Back in April, I promised to tell you about retirement options available for freelance writers. I’m three months late, but better late than never right? I have to admit, thinking about retirement savings is not the most interesting topic. In fact, it can be boring. But I’ll do boring if it means I get to spend my 50+ years enjoying the world’s beaches.
Let me start by saying that you can easily become overwhelmed with the amount of information available about each retirement option. I can’t possible cover all the details in a single post so the condensed version may feel a little heavy. It’s ok. Read through this list a few times. If you use one, you can talk about these options with your financial planner who can give you insight into which option is best for you.
There are a few types of IRA, or Individual Retirement Accounts, but the gist is that you can deposit a certain amount of money and receive a tax benefit. With a traditional IRA, the tax benefit is on the front-end. Your deposits are tax-deductible (or made pre-tax if done through an employer). Your earnings and deposits are taxed at withdrawal.
A Roth IRA requires you to contribute post-tax money, but allows you to withdraw your deposits and earnings tax-free as long as you wait a certain amount of time. There are contribution maximums for both the Roth IRA and traditional IRA and income phaseouts for Roth IRA. That means your maximum contribution limit is reduced as your income reaches a certain amount depending on your tax filing status.
The SEP-IRA allows you to contribute up to 20% of your freelance income (or 25% if your business is incorporated) or a maximum of $49,000. The drawback is that you may have to change plans if you later decide to hire someone.
The SIMPLE IRA, available only to employers who don’t have another retirement plan, allows you to contribute both as your employer and the employee of your business. You can contribute a maximum of $11,500 to a SIMPLE IRA and you’re required to contribute up to 3% of your employee’s (that includes you) compensation every year no matter what your business makes.
Both the SEP-IRA and SIMPLE IRA have pre-tax benefits and have higher maximum contribution limits than the Roth and traditional IRAs. But the Roth and traditional IRAs, which have a maximum contribution of $5,000 in 2010, are simpler, easier to understand, and can be contributed to even if you're not fully self-employed.
The solo or individual 401k is for individual freelancers (not corporations) who don’t have employees and is available in traditional and Roth versions. A traditional 401k would provide tax benefits upfront and tax your withdrawals, while the Roth 401k contributions are made with post-tax income and retirement withdrawals not taxed.
You can play two roles when you contribute to an individual 401k – the employer and the employee. As the employee, you can contribute up to $16,500 each year and as the employer you can contribute as much as 25% of your income, but not more than $49,500. There are no minimum contribution requirements, so in the years when your income is low, you don’t have to deal with required contributions.
If you ever decide to hire someone that’s not your spouse, you’re no longer eligible to contribute to an individual 401k and you’ll have to convert to another (usually more cumbersome) type of plan.
You generally have to wait until age 59 ½ to start withdrawing money from a retirement account. Withdrawing your money too early can result in early withdrawal penalties in addition to any taxes you have to pay on your withdrawal. There are some exceptions that will allow you to avoid the early withdrawal penalty, but not the taxes, e.g. to pay for certain medical expenses or to buy your first home.
Which one is best?
I am not a financial advisor and I don't have any financial certifications. I've simply done years of research on this stuff. Based on my understanding, traditional and Roth IRAs are good if you don't have a lot money to put into retirement right now, i.e. less than $5,000 per year. A traditional IRA is a great way to reduce your tax liability because you get an above the line tax deduction.
SEP-IRA and Solo 401k plans are good if you have more money to contribute, but plan on being the only employee of your business forever. Otherwise, you'll have to convert to another plan if you eventually hire someone else. There are no minimum required contributions.
The SIMPLE IRA doesn't allow you to contribute as much as the SEP-IRA and Solo 401k, but it's more accommodating for a business that hires employees. Furthermore, as long as your business offers the SIMPLE IRA, you'll have to contribute something (between 1-3% of their compensation) to your employees' IRAs.
Don’t put off retirement savings just because you don’t completely understand this list. Putting your retirement money into a special retirement account has obvious tax and interest advantages, but just for getting started, you can start putting retirement savings in an ordinary savings account. Then, when you have some money saved up and understand your options, you can transfer your money to a retirement account.