Are you a small business owner and a digital nomad? Then it’s time to start to invest in your retirement. Get the tax benefit now. Save for later and grow your net worth. It’s all a win-win, right!?!?!
How exactly do you multiply your net worth while also reducing your current taxable income? Invest in your retirement!
Invest in your retirement
Now is the time to take advantage of retirement savings and the tax benefits it offers. There are several reasons to invest in your retirement. They include:
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The money invested creates a tax deduction now.
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The investment grows inside your retirement savings and helps to increase your net worth.
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Anything you invest is tax-deferred (you don’t pay taxes until you withdraw the funds).
For example:
You invest $1,000 a month into your retirement. Let’s say you are a high-income earner and in the 40% tax bracket. You can earn 10% on your investments. At the end of 30 years, you would have $1.58 million in after-tax spendable cash.
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$1.2 million in after-tax cash from the retirement plan (this includes $2 million gross less the 40% in taxes)
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$380,000 in a side fund (created by investing the $400 of monthly tax savings – $1,000 deduction x 40%)
Remove the government and any taxes, let’s say you invest $1,000 a month in a fund that earns you 10% for 30 years, you would have just over $950,000.
Which plan wins?
The retirement investment with the tax savings. You’d have an additional $630,000 after taxes ($1.58 million vs. $950,000).
That’s the big picture to help encourage you to invest in tax-deferred growth inside a retirement plan.
This leads right to understanding which plan is the best option for you to invest in your retirement!
Which plan is right for you?
There are several options. It depends on your income, your business ownership, and other factors to truly know which choice is the best for you. However, there are two great options to invest in your retirement as a digital nomad.
I suggest you choose between the SEP IRA and the Solo 401k. Both of these options are great especially if you have no employees in your business (other than yourself and your spouse).
As a side note: If you do have employees, then the traditional 401k is probably your best bet for your contributions. You will need to match your employees as well but it counts as a business expense and it’s a way to attract good talent.
Let’s go over the differences to understand them better.
SEP IRA vs. Solo 401K
While the SEP IRA is easier to set up, it’s not that difficult to get a 401k plan established with the help of an advisor or investment firm. The SEP IRA might not always be the best option for contribution limits. I’ll share why and give examples to show you real numbers in a minute.
One other thing to consider with the Solo 401k is the additional requirement to file Form 5500 once your plan reaches $250,000 in assets. That form is an annual requirement and your advisor should help you get it filed. No big deal, right?!?
On the other hand, the SEP IRA has no such requirement.
If your goal to invest in your retirement is to stash away as much cash as possible, I suggest going with the Solo 401k option.
Why Choose a Solo 401(k)?
The biggest reason I push this option is that it allows for higher contribution amounts. This is especially true if your income is on the lower side.
A Solo 401k has two contribution sources:
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YOU by making elective employee salary deferral contributions. In 2021, you can contribute up to $19,500 ($26,000 if age 50 or over) of:
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your W-2 income if you have an S Corporation or
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your net self-employment income if you operate as a sole proprietor or single-member LLC
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YOUR BUSINESS with employer contributions. In addition to your elective deferral contribution, the Solo 401k allows an additional employer contribution of up to 25% of your salary or 20% of your net self-employment income. When calculating the employer contribution, your compensation or net self-employment income is not reduced by your elective deferral amount.
With a corporate plan, your corporation makes the employer contribution on your behalf.
With a plan established for a sole proprietorship or a single-member LLC, you are effectively treated as your own employer. Therefore, you make the employer contribution on your own behalf.
This might seem strange. But it’s true.
Confused?
Simply put… in a one-person business you are both an employee and employer for the Solo 401k.
What about the SEP IRA? Does it offer the same employer AND employee contribution? No.
With the SEP IRA, you contribute employer amounts only. This equals 25% of your W-2 salary or 20% of your net self-employment income. You must deduct half your self-employment taxes to help get your net self-employment income.
Let’s look at an example to compare the two options with real numbers:
Susan earns $19,000 from her business.
Under the Solo 401k rules, Susan could contribute almost all of her $19,000 in net earnings to a Solo 401k.
Under the SEP IRA rules, she could contribute only about $3,800 ($19,000 x 20%).
What about higher income?
If you are under age 50 and your income is on the higher side, the 2021 limit on contributions is $58,000. But if you are age 50 or older, the Solo 401k has a catch-up provision that allows you to contribute another $6,500. This gives the potential for $64,500. Any catch-up contribution must come from an employee deferral.
On the other hand, the SEP IRA does NOT allow any catch-up contributions.
For example:
Maria Smith, age 57, owns a profitable S Corp and she receives a nice W-2 salary. Maria makes an employee elective deferral of $26,000. This reduces her income for the year. The corporation can then contribute $38,000 to her 401k. That’s the maximum allowed. Again, she needs to have a high salary to do this because it’s the lesser of $64,500 total or 25% of her W-2 wages.
With the SEP IRA only employer contributions can be made.
Another example:
Jacob is a self-employed developer under age 50 with an annual profit of $120,000.
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With a SEP IRA, he can contribute a maximum of $22,304.
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With the Solo 401k, he can contribute a maximum of $41,804 ($19,500 employee and $22,305 employer)
I think you get the idea even if your salary or earnings aren’t quite that high.
What about the tax deduction?
If you’re curious how this helps your taxes, then understand that all the deductions to a SEP IRA or Solo 401k are tax-deductible. SEP IRA contributions are traditionally taken on your personal 1040. Solo 401k contributions have different deductions depending on the business structure:
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S Corp deductions are split between reducing your W-2 salary and reducing the net profit of the S Corp.
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Sole proprietor/single-member LLC are taken on the personal 1040 NOT a Schedule C.
To sum it up, the key to investing in your retirement is to start early and invest the money wisely.
In most cases, the owner of a one-person business can put away more money for retirement with the Solo 401k than with a SEP IRA because the Solo 401k allows for both the employee elective deferral and the employer contribution.
