4 Ways to Start a Retirement Account as a Self-Employed Freelancer
Self-employed people have just as many ways to save for retirement as those working a 9-5 job. Laura covers the rules, pros, and cons of four easy retirement account options that any freelancer or entrepreneur can use to create a comfortable, happy lifestyle in retirement.
If you’re self-employed, either full- or part-time, you can start a retirement account to cut your taxes and build financial security—just like someone with a 401(k) at a regular job.
Being self-employed gives you a certain amount of freedom, but it doesn’t give you a pass on saving for retirement. In fact, when you’re the boss, saving for retirement is even more important because you’re on your own. It’s completely up to you to have enough retirement savings to spend when you need it.
You can have a retirement account no matter what type of self-employed worker you call yourself, such as a:
- Freelancer
- Independent contractor
- 1099 worker
- Sole Proprietor
- Solopreneur
- One-Person business
- Side hustler
- Entrepreneur
- Small business owner
In this post, you’ll learn the rules, pros, and cons of four easy retirement account options for any freelancer or self-employed person. Using one or more of them could make the difference between having a comfortable, happy lifestyle in retirement—or just scraping by.
How to Know If You’re Self-Employed
First, let’s define who is self-employed. If you earn income through some kind of trade or business with the intent to make a profit, you’re self-employed. Having that income qualifies you for a variety of retirement accounts.
The gig economy has turned many people into entrepreneurs. You might work a regular day job and also earn income on the side, such as driving for a rideshare service, teaching piano, consulting, writing, creating apps, or walking dogs. If you have both self-employed and employee income, you have even more retirement account options.
If you earn income through some kind of trade or business with the intent to make a profit, you’re self-employed. Having that income qualifies you for a variety of retirement accounts.
Remember that you don’t have to work full-time, be incorporated, or have employees in order to call yourself “self-employed.” But if you are incorporated, you have retirement options as the owner or as an employee of your business.
The opposite of being self-employed is being an employee earning an hourly wage or a salary. So, if your only source of earned income is as a W-2 employee, then you don’t qualify for self-employed retirement accounts. However, you still have multiple options, which I’ll review here.
What Is a Retirement Account?
If you’re a regular Money Girl reader or podcast listener, you know that I love retirement accounts. Not only do they come with money-saving tax breaks, but they can make it easier to regularly invest.
But don’t make the mistake of thinking that a retirement account itself is an investment. It’s just a special financial “bucket” where you hold investments or cash that gets special tax treatment.
Once you contribute money to a retirement account, you must choose how to invest it. And the options depend on the investment firm that your employer or you use.
For instance, you might choose stocks, bonds, mutual funds, or exchange-traded funds. Or you can even put your money in super conservative options, such as a money market fund or certificate of deposit (CD).
I recommend choosing low-cost, diversified funds that allow your money to grow at a reasonable rate of return, without taking too much risk. To learn how to choose the right investments, for your age and goals, check out 7 Simple Principles to Invest Money Wisely No Matter Your Age.
Some of the most common retirement account rules include having to pay a 10% penalty if you take withdrawals before reaching age 59½. And with all retirement accounts, you must own them solely in your name, even if you’re married.
But different types of retirement accounts come with different annual contribution limits or income limits. Depending on your work and financial situation, you may qualify to use several types of retirement accounts all at once. The more accounts you max out, the bigger your retirement nest egg will be.
Depending on your work and financial situation, you may qualify to use several types of retirement accounts all at once.
Here are four easy-to-use retirement accounts if you’re a freelancer or self-employed:
1. Traditional IRA
IRA is short for Individual Retirement Arrangement, which means that it’s a plan for individuals. Having an IRA means that you manage every aspect of it, such as opening the account, sending contributions, and deciding how to invest it.
With “traditional” retirement accounts, contributions are tax-deductible. For example, if you earn $60,000 and contribute $5,000 to a traditional IRA, you will be taxed on $55,000 of income only—not on $60,000.
Plus, when your investments in a traditional IRA make money, your gains aren’t taxed until you take withdrawals from the account. This is very different from earning money in a regular brokerage account, which is subject to tax every year.
