You know how you sometimes take on a new part time job, take on more freelance writing, and go on vacation, and try to deal with all your old benefits/ rolling over 401k/new insurance all at once? Not recommended.
Anyhow, as is the theme of this blog- I wasn't able to plan for everything that came my way last month, but I'm none the poorer for it, so silver lining?
As I've thrust myself into the world of trying to insure myself and my family against catastrophe, and save for the future, I've started to realize that an army of freelancers that need a framework for making important financial decisions. The new freelancer throwdown series provides that framework. And hopefully, in short order I can sell my research to someone else who will pay me money for this info. Everybody wins!
Today's topic: Retirement Accounts
If you're self employed, and you want to invest money in a tax advantaged retirement account, then you need to choose the right tax advantaged vehicle. By right, I mean the account that will allow you to avoid the greatest amount of taxes. Should you choose a Solo 401(k) or a SEP-IRA? Find the right answer, for you.
A Few Quick Rules
The contribution limits for the tax advantaged accounts are as follows:
SEP-IRA: Up to 20% of (your profits less 1/2 self employment tax) with a maximum contribution of $53K
Solo 401(k): 100% of income up to $18,000 + 20% of (profits less 1/2 Self Employment tax) up to $35,000
In either case, with sufficient income you can contribute up to $53K.
Wait, isn't it 25%?
Wow! You've been studying the IRS tax code too.
Basically, the IRS made some convoluted rules surrounding how much money you can contribute to your retirement account as a self-employed person, and the rule for both 401K and SEP accounts is thus:
You can contribute 25% of your profits to your account, but you must take out remove your employer contributions from your profits. Recursive reasoning? Yes. But it amounts to 20% vs. 25% because math.
Don't believe me? Just check out the rate table in Publication 560.
Under Age 21? Solo 401(k)
If you're not 21, then you can't fund a SEP-IRA. That's bad news for entrepreneurial people who want to hire their minor children and shelter their children's income from taxation.
However, if you are self-employed and under the age of 21, open up a solo 401(k). It's the best way to defer taxes (or if you go for the Roth version, never pay taxes again).
You can contribute up to $18k to any 401(k)- This includes an employer 401(k). If you're dual employed and under age 21, you can contribute to an employer 401(k) and your own 401(k) combined "employee" side contributions up to 18K.
My recommendation is that you save up to an employer match in your employer 401(k) and save the rest in your own 401(k).
Don't forget, in your own 401(k) you can add "Employer" side contributions up to 20% of your income (after deducting 1/2 of your self employment tax from your income).
Side Hustler? Open the opposite of your work plan
If you have an IRA plan through work (SEP-IRA, Simple IRA, etc.), open up a solo 401k.
If you have a 401k, 403b, or TSP through work start a SEP-IRA.
Why? You can double dip! That's right you can have your retirement defer taxes twice over as long as you don't contribute twice to the same type of account.
I may do that this year. I maxed out a work 401K, but I can set aside up to 20% of my self-employment earnings in a SEP-IRA too.
One quick note- as a self employed person, you can't open both a 401K and a SEP-IRA. You have to be an employee (W-2) and self-employed.
Not a 1%er, and not afraid of paper cuts? Solo 401(k)
If you earn $190K as a self employed person, you can contribute the max $53K to your Solo 401K. If you opened a SEP-IRA you would have to earn $287K to set aside that much tax deferred. So if you want to defer as many taxes as possible, I recommend the Solo 401K.
Why isn't everyone recommending the solo 401K? Its more paperwork. Vanguard (for accounts greater than $50K), Charles Schwab, and Fidelity offer no maintenance fees on their plans, and minimal trading fees. If you go for the Solo 401K, you have to be a heads up player and open the account before December 31st, but don't worry, you can still add money until April 15th of the following year.
Ancient lore is that Solo 401Ks are a pain to start, but the paperwork seems reasonable to me (though it's slightly less clean than the SEP).
Fear paper cuts with your life? SEP-IRA
SEP-IRAs are a little bit simpler for self employed people who fear paper cuts and math. 20% of (your profits minus 1/2 self employment tax) is easy math, and opening an account takes about 30 minutes tops.
From a tax deferral standpoint your not optimizing, but you're more concerned about paper cuts, so go with the SEP.
Rolling around in huge piles of cash? SEP-IRA
If you earn more than $287K per year, just open a SEP-IRA. It's simple math, and your accountant will thank you. Also, you'll be able to hire employees more easily.
If you're clearing more than $287K per year, and your only strategy for sheltering your money is a retirement account, you need a better tax guy. If you can convert your income into capital gains, you'll pay much less in tax.
Most Self-Employed people would defer more taxes by choosing a Solo 401K. These days, the SEP carries few advantages (except the advantage of being able to have it and the solo 401K).
The framework for deciding which retirement account to open? Open the account that will allow you to defer the most compensation. Don't worry about contributing the max every year, but allow yourself the freedom to do so.
Join me on a yet to be determined future date for more Freelancer Throwdowns.
I'm a wife, a mom, an employee, and a personal finance nerd who is devoted to spreadsheeting my way through life.