I was recently asked to help some independent contractors with their retirement savings needs. Many people try to use some preset thought process of how to save for retirement. Often it is based on getting a matching contribution or some rule of thumb such as saving 10% of their income.
If you are an independent contractor with a volatile income, those approaches really don’t work. First, you are the match as you are the employer. Second, is 10% too much or maybe it’s too little? If your income is above the social security contributions cap, you will need to make up for that lost income. If you are under the cap, you may be concerned that Social Security will not pay what your statement says.
Have you calculated your retirement savings need?
I believe in a more focused and personalized approach. That approach calculates how much you need to save, at what rate of return, and for how long. These answers require some advanced mathematical calculations and may test one’s emotions. Some assumptions about the rate of inflation can give some significantly different answers, known as sensitivities.
In fact, one likely needs to plan for various scenarios and be prepared to make some tweaks to the plan based on how different variables actually pan out. Once you figure out how much you need to save, then you can use the charts below to figure out what types of retirement plans you may need to consider.
Retirement savings needs under $15,000
Let’s say you determine that you only need to save $4500. Then you could use a tax-deferred IRA or a tax-free Roth IRA to fund your retirement needs. However, you must be able to fund the IRA by the April 15 tax deadline. If you need to save more than that up to $15,000 then you would need to use a SIMPLE plan.
Unfortunately, if you like the idea of paying the taxes now and not paying them in the future, you lose that option with this plan type. While there may be some ways for your household to take advantage of a Roth, that conversion is beyond the scope here. A SIMPLE plan is an employer-sponsored plan, so depending upon the details of your situation you made to cover some other employees. The details of this coverage are outside of the focus of this blog which is savings.
Retirement savings needs $15,000 to $59,000
SEP IRA tax-deferred savings
If you need to save, more than that say up to $15,000 then you would need to use either a SEP IRA or a 401(k) plan. I like 401(k) plans that add a Roth feature. I have found that many independent contractors are familiar with the SEP IRA but not the solo employer 401(K), especially the solo Roth 401(k). Let’s highlight the solo Roth 401(k) versus the SEP IRA.
With the SEP IRA, you have the benefit of utilizing your tax extension deadline to save as much as $59,000. However, it must all be in tax-deferred savings. Meaning that while you get a tax break today in the future you will have to pay taxes on the money. While a lot of people seem to focus on the tax breaks today, one may find that it was better to have paid the taxes previously and be able to take the money out tax-free today.
While no one knows what the future tax rates will be, at least from an inflation-adjusted perspective you will need to have more money in the future. That is if it’s necessary for your spending to keep up with the lifestyle you currently enjoy. Additionally, if you have employees, you must also give them the same percentage contribution that you are giving yourself.
Solo Roth 401(k) tax-deferred and tax-free savings
With a Roth 401(k), you’re able to make an $18,000 Roth contribution in 2017 ($24,000 if over 50 years old). Yes, that is 3x more than the standard Roth contribution. You can make an additional $37,000 contribution to your retirement savings as a tax-deferred profit-sharing contribution. Don’t be thrown by terminology. A Solo Roth 401(k) has the same savings limits as an employer-sponsored Roth 401(k) profit-sharing plan. If you split your contributions this way, you get both current tax advantages and the future!
If you’re married, your spouse may also qualify to participate. Little-known benefits of a 401(k) versus a SEP IRA offer the highest creditor protection as well as the ability to take a loan should you need it. While I believe in having an emergency fund, there may be reasons that you wish you could take a loan against your retirement money. You cannot do that with the SEP IRA.
Retirement savings needs over $59,000
Many people have not heard of a cash balance plan. Its retirement savings opportunities are based on your age. The older you are the more you can put in. That’s because it is based on actuarial tables. Two people starting at different time periods would need to save at different rates to arrive at the same retirement savings amount, all things being equal. The attached Cash Balance Plan Contribution Limits Table from Kravitz shows their calculations for different ages. There are other qualifiers for this type of plan that are outside of this blog. I am simply highlighting options for filling the calculated savings need of the independent contractor.
Do you know how much you need to save, at what rate of return, and for how long? If you do, is that what you did last year? In my experience, I have not found anyone prospect who actually knew their answers. The sooner you find out, the better you are in terms of leveraging available retirement savings options. Delaying just increases the amount you need to save. A condition most people would rather avoid.
Ready to get on the road to fulfilling your savings need? Contact us.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor. Kravitz is not affiliated with Envision Wealth Planning.
The Roth IRA offers tax deferral on any earnings in the account. Withdrawals from the account may be tax-free, as long as they are considered qualified. Limitations and restrictions may apply. Withdrawals prior to age 59 or prior to the account being opened for 5 years, whichever is later, may result in a 10% IRS penalty tax. Future tax laws can change at any time and may impact the benefits of Roth IRAs. Their tax treatment may change.