When you’re self-employed, the full responsibility for retirement savings falls on your shoulders. If you’re already part of the gig economy, or are planning to become a freelancer and independent contractor, this guide to retirement plans describes the options available to you.
In a previous article, we looked at people who now work in the gig economy—taking contract jobs as a freelancer/small business owner rather than taking the more traditional route working as an employee for another business.
It’s not as simple as saying goodbye to your employer and setting out on your own. We looked at things like the self-employment tax and other tax considerations that significantly impact your earnings.
Along with taxes, there’s another consideration—retirement. Maybe you saved up a valuable nest egg before you left your previous job, but for many, they’ve barely started amassing retirement savings. Because of this, you have to consider your retirement income before going all-in on the gig economy. Yes, you’ll receive Social Security assuming you pay fully into the system, but relying on a government program to keep you financially afloat in your later years isn’t the wisest strategy.
Saving for Retirement is All On Your Shoulders
In our last article we talked about how your employer paid part of your Social Security and Medicare taxes but as a freelancer, you have to do it all on your own. The same holds true for retirement. Studies show that nearly 9 out of 10 employers matched a portion of the employee’s 401(k) contributions. That represented a large portion of your retirement savings but as a freelancer, you won’t get any employer match. It’s all on you to save enough to retire comfortably. If you’re 30 and haven’t saved anything, you will need to save about $649 or more per month depending on your income and lifestyle to retire with enough money to live comfortably on. You can estimate the amount you’d need from this calculator.
Have employees? This article may help you navigate their retirement options.
The IRA Dilemma
It’s easy, right? Just start an IRA, contribute as much as you can, and you’re set. There are a host of problems with that plan. First, an IRA comes with a $5,500 annual limit ($6,500 if you’re age 50 or older ) allowing you to contribute a maximum monthly amount of about $458 (or $541 starting at age 50)—not nearly enough if you’re significantly behind on savings. Your spouse can get an IRA, whether he or she is working or not, giving you an extra $5,500 to work with. That’s better but what about if you’re single?
The Simplified Employee Pension or SEP is an option. You can contribute the smaller of $53,000 or 25% of your total compensation. Learn more about it in IRS Publication 560. But be careful. Don’t “forget” to claim all of those small-dollar clients that didn’t pay you enough to file a 1099. If you “forget” to claim it, it lowers your maximum.
The SIMPLE IRA plan for small employers is about as simple as anything involving the IRS can be. It works the same as a regular IRA but your yearly limit is higher. Instead of $5,500, you have a $12,500 limit. If you’re over the age of 50, you can contribute as much as $15,500. Again, Publication 560 will tell you everything you want to know.
Other Retirement Planning Options for Freelancers
There are other ways to fund your personal retirement from your company but the SEP and SIMPLE IRA are the most common. There are also profit sharing plans and a self-employed 401(k) plan where you and your company make contributions but these are a little more difficult to set up.
Assuming you have some kind of formalized business like an LLC, any retirement benefits your company provides to you are a business expense. Your company can write that off as an expense in most cases. How that all works depends on some factors a tax expert will probably have to help you with but it is an expense like any other.
Your Retirement Planning’s Effect on Pricing
Be honest—as a young or new entrepreneur have you wondered why your competitors are charging so much more than you believe the service is worth? You’re probably beginning to figure out that even a consultant working out of their home has overhead expenses. You have to pay taxes on your earnings and you have to fund your retirement and even insurance. That should drive your hourly rate significantly higher.
Think about it this way. Let’s say that you figured you have to save at least $500 per month for retirement and you’re going to pay about 30% of your earnings in taxes and you work 40 hours per week, and you charge $50 per hour. (For the sake of simple math.)
Just the retirement portion makes your hourly rate $52.50 and taxes add another $15 so now you’re at $67 without taking into account any other expenses. There are surely some other expenses your business incurs like licensing, continuing education, equipment, and more. It wouldn’t be surprising to see that number make it to $80 or more.
You have to fund your retirement. You no longer have an employer helping you or forcing you into the system by dangling dollar bills in front of your face. If you don’t set up a monthly, automatic contribution plan, you’re going to find yourself short on cash at retirement.
The good news is that there are plenty of good retirement options for the self-employed as long as you’re disciplined enough to take part.