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3 Retirement Accounts For Your Side Hustle

Make more money from your side hustle by investing it in a retirement account.

By Brad Wright 

A side hustle is an entrepreneurial activity outside of your normal day job that generates extra cash flow. Ideally, a side hustle is flexible and pays well for the amount of time you put in. Think teachers who spend the summer tutoring or serving as a part-time virtual personal assistant.

Brad Wright, CFP®, is co-founder of Launch Financial Planning, LLC, a fee-only firm located in Andover, MA. He is a frequent contributor to WCVB-TV and Mix 104-1 Radio. Brad is past-President of the Financial Planning Association of Massachusetts. Learn more about Brad at www.LaunchFP.com

Brad Wright 

When your side hustle begins making money you will have an opportunity to simultaneously contribute more towards your retirement and lower your current tax bill. While working for someone else allows you to contribute to their company’s retirement plan, working for yourself permits you to open a separate, additional plan for yourself.

The plan that you choose, depends on the amount of money your side hustle is generating and how much you want to tuck away for your future self. There are three primary options:

  • SEP-IRA
  •  Solo 401(k)
  • Cash Balance Plan

Let’s explore each one, assuming that the only employee is you, and possibly your spouse.

SEP-IRA

A SEP-IRA or Simplified Employee Pension Individual Retirement Arrangement is a variation on the Traditional IRA. SEP-IRAs are adopted by business owners to provide retirement benefits for themselves and their employees. The cost of opening and maintaining a SEP-IRA is minimal as long as you don’t have any employees. If you do have employees who have worked for you in three of the previous five years and are at least age 21, they must all receive the same benefits that you do.

The benefits are payable by the company (you). The 2021 maximum annual contribution to a SEP-IRA is the lesser of 25% of self-employment net income, or $58,000, which is much larger than the allowable $6,000 ($7,000 if age 50 or older) annual contribution limit to a Traditional IRA. Contributions to a SEP-IRA are tax-deductible in the contribution year.

Bottom Line: According to Third-Party Administrators (TPAs), a SEP-IRA is a popular option because of its ease. You can open an account yourself and there is virtually no cost.

However, if you are looking to put more money away, there might be a better option.

Solo 401(k)

A Solo or Individual 401(k) is a qualified retirement plan for employers with no full-time employees other than the business owner and spouse. Self-employed workers who qualify for this type of plan can receive the same tax benefits as a traditional 401(k) plan. In this case, the business owner wears two hats: employee and employer. Contributions can be made to the plan in both capacities.

The total allowable contribution, for 2021, is the same as a SEP-IRA ($58,000, not including any catch-up amount for employees age 50 and older). The difference between a SEP-IRA and a Solo 401(k) is that you, as the employee, are allowed to make elective deferrals up to 100% of your earned income up to the 2021 annual limit. The limit is $19,500 or $26,000 if you are age 50 or older regardless of the company’s income. Keep in mind that if you are also employed by another company and participating in their 401(k) plan, your elective deferrals are in aggregate, per person.

TPAs suggest contributing enough to your employer’s 401(k) plan to maximize any match the company offers before contributing to your Solo 401(k). In addition, the employer (also you) can contribute up to 25% of compensation, based on IRS guidelines and calculations.

You’ll typically find you’re able to contribute more to a Solo 401(k) than to a SEP-IRA. You will need a third-party administrator (TPA) to draft your plan’s documents, and also file a Form 5500 each year after the plan’s value exceeds $250,000. The average annual cost for these services is around $1,200.

As an example, if your net income is $200,000 you could contribute up to $50,000 to a SEP-IRA, while for a Solo 401(k) you could contribute up to $58,000 plus a catch-up amount of $6,500 if you are age 50 or older.

Bottom Line: TPAs advise, The plan to choose is really based on how much money you’re looking to put away.

If you have a larger amount in mind than $58,000, there is a third option.

Cash Balance Plan

While the SEP-IRA and Solo 401(k) plans are defined contribution plans, meaning what you eventually get out of the plan depends on the amount contributed and the fund’s investment performance, a Cash Balance Plan is a defined benefit plan, which promises a specific income.

An employer (in this case, that’s you) makes annual contributions to the plan to ensure that the plan assets will be sufficient to pay the promised benefits at retirement. As part of this process, the plan is required to have an actuary perform annual "actuarial valuations" in which the present value of each worker's "accrued benefit" is estimated. Each present value for each worker covered by the plan is added up so that the minimum annual contribution can be determined.

These plans are more expensive to set up and maintain. The annual fees are approximately $3,000, but this option allows you to contribute more than either a SEP-IRA or a Solo 401(k). A Cash Balance Plan is designed to reach a specific dollar amount upon retirement, which is generally stated as age 62. Contributions can increase as you get older. For example, the maximum contribution for a 40-year-old in 2020 was potentially $138,158 while a 60-year-old’s was potentially $316,183. That’s a lot of money at either age and much more than the allowable $58,000 for a SEP-IRA or Solo 401(k).

Bottom Line: If your side hustle income is cranking along, you may want to consider a Cash Balance Plan. Note that this is not the correct choice if you only expect one or two years of high income, as the IRS usually requires these plans to remain open and continually funded for at least three to five years.

Summary

Whichever plan you decide on, you should perform an annual review to confirm that your current plan is still prudent. Always be aware if you’re hiring someone, to speak to your advisor or TPA beforehand, as your funding requirements could change drastically.

Fall is upon us, and most have a decent idea of where our incomes will land for the year. If you’re considering opening a Solo 401(k) or a Cash Balance Plan, you should begin the process soon because they each involve a TPA. Although the deadline to open any of the plans mentioned has been extended to your tax filing date (typically April 15th of the following year), the sooner you complete this the better.

In addition, TPAs tend to become extremely busy towards year-end.

You should most definitely consult with your financial advisor and tax professional before moving forward with any of the above plans.

About The Author

Brad Wright, CFP® is co-founder of Launch Financial Planning, LLC, a fee-only firm located in Andover, MA. He is a frequent contributor to WCVB-TV and Mix 104-1 Radio. Brad is Chair of the Financial Planning Association of Massachusetts. Learn more about Brad at www.LaunchFP.com

The opinions penned here are for general information only and are not intended to provide specific advice or recommendations for any individual. Launch Financial Planning does not prepare taxes.

The foregoing information has been obtained from sources considered to be reliable, but we do not guarantee that it is accurate or complete. Any opinions are those of Brad Wright.