Six Retirement Account Options For Freelancers

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One of the challenging financial aspects of being a freelancer is figuring out a retirement plan. Retirement will not look the same for everyone, so you have to thoughtfully consider how you envision retirement for yourself. Additionally, unlike employees, you will not have access to a company match. Therefore you have to calculate and generate the money you will need for retirement. As a freelancer or small business owner, you have six retirement account options. Below is an overview of the six options.

Money & Mimosas

Six Retirement Account Options For Freelancers 

1. Solo 401(k)

 The Solo 401(k) is also known as a one participant 401(k) plan. It is for a business owner with no employees. It can cover you as the business owner and your spouse if they work for the business. These plans have the same rules and requirements as any other 401(k) plan. The taxes are similar to the 401(k) plan in that it is tax deductible the year of the contribution, the interest grows tax free, and you are taxed on the withdrawals.

Contribution limits 

As a freelancer, you wear two hats under this plan: employee and employer. You can contribute to the plan under both hats. 

  • Under the employee hat you can contribute up to 100% of your compensation (i.e. earned income) up to the annual contribution limit. This is known as elective deferrals.

    • Contribution limits in 2020: $19,500 or $26,000 if age 50 or over.

    • Catch-up contributions: $6,000 (only applies to those age 50 or over)

  • Under the employer hat you can contribute up to: 

    • 25% of compensation as defined by the plan

 The total contributions to the account (not counting catch-up contributions) can not exceed $57,000 in 2020. 

Example: Amy, age 38, earned $50,000 in W-2 wages from her S Corporation in 2019. She deferred $19,500 in regular elective deferrals. Her freelance business also contributed 25% of her compensation to the plan, $12,500. Total contributions to her plan were $32,000.

If you have two companies, keep in mind that these limits are per person not by plan or by company. 

2. Traditional IRA

With the Traditional IRA, there is an upfront tax deduction. 

When you make a contribution to a traditional IRA, the amount of your contribution reduces your taxable income for the year. For example, if your income is $70,000 and you contribute $6,000 to a traditional IRA, then your taxable income that year will drop to $64,000, assuming you qualify for the tax deduction.

Contribution limits 

The annual limit for for both 2020 and 2019 is $6,000 ($7,000 if you’re 50 or older).

Key notes

  • If you freelance and work at a larger company, you can have an IRA and a workplace 401(k) plan

  • Anyone can contribute to a traditional IRA, but not everyone can deduct contributions.

  • Investments grow tax-deferred. You are only taxed on gains once you withdraw.

  • Early withdrawals may be taxed as income and assessed a 10% penalty.

3. Roth IRA

The Roth IRA is similar to the Traditional but with opposite tax advantages. With this option, you pay taxes on the amount you contribute but once you withdraw it from the account, you do so tax-free. 

Similar to the traditional, the interest in a Roth IRA grows tax-free.

In both 2019 and 2020, the annual contribution limit for the Roth is the same as the traditional IRA:

  • Under age 50: $6,000

  • Age 50 or older: $7,000

If you contribute to both a Roth IRA and a traditional IRA, the combined annual limit is $6,000 (or $7,000 if 50 or older).

4. SEP-IRA

A SEP-IRA is a simplified employee pension IRA. A SEP IRA is a basic retirement account, much like a traditional IRA. Contributions are tax-deductible, and investments grow tax-deferred until retirement. At this point it will be taxed as income.

This plan is best for freelancers, independent contractors or small-business owners with few or no employees. If you have employees, this plan requires equal contributions as a percentage of compensation. For instance, if you contribute 15% to your plan, you will also have to contribute 15% to each of your employees.

Contribution limits

These limits are much higher, up to $57,000 in 2020. However, it can not exceed the lesser of:

  • 25% of compensation

  • $57,000 in 2020

There’s no catch-up contribution at age 50+ for SEP IRAs.

You can combine a SEP IRA with a traditional or Roth IRA. There’s no catch-up contribution at age 50+ for SEP IRAs.

5. SIMPLE IRA

The SIMPLE IRA is best for larger businesses with up to 100 employees. Contributions are deductible, but distributions in retirement are taxed. Contributions made to employee accounts are deductible as a business expense. Unlike the SEP IRA, the contribution responsibility isn’t solely on you as the business owner.

Contribution limit:

Up to $13,500 in 2020 or $16,500 if over 50. Also you can do catch-up contributions of $3,000

6. Defined Benefit Plan

The Defined Benefit Plan is best for a freelancer with no employees, who has a high income and wants to save a lot for retirement on an ongoing basis. Contributions are generally tax deductible, and distributions in retirement are taxed as income. An actuary must figure your deduction limit, which adds an administrative layer.

Contribution limit

This is calculated based on the benefit you’ll receive at retirement, your age and expected investment returns. In other words, the limit is very high.

The tax savings can be enormous with this plan, but it is expensive to administer and maintain.