Freelancers have several options for accumulating savings for retirement using tax-advantaged accounts. Freelancers could utilize individual retirement accounts (IRAs), which are retirement plans designed for individual people. Freelancers can also utilize retirement plans specifically designed for small businesses, such as Simplified Employee Pension (SEP), 401(k), and SIMPLE plans.
With all these options, we need a way to clearly identify which retirement plan or plans offer the features that fit the needs for a particular freelancer.
The following five questions help freelancers clarify which retirement plans are appropriate for their needs:
- How much do you want to save for retirement each year?
- Do you want to make after-tax (“Roth”) contributions for retirement?
- When are you setting up the retirement plan? And do you want to make contributions for the previous year?
- Are you covered by another retirement plan, perhaps at a day job?
- Do you have employees now, or might you have employees in the near future?
How much do you want to save for retirement?
Andy is a freelance graphic designer. He plans to set aside $10,000 for retirement this year and wants to know what options he has.
In this example, what we are working with are the contribution limits for various retirement savings plans. We need to find out which retirement plans might be an option based on the desired level of money the freelancer wants to save.
The first thing we want to point out is that independent contractors can utilize an individual retirement account (IRA) in tandem with a small business retirement plan (which include the SEP, 401(k), and SIMPLE plans). We cannot use multiple business retirement plans together, however.
In Andy’s situation, since he wants to set aside $10,000, his options end up being to put:
- Up to $5,500 in an IRA and the remaining $4,500 in a SEP or SIMPLE or 401(k) plan
- All $10,000 in a SEP
- All $10,000 in a 401(k)
- All $10,000 in a SIMPLE plan
We’ll get into the specific contribution limits for each plan type momentarily.
We always start by analyzing whether an individual retirement account (IRA) by itself will be sufficient for the client’s needs. The reason for this: IRAs are relatively easy to set up and maintain.
In Andy’s situation, we see that an IRA by itself will not be sufficient for his needs. That’s because Andy wants to save $10,000 for retirement, but he can only put up to $5,500 into an IRA this year. So in this situation, Andy will need some other type of retirement plan that can accommodate his desired funding contribution. That means Andy will have to choose either a SEP, 401(k), or SIMPLE to use either alone or in conjunction with an IRA.
What are the maximum contribution limits for each type of retirement plan?
Below is a table showing the contribution limits for each type of retirement plan.
Notice that small business retirement plans can be funded with “employer contributions” or “employee contributions” or a combination of both. Since freelancers are self-employed, they fund both the employer and employee portions of a retirement plan.
So for freelancers, the important thing to notice is the structure and the math. The employer contribution plus the employee contribution (plus any catch-up contribution if the freelancer is over age 50) equals total contributions. Each component is limited. And the total amount is also limited.
|Retirement Savings Plan
Contribution Limits for Year 2018
|Retirement plan:||IRA||SEP||401(k)||SIMPLE IRA or SIMPLE 401(k)|
|Employer contribution limit:||Not applicable||20% of net self-employment income||20% of net self-employment income||2% or 3% of net self-employment income|
|Employee contribution limit:||$5,500||Not applicable||$18,500||$12,500|
|Catch-up contribution limit:||$1,000||Not applicable||$6,000||$3,000|
|Total contributions cannot exceed||$6,500||Sum of above not to exceed $55,000||Sum of above not to exceed $55,000||Sum of above not to exceed $55,000|
Do You Want to Make After-Tax Roth Contributions?
Sometimes, clients will prefer to make after-tax contributions (also called Roth contributions) to their retirement plans. Unlike pre-tax contributions, clients do not take a deduction for any Roth contributions. The advantage of Roth contributions is the original contributions plus any investment earnings can be withdrawn from the plan entirely tax-free, provided the client doesn’t touch the money until after reaching age 59.5 years old.
For clients who prefer Roth contributions, we would look first to whether the client is eligible to make contributions to a Roth IRA.
But if the client is already maxing out their Roth IRA or if the client is not eligible for a Roth IRA due to their income level, then the client might want to consider setting up a small business retirement plan that offers the ability to make Roth contributions. For the year 2018, the maximum amount that can be contributed to a Roth IRA is $5,500. Also for 2018, eligible for making contributions to a Roth IRA starts to be restricted once a client’s income reaches $120,000 (for unmarried clients) or $189,000 (for married clients).
Currently, only 401(k) plans can be set up to receive Roth contributions. So, if a freelancer wants to make Roth contributions and the Roth IRA is not a fully optimal solution, then the 401(k) is the only other option for consideration.
There are two important points to bear in mind when utilizing a 401(k) for Roth contributions.
First, only the employee contribution component of 401(k) plans can be treated as Roth contributions. For 2018, employee contributions to a 401(k) are limited to $18,500. The freelancer can designate how much of their employee contributions are Roth contributions and how much are tax-deductible contributions. (Employer contributions, by the way, must be made to the tax-deductible portion of the 401(k) plan.)
