Eager to Retire Early? Here’s 1 Mistake You Can’t Afford to Make.

Many people dream of leaving the workforce at an earlier age than most. And retiring early certainly has its benefits. If you go that route, you may get the opportunity to travel at a point in life when you have more energy to sightsee. Plus, there’s something to be said for living life on your own terms, without having a boss to answer to all the time.

a man standing next to a tree: Eager to Retire Early? Here's 1 Mistake You Can't Afford to Make.

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Eager to Retire Early? Here’s 1 Mistake You Can’t Afford to Make.

But in order to retire early, you’ll need money to live on. And that’s why you’ll need to plan very carefully to achieve that goal, which includes avoiding one key mistake.

Keep your savings accessible

You’ll often hear that it’s smart to save for retirement in an IRA or 401(k) plan. And that actually is good advice. With a traditional IRA or 401(k), your contributions go in tax-free so that you lower your tax burden from year to year. Plus, all investment gains in your plan are tax-deferred until you take withdrawals.

a man standing next to a tree: Middle-aged man and woman holding hands while walking on trail

With a Roth IRA or 401(k), your contributions aren’t tax-free, but investment gains and withdrawals are. That buys you a lot of freedom down the line.

Gallery: 10 Ways to Save for Retirement if You’re Self-Employed (The Motley Fool)

Self-employed workers need to set themselves up for a secure retirement

For many workers, investing for retirement is pretty easy. If you work in a traditional job, your employer may offer a 401(k). You can sign up to contribute to it and then have pre-tax contributions taken directly from your paycheck. Your employer may even match some of the money you’re putting in.

Self-employed individuals can’t rely on an employer to help with this process. But the good news is, if you work for yourself, you may be able to take advantage of many different kinds of retirement savings accounts that provide generous tax breaks and make it easy to save for the future.

Here are 10 possible accounts you could use to save for your retirement and build the nest egg you need to be secure in your later years — even if you’re self-employed or own your own business.

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1. Traditional IRA

A traditional IRA is an account that almost anyone can use to save for retirement, regardless of whether they are self-employed or not.

Traditional IRAs can be opened by individuals, and a wide variety of brokerage firms and other financial institutions offer them. Contributions are tax-deductible in the year they are made. However, there is an income limit for deductible contributions if either you or your spouse has access to a workplace retirement plan.

The downside of traditional IRAs is that the contribution limits are relatively low — but the upside is that they are very easy accounts to open and maintain.

2. Roth IRA

A Roth IRA is similar in many ways to a traditional IRA. In fact, the contribution limit applicable to both accounts is an aggregate one, so for 2021, you could contribute $6,000 total across both accounts (or $7,000 if you’re self-employed).

The big difference between a traditional and Roth IRA is that contributions to a Roth aren’t deductible in the year you make them. Instead, you contribute with after-tax dollars but benefit from tax-free withdrawals in retirement.

Roth IRAs are subject to a strict limit on income, and people who make too much can’t invest in them at all. Contribution limits are also lower than many of the other retirement accounts self-employed workers have access to.

Again, the big benefit is that Roth IRAs are very easy to open and contribute to, you can open them with many different financial institutions, and there’s little to no paperwork you need to fill out to maintain one.

3. SIMPLE IRA

A SIMPLE IRA is an option for self-employed workers, and business owners can offer them if they have fewer than 100 employees.

SIMPLE IRAs have a higher contribution limit than traditional or Roth IRAs, and the income restrictions that apply to traditional or Roth IRAs don’t apply to them. Contributions can be deducted in the year they are made.

While there’s a little more paperwork you have to do, the administrative burden is still very low with this type of account.

You can contribute to a SIMPLE IRA both as an employee or as an employer. If you have other people working for your business, you may be required to make matching contributions to their accounts once you set up this plan and start investing in it.

4. SEP-IRA

A SEP-IRA has a very high contribution limit and a low administrative burden. Both self-employed individuals and business owners can open one.

Like SIMPLE-IRAs, SEP-IRAs aren’t subject to income limits, and contributions are tax-deductible in the year they are made. It’s possible to open SEP-IRAs with many different brokerage firms and financial institutions. And the paperwork and administrative burdens aren’t cumbersome.

You are required to make contributions for all employees at the same fixed percentage of employer pay, though. So if you have people working for you, you need to be aware of this.

5. Solo 401(k)

A solo 401(k) is an option for self-employed workers who have no employees other than their spouse. They are very similar to the 401(k) accounts offered by traditional businesses, and they have high contribution limits.

When you use a solo 401(k), you can choose whether you want a traditional or a Roth 401(k). This means you have the option for contributions to be deductible in the year they are made, or for withdrawals to be made tax-free.

