5 Ways to Save for Retirement as a Full-Time Freelancer
So you’ve finally made the leap to full-time freelancer. For you, this means time freedom, flexibility, and the ability to control your income.
But as a self-employed person or independent contractor, you also miss out on certain employee benefits.
This includes the opportunity to invest in a 401(k), an employer-sponsored retirement account.
Some employers even offer a program where they’ll match an employee’s retirement contributions up to a certain percentage.
For those who contribute up to the yearly max, this program is one of the best ways to boost retirement income.
Unfortunately, you don't have access to a 401(k) as a full-time freelancer.
You can, however, take advantage of other planning tools; and the sooner you start saving for retirement the better.
But while saving for retirement is important, it shouldn’t be your only focus as a freelancer.
You have other financial concerns, so it’s important to prioritize how you save.
Read on to learn more about your retirement options as a freelancer.
1. Emergency Fund First
Building an emergency fund as a freelancer is just as important as saving for retirement.
You’re responsible for finding clients and generating income on a consistent basis.
If your business doesn’t profit, you don’t make money. For this reason, freelance income can be somewhat unpredictable compared to being an employee.
Employees know what they’re getting paid each pay period, so it’s easier for them to budget.
Freelance income, on the other hand, can fluctuate. You could lose a client and it might take weeks or months to replace this lost income.
Therefore, establishing an emergency fund should be a high-priority.
It takes a while to build a sizable emergency fund, but something is better than nothing. You can start with as little as $1,000 and increase your emergency fund to a minimum of 3 to 6 month’s worth of income.
Ideal Size of an Emergency Fund
|To start...||Ideal goal...||Super safe...|
|$1,000||3-6 months of essential expenses||12 months of expenses|
Chances are you won’t lose all your clients at once.
But if you did, consider the worst-case scenario to figure out how much you’ll need in your fund. Start by adding up your actual monthly expenses.
You might see a net profit of $4,000 a month after business expenses, yet you only need $3,000 a month for expenses. If so, aim for an emergency reserve between $9,000 and $18,000.
As you search for a place to hold your money, keep in mind that regular savings accounts don’t earn a lot of interest.
To earn a higher return, consider high-yield options like an online savings account.
2. Save for Quarterly Tax Payments
When you work for yourself, it’s your responsibility to pay your own taxes. So make sure you set aside a percentage of your income each month and make estimated quarterly tax payments.
The amount you’ll owe in income tax depends on multiple factors.
This includes your tax bracket and where you live because state tax percentages vary.
2020 Tax brackets
|10%||$0 - $9,875|
|12%||$9,876 - $40,125|
|22%||$40,126 - $85,525|
|24%||$85,526 - $163,300|
|32%||$163,301 - $207,350|
|35%||$207,351 - $518,400|
Be mindful of the fact that self-employed people or freelancers must also pay a 15 percent self-employment tax. This consists of Social Security and Medicare tax.
Self-employment tax is in addition to what you’ll pay for federal and state. To illustrate, let’s say you’re in the 15 percent tax bracket and your state tax is 5 percent. Once you add in self-employment tax, you’ll need to set aside about 30 percent of your income for taxes each month. Full-time freelancing requires meticulous record keeping of income and business expenses. Here is the schedule for making estimated tax payments every four months.
- Estimated taxes for income earned between January 1 and March 31 is due April 15
- Estimated taxes for income earned between April 1 and May 31 is due June 15
- Estimated taxes for income earned between June 1 and August 31 is due September 15
- Estimated taxes for income earned between September 1 and December 31 is due January 15 of the following year
You can work with an accountant to determine how much you owe in estimated taxes.
If you don’t make quarterly tax payments, but instead make a single tax payment by April 15 of the following year, you may have to pay a penalty for underpayment of estimated taxes.