Second, 401(k) plans need to be set up to allow for Roth contributions. Freelancers will be selecting a financial institution to administer their 401(k) plan. Those financial institutions have pre-written 401(k) plans, so the freelancer will want to select a plan that has Roth contributions permitted.
When are You Setting up the Retirement Plan?
What we are asking here is whether the client wants to make a contribution now that counts as if it were made in the last tax year?
If yes, then the follow up question is whether the client has already set up a retirement plan, or if they need to set up a new retirement plan.
That’s because there are two important deadlines. First, each retirement plan has a deadline for when the plan can be set up. Second, each retirement plan has a deadline for making funding contributions.
Table: Key Retirement Plan Deadlines for 2018
|Type of Plan||When to Set Up Plan||Last Date for Contribution|
|IRA||Any time up to the due date of individual’s tax return not including extensions. (April 17, 2018)||Any time up to the due date of the tax return not including extensions. (April 17, 2018)|
|SEP||Any time up to the due date of tax return including extensions. (April 17 or October 15, 2018)||Any time up to the due date of tax return including extensions. (April 17 or October 15, 2018)|
|401(k)||By the end of the calendar year. (December 31)||Any time up to the due date of tax return including extensions. (April 17 or October 15, 2018)|
|SIMPLE||By October 1 of the calendar year.||30 days after the end of the month for employee contributions, and by the due date of tax return including extensions for employer contributions.|
Let’s return to the example of Andy, the self-employed graphic designer who wants to save $10,000 for retirement. Previously, we figured out that Andy will need more than just an IRA if he wants to set aside $10,000 in a retirement account. Now we need to figure out if any of these deadlines make a difference in our decision making. For this example, let’s say it’s March 2018 and we are helping Andy prepare his 2017 tax return.
We ask Andy if he has already set up any retirement plans already? Andy said he has not set up any retirement plan accounts at all.
Then we ask Andy if he wants to make retirement contributions for last year (2017) or starting for this year (2018). Andy says he does want to make contributions to his retirement plan for 2017.
Notice: at this point in time, the 2017 calendar year is over but the due date for the 2017 tax return has not passed, and the client did not already have a retirement plan set up. Since Andy wants to make retirement contributions for tax year 2017, he has two options. Andy could set up and fund:
- Traditional IRA or Roth IRA (or both) by April 17, 2018; and/or
- SEP by April 17, 2018, or by October 15, 2018 if he files for an an extension on the due date of his tax return.
Are You Covered by Another Retirement Plan?
Sometimes a freelancer might have a day job and already be participating in a 401(k) or similar retirement plan.
In this situation, we need to pay careful attention to the employee contribution portion of retirement plans.The $18,500 employee contribution limit for 401(k) plans applies across all 401(k) or 403(b) plans in which a person might be eligible to participate.
For example, suppose that Andy has a day job and participates in his company’s 401(k) plan. In fact, he already contributes the maximum $18,500 to his 401(k) plan. In this situation, if Andy were to set up a 401(k) plan for his self-employment income, he would not be eligible to make additional employee contributions to his self-employed 401(k) plan; he would only be able to make employer contributions to his self-employed 401(k) plan.
This rule can play out in interesting ways.
If the freelancer is happy with their 401(k) plan at their day job, then maybe the freelancer does not need to set up another 401(k) plan for their self-employment income. In this situation, the freelancer first should consider whether a SEP will suit their needs for setting aside additional savings for retirement.
But perhaps the freelancer isn’t entirely happy with their 401(k) plan at their day job. Perhaps the 401(k) at their day job doesn’t offer good investment options. Or perhaps the 401(k) at their day job doesn’t offer the option of making Roth contributions. In this situation, setting up a separate 401(k) for their self-employment income might be desirable, as then the freelancer can select their own investments and/or make Roth contributions. Just be aware — in this situation where the freelancer has two 401(k) plans — that the employer contribution limit applies across both plans.
Do You Have Employees Now, or Might You Have Employees in the Near Future?
If a freelancer sets up a small business retirement plan such as a SEP or 401(k) or SIMPLE plan, they must permit all eligible employees to participate in the retirement plan. And the freelancer would have to make employer contributions both for themselves and for their employees.
If a freelancer is not able or willing to make contributions to a retirement plan on behalf of their employees, then the best option is to stick with IRAs only.
Tax Move Takeaways
- Freelancers may want to consider setting up a small business retirement plan if they want to save more for retirement in a particular year than the $5,500 IRA limit.
- If a freelancer wants to make after-tax Roth contributions, they should consider whether a solo 401(k) plan will suit their needs.
- If freelancers are setting up a new retirement plan after the end of the year and want to make funding contributions for the previous year, they should consider whether a SEP plan will suit their needs.
- If a freelancer is covered by another retirement plan, such as at a day job, they need to be aware that the employee contribution limit applies across all their retirement plans.
- Any employees hired by a freelancer must be allowed to participate in any small business retirement plans that are set up.
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