401k vs. no 401k

Investing when you are freelance or self-employed can be a bit trickier then it was at a fulltime job with benefits.  Most employers offer their employees access to a 401k plan, which can simplify investing.  The contributions to the account come from your payroll checks, so there is no worry about forgetting to send in the amount of desired cash.  The investment choices are presented on a platter for you to choose from, versus the thousands of options that exist when doing your own investing.  Each 401k differs in the actual number of investments you can choose, but for most picking between a few is not an issue.

For many individuals a 401k represents the majority of the investing that they do.  A big bonus of 401k investing is that you can reduce your income by the amount contributed on a pretax basis.  As a freelancer or self-employed person you may not have access to an employer offered 401k plan, but may have access to a solo 401k plan.  A solo 401k plan allows a participant to make elective deferrals up to 100% of compensation or earned income.  For 2014 the annual contribution limit is $17,500 or $23,000 for those age 50 and over.  The solo 401k also has a profit sharing component which allows up to 25% of compensation to be added, until an annual maximum of $52,000 is reached.

Other Account Types

An IRA or Individual Retirement Account would be an option.  Normally when people refer to an IRA they are speaking of a Traditional IRA.  Although you have several types of IRAs, which include ROTH, SIMPLE, SEP, Rollover, and Inherited IRAs.  A Roth IRA is one that you contribute to on an after tax basis, so no income reduction.  Rollover IRAs are a type of Traditional IRA account which receives the assets from inactive workplace savings plans (401K, 457B, 403B).    Both SIMPLE and SEP IRAs are considered options for self-employed and small business owners.  An inherited IRA is one which is designed to receive the remains of an IRA or 401k account for the beneficiary of those assets (these have very specific rules about what is to happen with assets in these types of accounts).   

Here is a link to the IRS website, which goes into more detail about retirement plans offered for self-employed individuals http://www.irs.gov/Retirement-Plans/Retirement-Plans-for-Self-Employed-People.  The proceeding link provides descriptions of the accounts, contribution limits, and rules to be followed.

Getting Started

Speak to your broker or consider getting one if you do not have one.  Also a broker is the person or firm that you do your investing with.  Most brokerage firms do offer free investment advice.  So give them a call, explain your situation and see what plan can be put in place to help you get invested.  Lots of resources are offered by brokers to simplify investing, like access to online courses, research, and account features.  Some brokers even offer an online questionnaire that will help you choose the right type of retirement plan.  Several variables like age, income, filing status, and preference for a tax deduction will affect what plan is most appropriate.  It’s always a good idea to speak to a tax advisor when considering making changes to an investment portfolio.

According to a recent survey in part commissioned by the Freelancers Union, the number of Americans freelancing stands at 53 million.  That group of 53 million freelancers represents about 34% of the entire workforce.  As so many talented people pursue the paths of self-employment and freelancing it will continue to be of vital importance to be properly invested.



Take Advantage of Lower Income

Chances are that as a Millennial you have a lower income than you will have as you progress in your career.  The great thing about a lower income now is that you will pay less in taxes.  Contributions made to a Roth IRA are done so on an after tax basis, meaning it will not lower your income for the year. Also at certain income levels you could be phased out from contributing to a Roth or have to make partial contributions.  For most individuals the long term tax saving potential exceeds the cost of not receiving a reduction in income.

Tax Free Contributions

Individuals under 59 ½ can make full contributions up to $5,500 for 2014 to a Roth if their adjusted gross income is below $114,000, the amount for couples would be $181,000.  Contributions to Roth IRA’s are always tax free.  If you happen to invest the funds, and make a profit you will be taxed on the earnings if you take a distribution and certain conditions are not met.  For example, let’s assume you contribute the full $5,500 to the account and the value grows to $7,000.  The $5,500 can be taken out of the account tax free; the remaining $1,500 may be subject to taxes and a 10% early withdrawal penalty.  In a sense taking a distribution from what you have contributed is like getting a tax free loan. 

Potential Tax Free Distributions

At some point the entire value of the account may be tax free.  Withdrawals of earnings taken from a Roth IRA after the five-year aging period has been met are tax and penalty free if one of the following conditions is met: 59 ½, disability, death, or qualified first time home purchase. 

Compounding of Money

The younger you begin to save the more time your investments have to grow and benefit from compounding.  Another benefit to Roth IRAs is that they do not require original account owners to begin taking a minimum required distribution (MRD) at age 70 ½, meaning your money has even more time to grow if not needed.  Below is a graph which shows the effects of compounding at different returns.

This hypothetical example is provided for illustrative purposes only and is not meant to represent the return of any specific investment product. Data assumes that each age group is making their maximum eligible contribution to an IRA account at the beginning of each annual period. $5,500 is contributed annually until reaching age 50, then $6,500 is contributed thereafter until age 65. Investment returns and principal value will fluctuate so that investments, when redeemed, may be worth more or less than original investment. Chart taken from etrade website.