You may be wondering at what age you should start saving for retirement. The answer is simple: as soon as possible. The earlier you start, the less money you’ll need to contribute, thanks to the power of compounding. Creating a retirement strategy is extra important when you are a freelancer, because there’s no one looking out for your retirement but you. Many people miss the steps that you must take in order to control your finances, so that they are in place and ready when you need them.
Pay Yourself First
Many people think of retirement savings as the money they put away if there is any cash left at the end of the month. “Paying yourself first means saving before you do anything else,” says David Blaylock, CFP, senior financial planner at LearnVest Planning Services. “Try and set aside a certain portion of your income the day you get paid before you spend any discretionary money. Most people wait and only save what’s left over—that’s paying yourself last.”
Let's say you save $40 per month and invest that money at 4.65 percent, which is what the Vanguard Total Bond Market Index Fund earned over 10 years. Using an online savings calculator, an initial amount of $40, plus $40 per month for 30 years adds up to $31,550. Raise the interest rate to 8.79 percent, the average yield of the Vanguard Total Stock Market Index Fund over 10 years, and the number rises to more than $70,000.
You can increase your savings as your income increases and your nest egg can be a lot larger. Determine the investment mix that’s best for you and use a savings calculator to see how fast your money can grow based on the amount you can pay yourself first.
Get Your Free Money From Your Employer
If you who work for an employer that offers a retirement savings option, be certain you take full advantage of any employer match for that plan. The first part of the free money is that your contributions are made with pre-tax dollars and lower your taxable income. Even better, many employers offer to match your contributions to the retirement savings plan. For example, an employer may contribute up to six percent, but that contribution is based on you making the same contribution out of your paycheck. You don’t want to leave that money on the table, so be sure to find out the details of your company’s retirement savings plan and try to put in enough money to match that employer guarantee.
If you can’t afford to contribute enough for the full employer match, add to your percentage contribution each time you get a raise. For example, if you were to get a four percent raise, increase your retirement savings contribution by one percent. That way you still enjoy some increase in your pay, but pay yourself first as well. Since contributions to these retirement saving plans are tax-deferred, the actual amount of cash that will be taken out of your raise will be less than one percent depending on your tax bracket.
Self-Employed Retirement Saving Options
The joys of self-employment are many, but so are the stressors. High among those are financial unpredictability and the need to plan for retirement entirely on your own. You are in charge of creating a satisfying quality of life post-retirement. And when it comes to building that life, the earlier you start, the better.
According to a study by Freshbooks, by the year 2020, 42 million Americans may choose to be self-employed professionals, which is roughly a third of all working Americans. While the spirit of entrepreneurialism is to be applauded, less laudable is the fact that a substantial 40 percent of self-employed workers save for retirement only sporadically; by contrast, just 12 percent of traditionally employed workers are sporadic savers. Scarier still, 28 percent of the self-employed, versus 10 percent of traditionally employed workers, say they aren’t saving for retirement at all.
The reasons given for not saving towards retirement won’t be a surprise to anyone who is self-employed. The most common include:
- Lack of steady income
- Paying off major debt
- Healthcare expenses
- Education expenses
- Business costs
Still, when your future is your own, you need to make the investment in yourself, even if it means living more frugally while you are still working.
“Self-employed individuals, just like anybody else, need to save for retirement. By not saving enough of their income, they are susceptible to the same problems that employees face in terms of not being prepared for retirement. The same rules apply,” says Mark Hebner, founder and president of Index Fund Advisors, Inc. in Irvine, Calif., and author of “Index Funds: The 12-Step Recovery Program for Active Investors.”
Unfortunately, the retirement savings options for the self-employed aren't quite as obvious or automatic as they are for regular employees. Whenever someone starts a new job, HR often tells them about any company-sponsored retirement programs that are available, but there's no similar mechanism for the entrepreneur. When you work for a company with a retirement plan as part of its benefits package, your options are pretty clear, largely because you have someone who can walk you through getting the account set up and scheduling contributions. You also have a regular income stream that doesn't fluctuate the way contract work can.