There are no income limits on who can contribute, and many brokerage firms offer solo 401(k)s, although it’s common for them to charge a fee. Unfortunately, the administrative burden associated with this type of account can be substantial compared with SIMPLE, SEP, Roth, and traditional IRAs.

6. Health savings account

A health savings account is available if you have a qualifying high-deductible healthcare plan.

HSAs can be used to cover the costs of immediate healthcare needs, but they can also be a great retirement savings plan. You can contribute to them with pre-tax funds, your money can be invested and grow tax free, and you can withdraw money from your HSA without owing taxes on it if you use it for qualifying medical expenses.

An HSA can help you save for the cost of healthcare in retirement, which can be substantial. But you’re also allowed to make withdrawals for any reason after age 65 and just pay taxes at your ordinary rate without owing penalties. That means they can be a good option for general retirement savings as well.

ALSO READ: What Will Healthcare Cost You in Retirement? Prepare to Be Shocked

7. Profit-sharing plans

Business owners can create profit-sharing plans to share a portion of company profits with their workers. You can use a profit-sharing plan along with other retirement accounts and can choose whether to share profits based on quarterly or annual earnings.

You contribute to profit-sharing plans only as an employer, and the contribution limits are very high. You’ll have discretion over whether to contribute to employee profit-sharing plans if you have people working for you, but can’t discriminate in favor of highly compensated workers.

There’s a high administrative burden to setting up a profit-sharing plan, with lots of paperwork to complete and requirements to fulfill.

8. Money purchase plans

Business owners can establish money purchase plans and set contribution rates. There are high contribution limits, and employers are required to make contributions based on the formula they established.

The specific amount employers contribute isn’t based on company profits and doesn’t vary from year to year. While these plans allow you to set aside a lot of money for yourself and other employees, the administrative burden and paperwork requirements can be extensive.

However, there are preapproved plans you can use to make things easier.

9. Defined benefit plans

As an employer, you may have the option to set up a defined benefit plan. This is different from a defined contribution plan, because you can essentially set up a plan that provides you with a guaranteed amount of income in retirement.

Businesses of any size are allowed to set up defined benefit plans, and they can be offered in conjunction with other retirement plans. Employers typically make contributions, and they are not permitted to retroactively decrease benefits.

Defined benefit plans have very high contribution limits, but the administrative burden and paperwork requirements are extremely complex and the plans can be very costly to administer.

ALSO READ: How to Work for Yourself: A Practical Guide (2021)

10. Taxable brokerage account

Finally, you also have the option to save for retirement in a regular taxable brokerage account.

You can open this type of account with any broker or financial institution, invest in anything you like, and take the money out of your account anytime you want (unlike with most other retirement accounts, which come with restrictions on penalty-free withdrawals).

The obvious downside of this approach is that you don’t get any tax benefits associated with contributions or withdrawals and you can’t defer taxes on gains. But the upside is there’s no extra paperwork required and far fewer restrictions on your account.

What type of account is right for you?

The right type of self-employed retirement account will vary depending on how your business is organized, whether you have people working for you, how much you want to contribute to your account, and what level of administrative work you’re willing to take on.

The good news is that you have lots of options, so there’s no reason not to start saving for a secure retirement today.

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12/12 SLIDES

There’s just one problem with housing all of your savings in a tax-advantaged retirement plan — you can’t take withdrawals before the age of 59 1/2. In fact, if you remove funds from your retirement plan early, you’ll be hit with a 10% penalty on the sum you take out.

Load Error

That’s why if your goal is to retire early, you can’t afford to lock up all of your savings in a traditional retirement plan alone (with a Roth, you can technically withdraw your principal contributions early without penalty — just not your gains). Rather, you’ll need to spread out your savings across a tax-advantaged retirement plan and other accounts or investments.

Now in this regard, you have some options. You could always open a traditional brokerage account and invest your money there. These accounts don’t offer any tax benefits, but they’re also not restrictive — you can cash out investments at any time and use that money to cover your living costs (keeping in mind, of course, that if you sell stocks for more than what you paid for them, you will be liable for capital gains taxes).

Another option is to fund your early retirement with an income property. If you buy a home to rent out, that rental income could help you cover your bills if you’re too young to access your retirement plan penalty-free.

Of course, these are just a couple of options, but the point is that if you’re planning to retire at some point in your 40s or 50s, you’ll need savings outside of a traditional IRA or 401(k) to pull that off — and so your best bet is to strategize and figure out how you’ll spread out your wealth. The sooner you come up with a plan, the more likely you’ll be to pull off an early retirement — and enjoy the many benefits of getting to leave the workforce when you decide you’re ready.