also feel like I could call them anytime. They are friendly and not intimidating or pushy.
All in all, I’m satisfied with Vanguard. The only problem I have is the inability to invest in their Admiral Shares. I wasn’t sure how much I could contribute in 2013 so I waited until November to open an account and contributed $17,500 in one shot. Normally, you need the minimum of $10,000 to start investing in Admiral Shares. I met that minimal qualification so I thought I should be able to invest in the Admiral Shares. For some reason, they won’t let you invest in Admiral Shares in the i401k account. That’s a bit baffling to me.
For 2014, I will contribute $1,450/month so I can take advantage of dollar cost averaging. The good thing about Vanguard is you won’t have to pay a transaction fee each time you invest. At Firstrade, I have to pay $10 for each trade. At Etrade, it is $20 each. I know, I have accounts in too many brokerages. I’ll consolidate them one of these days. If we have extra money at the end of the year, then I’ll add the employer contribution again.
Let me know if you have any questions and I will try to answer them. As for the 401k from my previous employer, I rolled it over to an IRA and that worked out very well last year.
Are you self employed? If so, are you saving for retirement? I know it can be difficult to save when you’re struggling day to day, but you need to plan for the future as well.
Disclaimer: I’m not a financial adviser and the information here might not be 100% accurate. You need to do your own research before investing.
For 2018, Joe plans to diversify his passive income by investing in US heartland real estate through RealtyShares. He has 3 rental units in Portland and he believes the local market is getting overpriced.
Joe highly recommends Personal Capital for DIY investors. He logs on to Personal Capital almost daily to check his cash flow and net worth. They have many useful tools that will help every investor analyze their portfolio and plan for retirement.
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