Freelancers have unique challenges and opportunities when it comes to saving for retirement: you don’t have an employer-sponsored retirement plan and no one is giving you a matching contribution. You are not getting any shares of company stock. However, as a small business owner, you can potentially save a higher dollar amount and a higher percentage of your income than an employee can.
Because the amount you can put in your retirement accounts depends on how much you earn, you won’t really know until the end of the year how much you can contribute. So unlike an employee, you won’t be taking small amounts out of each paycheck and putting them in your retirement account. However, if you wait until the end of the year to set aside a chunk of your income, you might find that the money isn’t there because you’ve spent it.
Luckily, there is a wide range of options available to those who run their own business. While some approaches are compelling in their simplicity, others allow an owner or operator to squirrel away truly considerable amounts of money for retirement.
Here are three retirement savings options favored by the self-employed. They are:
- One-Participant 401(k)
- SEP IRA
- SIMPLE IRA
With all three, your contributions are tax-deductible, and you won’t pay taxes as they grow over the years (until you cash out at retirement).
A One-Participant 401(k) – the IRS term – is also sometimes called a Solo 401(k), Solo-k, Uni-k or Independent 401(k) or individual 401(k). This plan is similar to a traditional 401(k), but is reserved for sole proprietors with no employees, other than a spouse working for the business. It offers the most generous contribution limits of the three plans.
It is a plan for self-run businesses that closely mirrors the 401(k) plans offered by many larger companies. What is different, though, is that an individual 401(k) combines the features of a "regular" 401(k) with a profit-sharing plan. With a solo 401(k), you get to contribute as both the employee and the employer, giving you a higher limit than many other saving plans. If you were covered by an employer, you would make contributions as a pre-tax payroll deduction from your paycheck and your employer would have the option of matching those contributions up to certain amounts. With a One-Participant 401(k) plan, you have the advantage of being the employee and the employer. This allows you to contribute more than you could if you were under an employer’s plan.
This plan requires more paperwork than the SEP IRA, but the business owner can contribute even more. The business owner can contribute both as an employee (elective deferral) and as a business owner (employee non-elective contribution). Elective deferrals for 2018 is up to $18,500, or $24,500 if over 50 years old. Total contributions cannot exceed $55,000, or $61,000 including the catch-up contribution for people over 50 years of age. If a spouse is employed by the company, similar contributions can be made for the spouse as well.
“Generally, 401(k)s are complex plans, with significant accounting, administration and filing requirements,” says James B. Twining, CFP®, founder and wealth manager of Financial Plan, Inc., Bellingham, Wash. “However, a solo 401(k) is quite simple. Until the assets exceed $250,000, there is no filing required at all. Yet a solo 401(k) has all the major tax advantages of a multiple-participant 401(k) plan: The before-tax contribution limits and tax treatment are identical.”
To avoid penalties, you’ll need to leave your savings in the account until you are 59½, although there are exceptions, including:
- Purchasing your first home
- Education expenses
To establish an individual 401(k), a business owner has to work with a financial institution, and that institution may impose fees and certain limits as to what investments are available in the plan. Some plans, for instance, may limit you to a fixed list of mutual funds (typically sponsored by that institution), but a little bit of shopping will turn up many reputable and well-known firms that offer low-cost plans with a great deal of flexibility.
While tax-free loans from plan assets are possible, only the self-employed and his or her spouse are eligible for such a plan.
Like the SEP Plan, use the table in IRS Publication 560 to calculate your contribution limit.
Standing for Simplified Employee Pension, a SEP IRA is easy to establish and operate. You can easily open one at an online brokerage like Charles Schwab. Employers can contribute up to 25 percent of employee compensation, or up to a maximum of $55,000 in 2018. This is the easiest plan to set up and maintain and a great option for sole proprietors.
“You can contribute more to a SEP IRA than a solo 401(k), excluding the profit sharing, but you must make enough money since it’s based on the percentage of profits,” says Joseph Anderson, CFP®, president of Pure Financial Advisors, Inc, based in San Diego, Calif.
