Freelancing has many benefits – you can create your own schedule, maintain creative control over your work, and pursue your passion more effectively. However, a downside is not having an employer pension plan to secure your financial future.
According to the US Census Bureau, 49% of Americans between the ages of 55 and 65 are financially ill-prepared for retirement. Women, in particular, make up most of those with no 50% retirement savings.
Self-employment means you have to save enough money yourself for your future retirement. Fortunately, there are options to help you secure enough savings even without a traditional 9 to 5 career.
Why should you save for retirement
We can get used to a particular way of life throughout our working lives. In addition to having a roof over our heads, our income allows us to enjoy the simple pleasures of life like eating out, having fun, traveling, giving gifts, shopping and more. When we retire, many of us only have the savings in our bank accounts and our Social Security benefits. For many people who decide not to contribute to a retirement plan, living their golden years requires considerable sacrifice and the possibility of financial hardship.
You may find excuses not to invest in your future after retirement, but there are many reasons why you should reconsider your position, such as the following:
- Social Security benefits are often not enough to maintain your current lifestyle.
- You don’t want to burden your children with your financial difficulties.
- A retirement plan gives you access to a tax-deferred retirement account that reduces your taxes.
- Investing in your retirement account allows you to enjoy your non-working years more comfortably and with less worry.
For self-employed people who think their Social Security benefits will help them get by after retirement, the Social Security Administration (SSA) can’t agree.
The SSA states that Social Security benefits are only 40% of your highest earnings over 35 years at retirement age. Plus, financial advisers agree that you probably need about 70% of pre-retirement income — including Social Security, personal savings, investments, and other retirement accounts — to live comfortably without income.
4 retirement plan options for the self-employed
Saving for retirement is essential, especially if you are self-employed. Sole proprietors have many options, but these four savings plans are the most common.
Company employees may have the option of participating in a 401(k) retirement plan. Self-employed people can still contribute to a 401(k) — however, it will only be for one participant.
A single-member 401(k) works the same way as a workplace retirement plan, meaning you make pre-tax contributions that are taxed when you start making withdrawals from 59 1 /2. Some people may refer to these 401(k) plans as individual 401(k), solo 401(k), uni-401(k), or self-employed 401(k).
Contributing to a solo 401(k) is possible, regardless of age or income. From 2022, individuals can contribute up to $61,000while anyone over 50 can add a $6,500 catch-up contribution.
Self-employed individuals might consider the following benefits of opening a single participant 401(k) account:
- Some contributors can save more than they would with other pension plans.
- You can contribute 100% of your adjusted net self-employment income — up to the ceiling — for the year as an employee or 25% of self-employment earnings as an employer.
- You can borrow up to 50% of your 401(k) for a loan, but you must repay the amount in five years.
- A Roth solo 401(k) is also possible for tax-free retirement withdrawals.
When you start withdrawing from your solo 401(k) determines how many taxes or penalties you will accrue. The Internal Revenue Service (IRS) asks you to start receive distributions at age 72whether you are retired or not.
Meanwhile, the IRS can tax up to 10% on early distributions unless it meets a qualifying exemption, such as disability, medical care deductions, or goes to a beneficiary as a result of ‘a death.
Traditional and Roth Individual Retirement Accounts (IRAs) are great savings plans you can consider contributing to if you’re self-employed. However, their eligibility, tax and distribution rules differ.
A traditional IRA is independent of a workplace and tax-deferred retirement plan, meaning you won’t be taxed on your contributions until you start withdrawing money of your account at federal retirement age. Like a 401(k), you must make your first retirement no later than age 72 — however, you can continue to contribute until the age of 70.
To be eligible for tax deductions on contributions to your traditional IRA, you must meet specific criteria related to your income, filing status, and coverage under a workplace retirement plan. For example, the maximum tax deductions for self-employed filers in 2022 are as follows:
- Single filers without workplace pension coverage: Eligible for a maximum tax deduction of $6,000 on any modified adjusted gross income (AGI) or $7,000 if you are over 50
- Joint filers without occupational pension coverage: Eligible for a maximum tax deduction of $6,000 on any modified AGI or $7,000 if you are over 50
- Co-filers without a company pension plan whose spouse is covered: Eligible for $6,000 if joint earnings are $204,000 or less.
Filers who earn between $204,000 and $214,000 could qualify for a reduced tax deduction on their traditional IRA. Otherwise, any income over $214,000 is not eligible.
Unlike traditional IRAs, contributions to Roth IRA accounts are taxed up front and accrue tax-free the longer the money remains in the account. You also receive tax-free distributions when you reach retirement age. However, withdrawing funds before reaching age 59 may subject the withdrawal to fees and other penalties.
Another key difference between traditional and Roth IRAs is that you can contribute to the latter for your entire life without withdrawing any money if you don’t want to.
Depending on your annual salary, you may or may not be able to use a Roth IRA to plan for your retirement. From 2021, joint filers can contribute up to $6,000 annually unless they have a modified AGI of $208,000. Similarly, single registrants cannot contribute if they have an amended AGI of $140,000 or more.
A Roth IRA allows you to invest in assets that could benefit you during your retirement years. For example, some account holders use their IRA accounts to put money into rental properties. Of course, there are several restrictions on what you can do with an IRA-owned rental unit.
Prohibited transactions – doing business with disqualified people, using the property as a personal retreat, or carrying out maintenance and repairs yourself – have serious financial implications.
Property may also be subject to income taxes, such as Unrelated Business Income Tax (UBIT) for business conducted inside the IRA or Unrelated Debt-Funded Income (UDFI) when you use leverage to take out a loan to purchase real estate. You also risk termination of your Roth IRA account, in which case the IRS could penalize you.
Simplified Employee Retirement Plan (SEP) IRA
Self-employed people or business owners may want to open a SEP IRA, in which investments are tax-deductible until retirement. At this point, income tax applies to any withdrawal.
A SEP IRA is ideal for business owners with only a few employees since the IRS requires employers to pay an equal percentage of their remuneration on behalf of their workers. For example, if you intend to invest 15% of your earnings, you must contribute 15% of your employee’s earnings to their plan.
If you supervise employees, the IRS requires that all participants be 21 or older, have worked for you for three of the last five years, and have earned at least $650 from you in 2021.
Since an employer is the only person who contributes to a SEP IRA, those who work for themselves can appreciate the flexibility and manageability of this particular retirement savings plan.
The contribution limits of a SEP IRA are much higher than traditional and Roth IRAs. In 2022, sole proprietors can pay a maximum of $61,000 to a SEP IRA or no more than 25% of their earnings.
An Employee Savings Incentive Plan (SIMPLE) IRA is another retirement option for the self-employed, but it may be more beneficial for small business owners.
Like a traditional IRA, SIMPLE account holders contribute pre-tax income and only pay taxes upon withdrawal at retirement age.
The 2022 the individual contribution limit is $14,000 for SIMPLE IRAs – in comparison, a 401(k) allows a maximum contribution of $20,000 while traditional and Roth IRAs limit you to $6,000. You can also contribute to catch-ups if you are over 50.
Business owners must have fewer than 100 employees working for them to be eligible. Additionally, proprietors and sole proprietors should not have contributed to other pension plans during the last calendar year.
SIMPLE IRAs are easy to set up, but remember that other retirement plans have much higher contribution limits than you can meet.
No better time to save for retirement than now
Being in control of your career and your time is great, but securing your financial future by creating a retirement plan is key. If you’re not saving now, start now. The more you contribute to your golden years, the more comfortable you will be.
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