Typically, you should make estimated tax payments if you expect to owe more than $1,000. According to the Internal Revenue Service, you’ll avoid penalty “if you owe less than $1,000 or if you paid withholding and estimated tax of at least 90 percent of the tax for the current year or 100 percent of the tax shown on the return for the prior year, whichever is smaller.” The underpayment penalty is 3 percent per year. Use IRS Form 1040-ES, Estimated Tax for Individuals to make an estimated tax payment.
Open a separate savings account to keep your tax money separate from your emergency savings.
3. Start a Traditional or Roth IRA
Once you have an emergency fund and you’ve saved for quarterly taxes, the next step is to fund your retirement account.
If you’re a freelancer or self-employed and not eligible for a company 401(k), look into opening an individual retirement account (IRA). You can set up a traditional or Roth IRA with a brokerage firm or a bank.
An IRA isn’t an investment in itself. Rather it is an investment account with a collection of stocks, bonds, mutual funds, and other securities.
Traditional and Roth IRAs are both excellent options if you’re young and earn a modest income. You can contribute a maximum of $5,500 a year to an IRA. Or if you need to play catch up, you can contribute up to $6,500 a year if you’re age 50 or older.
The main difference between these accounts:
Contributions to a traditional IRA are tax-deductible and tax deferred.
Therefore, you don’t pay taxes on this income until retirement.
There’s no tax deduction with a Roth IRA, so you can withdraw your money tax-free in retirement.
Traditional IRA Vs. Roth IRA
|Traditional IRA||Roth IRA|
|Contributions may be tax-deductible.||Contributions are not tax-deductible.|
|Pay taxes upon withdrawal.||Earnings can be withdrawn tax-free and without penalties if the funds were in the Roth IRA for 5 years and you've reached age 59 1/2.|
|You must be under age 70 1/2 to contribute.||You can contribute at any age.|
|Required minimum distributions (RMDs) are required starting at age 70 1/2.||No RMDs required.|
4. Open a SEP IRA
Another IRA option is a SEP IRA (simplified employee pension plan). To be eligible for this account, you must be a business owner or a self-employed individual.
Similar to a traditional IRA, SEP IRA contributions are also tax-deductible. You don’t pay taxes on the money until you withdraw funds in retirement.
An SEP IRA is useful because you can combine it with a Roth or a traditional IRA.
So it’s an excellent solution if you’ve maxed out contributions to a Roth or traditional IRA and you’re looking for another place to sock away money for retirement.
In 2020, accountholders were able to contribute 25 percent of their compensation or up to $57,000, whichever was smaller. In 2021, you can contribute 25 percent of your compensation or up to $58,000.
You can choose from a variety of different investments to handle your IRA based on your retirement age and your tolerance risk. But a few options include well-known firms such as Vanguard, Charles Schwab, and Fidelity Investments.
These companies offer diversified index funds and low expense ratios.
5. Consider a Taxable Brokerage Account
What if you want to continue saving for retirement after maxing out a traditional or Roth IRA and contributing the maximum to a SEP IRA?
What are your options?
Maxing out your IRAs doesn’t mean you have to stop saving for the future.
In this situation, it might be worth opening a taxable brokerage account.
You might be asking:
How do you open a taxable brokerage account?
What you’ll do is open and fund an investment account with a brokerage firm, and then use these funds to buy stocks and other types of securities. These include bonds, mutual funds, real estate investment trusts, certificate of deposits, and exchange-traded funds. This investment account is an excellent addition to your portfolio.
There are no income restrictions -- you can invest without limit, and you can withdraw your money at any time without tax or penalty.
There are also no mandatory distributions at age 70 1/2. Mandatory distributions are typical with individual retirement accounts.
But while this investment strategy can help you further prepare for the future, it is a taxable account as its name suggests.
Therefore, you must pay taxes on any capital gains from the account.
Things to Consider When Choosing a Plan
When saving for retirement as a freelancer, there are other factors that are important to take into consideration when stashing away for your dream home in Boca:
Tax bracket: high or low?
If you're subject to the highest tax rate, that usually means you'll owe more taxes unless you've got some deductions to offset what you earn.