In a SEP IRA, the employer contributes to the fund, not the employees. So although you do not have to contribute to the plan each year, when you do contribute, you will need to contribute for all of your eligible employees. This makes the plan most desirable for one-person businesses. Remember that you will be hit with a 10 percent fine, along with taxes if you withdraw money from your SEP IRA before you are 59½ years old.
This is a good option to maximize contributions with minimum paperwork, whether the business has employees or not. It also offers flexibility to vary contributions or skip them altogether, according to the needs of the business.
While SEP IRAs are simple, they are not necessarily the most effective means of saving for retirement. Contributions are limited to 25 percent of employee wages or 20 percent of net earnings (before self-employment tax) of owner or operators, which works out to about 18.6 percent of profits. These contributions are also capped at $49,000 per year, but any contribution can be made in a lump sum at the end of the year. Employers should also note that under most circumstances they will have to contribute the same amount for employees (on a percentage basis) as for themselves, but there is no annual funding requirement.
While investors can usually roll 401(k) distributions into a SEP IRA, it is not possible to borrow against these funds and early withdrawals come with a 10 percent penalty in addition to regular taxes.
Savings Incentive Match Plan for Employees (SIMPLE IRA)
The Simple IRA is this third option for small business people or people who are self-employed. This, too, is easy to set up and operate but has lower contribution thresholds. Just as the name says, the SIMPLE IRA is designed to be an easy, hassle-free way to save for retirement. The plan follows the same investment, rollover and distribution rules as a traditional IRA except for the contribution limits. According to the IRS, "You can put all your net earnings from self-employment in the plan: up to $12,500 in 2017, plus an additional $3,000 if you are 50 or older, plus either a two percent fixed contribution or a three percent matching contribution."
Savings Incentive Match Plan for Employees (SIMPLE) IRAs are similar to SEP IRAs, but with the SIMPLE, employees can contribute along with employers. As the employer, however, you are required to contribute dollar-for-dollar up to three percent of each eligible employee’s income to the plan each year that the employee contributes to the fund; and two percent of the eligible employee’s income if he/she does not contribute that year.
Like other IRAs, these accounts or plans must be opened with a financial institution, and that institution will have rules as to what sorts of investments can be bought under the plan, and may charge fees for plan administration and participation.
While a SIMPLE IRA is easy to establish and operate, the limit of $13,000 in 2019 ($16,000 if you are over 50) annual contribution, plus the requirement to match employee’s contributions, makes a SIMPLE IRA best for those with no employees and an annual income of less than $45,000. There is a 10 percent penalty for withdrawals if you are under age 59½.
The table in IRS Publication 560 is also the way to calculate your contribution limit.
A SIMPLE IRA is for businesses with 100 or fewer employees. Just like a 401(k) plan, it is funded by tax‑deductible employer contributions and pre-tax employee contributions. Under this plan the obligation of the employer is less, but so is the amount the business owner can contribute for herself. This is because the business owner is subject to the same contribution limit as the employees.
SIMPLE IRA plans only make a lot of sense in certain specific cases. Because they represent much less potential retirement savings for the proprietor, they really only make sense in cases where the number of employees involved would make other plans too expensive.
The Keogh plan is arguably the most complex of the plans intended for self-employed workers, but it is also the option that allows for the most potential retirement savings.
Keogh plans can take the form of a defined contribution plan where a fixed sum or percentage is contributed every pay period. These plans cap total contributions in a year at $54,000. Another option, though, allows these to be structured as defined benefit plans. These plans rely on IRA contribution formulas that can be rather complex, but the upshot is that certain eligible proprietors can contribute nearly $200,000 to the plan in a year.
