Freelancers can often make larger contributions to their retirement savings than employees can. The amounts you can contribute can change each year – for 2021 there is a $6,000 maximum for a traditional IRA ($7,000 if you’re over 50), and $19,500 for a 401(k) but limits are over $50,000 for SEP IRAs and Solo 401(k)s. Previously, SEP-IRAs were thought to be easier and cheaper to set up. However, Solo 401(k)s may permit for more contributions. Deadlines can vary by vehicle, but typically need to be set up by year end.
A few definitions:
- 401(k) – an employer sponsored retirement plan. Some employers offer a “match” where they’ll contribute $1 for each $1 you contribute, up to a set amount (this is not part of the 401(k) but rather an optional benefit some employers provide – if you have this you should take advantage of it as it’s free money!). The money you contribute goes into the savings account tax free – so if you earn $100k in a year and contribute $10k to your 401(k), then you’d only have to pay income taxes on the remaining $90k. This money grows in the savings account tax free (you don’t pay capital gains taxes on any investments you sell, or income taxes on any dividends). Then when you retire, you can draw down the money and at that point you pay income taxes on it.
- Individual Retirement Account (“IRA”) – This is similar to a 401(k) but it is not employer sponsored. The government regulates 401(k)s and so they have to comply with strict standards. The Employee Retirement Income Security Act of 1974 (“ERISA”) sets these standards. This often means that there are limited investment options chosen by the employer in a 401(k). Since an IRA is not sponsored by an employer, it doesn’t have these limitations and you can typically choose from a wider array of investments. When people leave jobs, they’ll often roll their 401(k) into an IRA. If you have had multiple jobs, rolling the 401(k)s into an IRA will allow you to consolidate multiple 401(k)s into one place (so you won’t have to go to multiple websites to manage the investments) and it will give you more investment options than a 401(k). This can also be a good idea because some 401(k) plans require a plan administrator’s approval to transfer the funds to an IRA, so if you left the company a long time ago it can be difficult to find someone to help with this.
- Roth Individual Retirement Account (“Roth IRA”) – a Roth IRA works slightly differently than a traditional IRA. In our traditional IRA example, you earned $100k and decided to save $10k. You wouldn’t owe taxes on that $10k (you’d pay taxes on the remaining $90k). Then the $10k you saved would grow tax free until you withdrew it in retirement, at which point it would be taxed as income. If you chose a Roth IRA instead, you would be taxed on the full $100k. The $10k (net of income taxes) that you put into your Roth IRA would then grow tax free (similar to the traditional IRA). When you withdraw the money from a Roth IRA in retirement you don’t owe taxes then, as you already paid them up front. The main difference between the Roth and traditional IRA primarily boils down to when you owe taxes. If you think your tax rate will be higher in retirement (either because your income goes up or because of changes in the country’s tax rates), then you should choose a Roth IRA. Typically though, people have lower incomes in retirement and so a traditional IRA would make more sense. If you’re uncertain, you could split your savings between the two vehicles.
Self-employed people don’t have an employer sponsored 401(k) as an option. However, they do have IRAs and two other options – the Solo 401(k) and the Simplified Employee Pension Plan (“SEP”) IRA.
- Solo 401(k) – A Solo 401(k) is a retirement plan designed for self-employed people. Even if you have a traditional job and work a side job as an Uber or Lyft driver, that self-employed income would qualify you for this vehicle. For a Solo 401(k) you cannot have any full-time employees, aside from your spouse or a business partner (defined as someone working more than 1,000 hours for you during the year). For Solo 401(k)s you can contribute up to 25% of your income in a year to a max of $57,000, or $63,500 if you’re over age 50. Notably, you can get a traditional Solo 401(k) or a Roth Solo 401(k).
Simplified Employee Pension Plan (“SEP”) IRA – these vehicles are beneficial for a small business owner who has full-time employees. SEP IRAs have some differences from a Solo 401(k). For a SEP IRA there is no “catch-up”, meaning an additional amount you can contribute if you’re over 50. The biggest difference though, is a lack of employee deferral (meaning your employees don’t get to choose how much is contributed). The SEP IRA allows only the employer to contribute. For a SEP IRA all contributions are made as a percentage of your annual income. Generally, it’s 20% for business owners and 25% for self-employment work, up to a max of $57,000 for 2020. Notably, whatever percentage of compensation you chose to set aside for yourself in the plan, is the same percentage of pay that you must contribute for each eligible employee. Note that you don’t have to make contributions every year, so if there is a recession you may skip saving altogether.