Important rules: Anyone with earned income (including business income) under the age of 70½—including the self-employed, minors, and non-working spouses who file a joint tax return—can have a traditional IRA.
For 2019, you can contribute up to $6,000, or $7,000 if you’re age 50 or older, as long as you earn that much. You have until the tax filing deadline (including extensions) to make IRA contributions for the previous year.
Pros: You can have a traditional IRA no matter where you work. It allows you to save for retirement and defer tax on both your original contributions and earnings.
Cons: If you or a spouse participate in a retirement plan at work, such as a 401(k) or 403(b), some or all of your contributions to a traditional IRA may not be tax deductible, depending on your income. Another IRA downside is having a low annual contribution limit compared to other retirement plans for the self-employed.
How to start: There are many places to open a traditional IRA, such as banks, investment firms, and insurance companies. Check out Betterment for simplified investing with low-cost exchange-traded funds.
Opening an account online is easy and you can transfer funds from your bank or rollover an old 401(k) or 403(b) balance with a previous employer. You claim traditional IRA deductions on Form 1040opens PDF file .
2. Roth IRA
A Roth IRA is subject to most of the rules that apply to a traditional IRA—except when it comes to taxes and withdrawals. Contributions to a Roth IRA are not tax deductible, however, withdrawals of contributions and earnings during retirement are completely tax-free.
Unlike a traditional IRA, with a Roth IRA you don’t get an immediate tax break. But you can come out ahead if your tax rate is lower now than it will be in retirement. And depending on when you open your account, skipping tax on decades of growth could add up to massive savings.
Also, you don’t have to take any money out of a Roth IRA as long as you live. But with a traditional IRA, you must start drawing down the account after you reach age 70½.
You can withdraw your Roth IRA contributions without triggering tax or penalties before retirement. However, this doesn’t apply to earnings in the account, which would be subject to tax and the 10% early withdrawal penalty if you’re younger than age 59½.
Important rules: Anyone with earned income (including business income)—including the self-employed, minors, and non-working spouses who file a joint tax return—can have a Roth IRA.
For 2019, you can contribute up to $6,000, or $7,000 if you’re age 50 or older, as long as you earn that much. You have until the tax filing deadline (including extensions) to make IRA contributions for the previous year.
Pros: A Roth IRA allows you to save for retirement and avoid paying tax on decades of earnings and growth in the account. You get the full tax benefit even if you (or a spouse) participate in a retirement plan at work.
An IRA is the easiest account to start if you’re self-employed or you don’t have much income to invest. If you’re not sure whether to use a traditional or a Roth IRA, you can use both, as long as you don’t exceed the contribution limit. For example, you could contribute $2,000 to a traditional IRA and $4,000 to a Roth IRA in the same year.
Cons: As I previously mentioned, one downside is the relatively low annual contribution limit. A Roth IRA is unique because it’s the only retirement account that imposes limits based on your income and tax filing status. If you make over a certain amount, you may not qualify to contribute. That makes a Roth IRA ideal when you’re just starting out and not making much money.
How to start: There are many places to open a Roth IRA, such as banks, investment firms, and insurance companies. Just like for a traditional account, you can open a Roth IRA online.
While you can’t roll over funds from a traditional workplace retirement account into a Roth IRA, you can roll over from a Roth 401(k) or a Roth 403(b). Since contributions to a Roth IRA aren’t deductible, you don’t report them on your tax return.
3. Solo 401(k)
While you’ve probably familiar with a 401(k) offered by some companies, you might not know that the self-employed can have one too. These plans are sometimes called a:
- One-Participant 401(k)
- Individual 401(k)
- Uni-401(k)
Important rules: Anyone who is self-employed without employees other than a spouse can have a solo 401(k). You can make contributions as both an employee of your business and as the owner.
For 2019, your solo 401(k) contributions as an employee can be 100% of your earned income up to $19,000, or $25,000 if you’re over age 50. As your own employer, you can contribute an additional amount, up to 25% of your net income.