A business must typically be incorporated to use a Keogh and they are only permitted for businesses with 10 or fewer workers. Although all contributions are made on a pre-tax basis, there can be a vesting requirement. There are federal filing requirements for these plans and the paperwork and complexity often means that professional help (be it from an accountant, investment advisor or financial institution) is necessary
As you might imagine, these plans are typically only beneficial to high earners. Because of the defined benefit structure, though, it can offer a convenient and legal workaround for situations where there is a single high-earning boss and several lower-earning employees (as in the case of a medical or legal practice).
Traditional or Roth IRA
If none of the above options are available to you, start your own IRA. There are two types – a traditional IRA, which lets you save tax-deferred, and a Roth IRA, which you open with post-tax money. When you use a traditional IRA, you can deduct the amount you contribute each year from your income, but you will have to pay taxes on the money as you take it out. You pay taxes on both your contributions and any gains earned while the money is invested.
Although the money you put into a Roth IRA is after-tax cash, it means that when you take the money out at retirement, you don’t have to pay any taxes – either on the money you originally contributed to the Roth IRA or on the gains your money earned.
Roth and traditional IRAs are available to anyone with employment income. That includes freelancers, and you can contribute to an IRA in addition to a self-employed 401(k). A working spouse can also contribute to an IRA on behalf of a nonworking spouse. Roth IRAs let you contribute after-tax dollars, while traditional IRAs let you contribute pretax dollars. The maximum annual contribution is $6,500 in 2018 or your total earned income, whichever is less. If you’ve maxed out your contributions to your self-employed 401(k), or if you want to make a combination of before-tax and after-tax contributions, add a traditional or Roth IRA to your retirement portfolio.
Most freelancers worked for someone else before striking out on their own. If you had a retirement plan with a former employer, have you kept tabs on it? Most of the time, the best way to manage the retirement savings you accumulated at your old job is to transfer them to a rollover IRA. A rollover IRA lets you transfer all the assets in your former employer’s plan, such as a 401(k), 403(b), or 457(b), into a rollover IRA, a type of traditional IRA. You’ll be able to choose your own investments and you’ll have greater control over your account.
Keep Control of Your Retirement Funds
When you change jobs, you’ll need to decide what to do with your employee retirement saving accounts. You’ll have the choice to cash them out, leave them with the employer (if the employer allows this) or roll them over into an IRA or, perhaps, into the 401(k) at your new job.
Rolling your employee retirement savings into an IRA is your best option: “Rolling money into an IRA opens the toolbox, so to speak, for the investor to invest in individual stocks, bonds – the whole range of investments is now available," says Daniel Galli, a Norwell, Mass., certified financial planner. With an IRA, you can choose how to invest the money, rather than being limited by the choices in an employee plan.
As your savings build, you may want to get the help of a financial advisor to determine the best way to apportion your funds. Some companies even offer free or low-cost retirement planning advice as part of their 401(k) programs. Recently roboadvisors like Betterment and Wealthfront provide automated planning and portfolio building as a low-cost alternative to human financial advisors.
Think About Life in Retirement
As you begin to establish financial goals for your future, start imagining how you might want to live. Do you want to travel the world? Is there a business you want to start or a second career you've dreamed of exploring? Do you just want time to enjoy where you are living and get better at golf or help your kids. Saving for retirement before anything else will give you the best chance of ending up with a nest egg that will enable you to support your family and your life. Your goals will change, but they probably won't be free. These changes don't have to wait until you hit 65 or 66.
The Bottom Line
Start saving for retirement as soon as you start earning income, even if you can’t afford much at the beginning. Paying yourself first is the most important habit you can develop if you want to enjoy a financially healthy retirement.
If you are self-employed, you are busy – crazy busy, probably – but retirement saving has to be a priority for at least two reasons. First: Social Security will not be your primary source of retirement income. It was not designed for that role. Second, funding your retirement account is part of your company expenses just as it is at companies of all sizes. You have to work that expense into your pricing structure.
Start today. The differences among these choices – and their tax ramifications – are complex. Once you know what you need, making the payments should be straightforward.
Above all, though, it is vital to do something. Retirement is just as real for the self-employed and it is every bit as important to make the most of existing tax laws to maximizing your earning and savings potential.