When you quit your job to go freelance, you give up the ability to contribute to your employer-sponsored retirement plan. You also lose out on future contribution matches from the company. It can be a tough pill to swallow, but there are ways that you can save for your future while self-employed.
Let’s look at a few of your options.
Individual Retirement Arrangement (IRA)
The Individual Retirement Arrangement, often referred to as the Individual Retirement Account (IRA), can be a great way to save modest sums. As of 2020, you can contribute up to $6,000 a year, or $7,000 if you’re over age 50 (known as a catch-up contribution).
IRAs come in two forms: traditional and Roth.
A traditional IRA allows you to deduct the contributions that you make on your taxes. But, you’ll have to pay tax on the money you withdraw in retirement. And, unless you have an IRS approved exception, you’ll be penalized for withdrawing any funds before you reach age 59.5.
Conversely, a Roth IRA lets you withdraw your money tax-free in retirement. And, you may withdraw your contributions any time — penalty-free. (Investment gains may be subject to IRA early withdrawal and other rules.) However, you can’t deduct your contributions on your taxes.
Basically, you can receive a tax advantage now or when you retire. If you expect to have more income in retirement, the Roth IRA could be a good choice.
Note: You can’t contribute to a Roth IRA if your modified adjusted gross income (MAGI) exceeds IRS limits.
Solo 401k (aka the self-directed 401k)
Want to sock away more cash?
The Solo 401k could be right for you.
This plan is designed for freelancers and solopreneurs with no employees other than a spouse.
The Solo 401k functions just like an employer-sponsored 401k. It also comes in both traditional and Roth forms.
That means you can deduct your contributions on your taxes and pay Uncle Sam when you make withdrawals in retirement. Or, you can forgo the upfront tax benefit and access your money tax-free in your golden years.
As of 2020, you can contribute up to $57,000 per year ($63,500 if you’re over age 50). The contribution limit doubles if your spouse is also participating.
With a Solo 401k, you can contribute to the plan as both the employer and an employee of your own company.
As an employee, your contributions are capped at $19,500 per year ($26,000 if you’re over age 50). As an employer, you can contribute up to 25% of your compensation for that year.
For example, as an employee of your company, you earn $150,000 in 2020. You contribute $19,500 to your Solo 401k as the employee. You also contribute $37,500 (25% of $150,000) as the employer. The result? You’ve maxed out your Solo 401k for the year!
A brokerage account isn’t a retirement account. It’s a multipurpose investment account.
While it doesn’t offer the same tax advantages as an IRA or Solo 401k, it does allow you to make withdrawals any time you want, penalty-free — including investment gains. (Just remember: penalty-free doesn’t mean tax-free!)
So, if you’re thinking about retiring before age 59.5, or just like knowing your funds are available whenever you want them, a brokerage account may be right for you.
More perks: There is no contribution limit and, unlike the Roth IRA, your MAGI can be as high as you can get it!
Important note: There are other retirement savings options for entrepreneurs, like a SEP IRA, SIMPLE IRA, or Defined benefit plan. These options may be worth looking into as your business grows, but they’re not a good fit for new freelancers or solopreneurs.
How to Open an Account
You can open the above-referenced accounts with a brokerage firm (think Fidelity, Charles Schwab, Vanguard, etc.).
Every firm’s offerings and fee structures will differ. So, be sure to shop around for the best fit and review all of the documentation carefully before opening an account.
Note: If you open a Solo 401k, you’ll need an Employer Identification Number (EIN).
What to Do with Your Old Retirement Plan
Wondering what to do with your old employer-sponsored retirement plan?
You have options:
- Leave it be — if it’s performing well and you’re happy with the plan
- Roll it over to a traditional or Roth IRA (rollovers don’t count towards the annual contribution limit)
- Cash it out, but be forewarned — you’ll likely pay income tax and a 10% early withdrawal penalty if you’re younger than age 59.5
This blog post provides very basic information about how these plans work so that you can learn about your options without being overwhelmed. There are additional nuances that you’ll need to understand once you decide which type of account may be right for you.
You’re encouraged to consult with a financial and tax professional for additional information and guidance tailored to your specific situation. IRS rules for these plans change, particularly regarding contribution limits — so be sure to stay on top of them.
Once you’re making a solid income freelancing, and you have an adequate nest egg, saving for retirement should be high up on your list of financial goals!
Related reading: Health Care Options for Freelancers