By James O'Brien.
When we talk about retirement planning, we're often basing our conversation on the presumption of traditional employment, which comes with certain assumptions -- benefits, employer contributions, the whole works.
However, retirement planning is a much different proposition for freelancers. For all the freedom that might come with being one's own boss, there's a downside to sailing solo in the workforce. You have to handle all the rigging by yourself. You have to navigate, too. You're on your own.
And so, from SEP IRAs to solo 401(k)s to Roth plans, let's look at retirement for freelancers -- how one saves for it, what to expect, and the advantages and disadvantages that freelance retirees often encounter.
The "missing leg"
Freelancers start off with only two legs of the "three-legged stool" on which most traditionally employed professionals rely in retirement. One "leg" is their personal savings; the second is Social Security and other government programs. But they don't have the third leg, i.e, a group employer-managed retirement plan. So they have to create something like it for themselves -- not that they always do.
"The reality for self-employed individuals, such as freelancers, is that most of them are not saving regularly for retirement, and roughly 28% of them are not saving at all for retirement," says Jamie Hopkins, assistant professor of taxation at The American College. "One reason is because income is often more volatile and less predictable. It becomes harder to save for retirement when your paychecks fluctuate."
While freelancers often turn to instruments that are different from the ones many workplaces offer -- and their capacity to save can be fluid -- their retirement goals are still the same as those of the traditionally employed. They seek to create a nest egg that can grow via investments within a plan. And though there are numerous retirement plans into which freelancers can tap, the three that follow are common and relatively uncomplicated for self-employed professionals, especially if they happen to be approaching the process for the first time.
Simplified Employee Pension IRA
A one-person company often turns to the SEP IRA. As of 2014, this form of IRA allows you to save either 25% of your annual net compensation or $52,000 -- whichever is the lesser amount. (When it comes to the contribution cap, note that you'd have to generate net earnings, after expenses, of more than $208,000 to make $52,000 the lesser number.) SEP IRAs tend to be inexpensive. Freelancers can find some with no annual fees and no establishment fees. There's typically a small fee for whatever trades you enact, however. As with many retirement plans, in most cases withdrawals from a SEP IRA prior to age 59-1/2 come with a 10% penalty. You'll also pay income tax on the withdrawals, but that happens whether you take them early or after the age threshold.
The strength of this plan is that it allows you to contribute twice: once as employee and once as employer. For 2014, the caps are $17,500 on the employee side and 25% of your net earnings on the employer side. There's a combined contribution cap: the lesser of 100% of your annual net earnings or $52,000. If you're age 50 or older, your employee-side contribution cap is higher -- $23,000 -- thanks to a catch-up allowance. Tax on the money you put away is deferred until withdrawal, but taking a distribution before age 59-1/2 incurs a 10% fee, plus taxes.
Here's a plan that acknowledges one of the realities of being a freelancer: You have the occasional run of low cash flow. If the concept of socking away money that you can't touch without penalties until 59-1/2 seems unrealistic, then consider a Roth IRA. To qualify for one as a single participant, your adjusted gross income needs to be below $120,000. Married contributors filing jointly get an income cap of $191,000. Once you're in the plan, you can contribute up to $5,500 annually, in most cases -- though potential contributions are phased out as one approaches the stated limits. Participants aged 50-plus can contribute an additional $1,000 annually.
And here's the freelancer-friendly part: You can make tax-free and penalty-free withdrawals from your Roth IRA anytime you like -- but only from the principal. In other words, if you tap into the earnings your account has generated before you reach age 59-1/2 -- or, if you're that age but have had the account for less than five years -- you'll incur a 10% penalty, plus taxes. For some freelancers, this kind of flexibility could prove critical during an income emergency.
Savvy retirement-planning is a must
There is, however, a downside to retirement plans for freelancers: They often lack some of the advantages that come with a qualified group plan. In the realm of annuities and other products that, in group plans, reap rewards at beyond-market rates -- typically because of institutional pricing -- solo plans simply can't compete. To some extent, that's just the way it goes for freelancers.
One advantage the freelancer can enjoy, however, is that their careers can extend longer than those of traditionally employed workers. Freelancers often love their work and enjoy flexible schedules, and for them there is perhaps less of a distinction between passion and paycheck. So, even if you're getting started later and moving slower because of the realities of self-employed compensation and savings, the good news is that, with a plan like one of the above examples, you may be able to make up for lost time.
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