For freelancers who are on the threshold between two tax brackets, the retirement plan you choose can make a big difference.
For instance, let's say you're single and you're making $50,000 from your freelance efforts.
That would put you in the 22 percent tax bracket for 2021.
Now, assume that you made $14,000 in deductible contributions to a tax-advantaged retirement account.
You'd knock your income down to $36,000, which would drop your tax rate to just 12 percent instead. Best choice for high earners:
If you're going to be bringing in a decent amount of money through self-employment, either a solo 401(k) or SEP IRA is the way to go. You can put up to $58,000 in a solo 401(k) versus the $13,500 allowed for a SIMPLE IRA, which means a bigger tax break.
Single savers vs. married freelancers
When you're flying solo as a freelancer, coming up with the cash to meet the higher contribution limits for a SIMPLE or SEP plan might not be feasible -- if your business hasn't taken off yet.
If you can only afford to save a few thousand dollars a year:
You might benefit more from opening a traditional IRA.
A traditional IRA still offers a deduction but is easier to set up and maintain than other self-employed retirement plans.
However, if you're married and you're both pulling in a sizable income:
A solo 401(k) or SEP is definitely worth a second look.
Aside from pushing you into a lower tax bracket:
Being able to deduct a big chunk of your earnings may help you to qualify or certain credits, deductions and benefits that you might not otherwise be eligible for.
These include things like the student loan interest deduction and personal exemptions, all of which can lower your tax bill.
Best choice for singles:
This one really comes down to how much you're making and what you can reasonably afford to save. The limit for a traditional IRA is set at $6,000 for 2021, so if you think you'll be able to stash away a little more than that, a SIMPLE IRA might be the smarter option.
Tax savings now or later?
Solo 401(k)s, SEP IRAs and SIMPLE IRAs are designed to give you a tax benefit now while you're actively contributing to them.
Once you start taking the money out, you'll have to pay taxes on it based on whatever bracket you're in at the time.
If you expect your income to go down as you get older, it's usually not an issue.
However if you plan to continue freelancing full-time into your golden years, that could be a problem.
For instance, imagine you're a single freelancer earning $50,000.
If you manage to double your income to $100,000 by the time you turn 59 1/2, which is the age when you can start making qualified withdrawals from your retirement account, you're going to be in a higher tax bracket.
In that case, you'd be better off with a retirement account that lets you take money out tax-free. Best choice for future savings:
If you're worried about taking a tax hit down the road, you can minimize the damage by saving in a Roth solo 401(k). Like a regular Roth IRA, your contributions aren't deductible but you won't pay taxes on your qualified withdrawals later on. Remember, for 2021, the maximum contribution amount is $19,500, plus a $6,500 catch-up contribution if you are aged 50 or older.
Accessing the money
Pulling money out of your retirement plan early is a bad idea for a couple of reasons.
One, when you make withdrawals ahead of schedule you're missing out on the potential growth you could have gotten if you'd just left the cash alone.
The other issue is how it can affect your taxes.
Not only will you have to pay regular income taxes on the money, but you'll also get hit with a 10 percent early withdrawal penalty if you're under 59 1/2 at the time.
You also have to keep in mind what the rules are about required minimum distributions.
If you've got a solo 401(k), SEP or SIMPLE IRA, you have to start taking money out of your account once you turn 70 1/2.
The only retirement plan that allows you to sidestep this requirement is a Roth IRA, but you can't put as much money into these accounts. Best choice if you need to tap your account early:
A solo 401(k) is the right pick if you want more flexibility with taking money out of the account. You can make hardship withdrawals without a tax penalty in certain situations and some plans also allow you to take out loans of up to $50,000. Just keep in mind that loans typically need to be repaid within five years, otherwise it ends up being a taxable distribution.
Realizing your dream of becoming a full-time freelancer is a major achievement.
But when you’re in control of your income, you’re also in control of your own retirement planning.
So make sure you have a clear financial plan.
This not only helps you save for an emergency and estimated taxes but also allows you to maximize your retirement account.