Your maximum annual contribution can be $56,000, or $62,000 if you’re over age 50. This allows you to contribute more to a solo 401(k) than other types of retirement accounts for the self-employed.
Pros: Since a solo 401(k) offers high contributions limits, it’s perfect when you have high self-employment income and no employees. They’re available as a traditional or Roth account, offering pre- or post-tax contributions.
Just like with a Roth IRA, withdrawals of contributions and earnings from a Roth solo 401(k) are completely tax-free. But unlike a Roth IRA, which imposes annual income limits, you can contribute to a Roth solo account no matter how much you earn.
Con: The main downside to a solo 401(k) is that if you plan to hire employees, you’ll have to complete IRS paperwork to convert it into a regular 401(k). These come with more administrative hassles and restrictions than a solo account.
Note that if you also have a regular 401(k) at your day job, the most you can put in both plans for 2019 is $19,000 or $25,000 if you’re age 50 or older. Retirement account limits are set by person, not by plan.
How to start: There are many places to open a traditional or Roth solo 401(k), such as banks, investment firms, and insurance companies.
You can use the worksheets in IRS Publication 560 to calculate your allowable annual 401(k) contributions. Once your account balance reaches $250,000, you’re typically required to file Form 5500-SF.
4. SEP-IRA
But what if you’re a small business with employees or plan to hire staff someday? One of the easiest and least expensive retirement plans for entrepreneurs to administer is a SEP-IRA, which stands for Simplified Employee Pension. It’s an option for any size business or those who are self-employed with or without employees.
One of the easiest and least expensive retirement plans for entrepreneurs to administer is a SEP-IRA, which stands for Simplified Employee Pension.
With a SEP-IRA, contributions can only come from an employer. Employees can never contribute their own money. As the business owner, you choose the amount to contribute each year. However, you must give all employees the same percentage of income that you give yourself.
For example, let’s say you have a consulting business with one employee named Susan. If you choose to contribute 15% of your pay to your own SEP-IRA, you’d also have to contribute 15% of Susan’s pay to her SEP-IRA.
But if you have a bad year with little profit, you can choose not to make any contributions. Employees are always vested in their SEP-IRA account, which means if Susan quits, she can take her retirement money with her.
Important rules: For 2019, you can make SEP-IRA contributions for each of your employees (including yourself) up to 25% of each employee’s compensation for a maximum amount of $56,000.
You can also have a SEP-IRA in addition to other retirement accounts, such as a traditional IRA or Roth IRA. You can even have a 401(k) or 403(b) with another employer. However, the total amount you can contribute to an employer plan plus your SEP-IRA is limited to 100% of your compensation up to $56,000.
Just like with a traditional IRA, contributions to a SEP-IRA are tax deductible. You defer all tax until you take distributions in retirement. However, any early withdrawals before age 59½ are subject to income tax plus an additional 10% penalty.
Pros: The major advantage of a SEP-IRA is the flexibility to make contributions in years when your business cash flow allows it, and to opt out when money is tight. It comes with no administrative hassles or annual reporting to the IRS. Like the solo 401(k), a SEP-IRA gives you high contribution limits.
Cons: The main downside to a SEP-IRA is that when you have employees, you must contribute an equal percentage of income to their accounts. Also, there isn’t a Roth option or a “catch-up” provision that allows you to contribute more when you’re over age 50.
How to start: You can open a SEP-IRA at any financial institution or online investing company where you would get a traditional or Roth IRA, such as Betterment or TD Ameritrade. You must complete Form 5305-SEP, a simple one-page form.
Once you’ve decided to use one or more of these retirement accounts, the investment firm you choose will walk you through the process of opening and funding it. They’ll inform you of any paperwork you need to file with the IRS.
So, if you haven’t started, make a goal to begin making regular retirement contributions this year. Making sure that you have a secure financial future is part of being a successful business owner or entrepreneur.
Ready to get out of debt and create a clear financial plan? Check out Laura’s best-selling debt course, Get Out of Debt Fast—A Proven Plan to Stay Debt-Free Forever. It’s available at 50% off for a limited time.
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