One of the precious, oh-so-sweet things you give up when you go freelance is an employer-sponsored 401(k)—along with any matching contributions. But on the flipside, freelancers have quite a few options when it comes to saving for a retirement nest egg.
If you’re wondering whether you should consider making contributions to an IRA retirement account, the short answer is a resounding “yes.”
While there are other options to save for retirement when you’re self-employed—SEP IRA, SIMPLE IRAs, Individual 401(k) and Health Savings Accounts (HSA)—an IRA is not to be overlooked.
I opened an IRA long before I took the leap into full-time freelancing. And to this day I still make contributions on the regular. Besides giving you the low-down on why you should consider setting up an IRA, we’ll delve into a few tax-saving strategies with your IRAs.
Take Advantage of Compound Interest
The earlier you start making contributions to your IRA accounts, the more your money will grow. Because your retirement assets will compound over time, the sooner you can take advantage of them, the less they will have to contribute at a later date, explains Adam Beatty, a CFP® and founder of Bullogic Wealth Management. “It’ll be easier to save 5 percent of your salary today than 20 percent of your salary in 10 years,” says Beatty.
To illustrate the magical power of compound interest, let’s say that one person maxes out their 401(k) for the first 10 years of their career. After that, they don’t put in another dime. The second person doesn’t contribute anything the first 10 years of their career, then maxes out their contributions for the next 33 years until they retire. It turns out that the first person will come out ahead by a couple hundred thousand, despite contributing $400,000 more.
There’s Sweet Tax Savings
Confused over what the difference between a traditional versus a Roth IRA is? While the annual contribution limits are the same—$5,500 in 2018, and $1,000 additional “catch-up” if you’re 50 and over—the major difference is when you’ll be taxed.
Traditional IRAs are tax-deferred, which means you’ll be taxed when you start taking out contributions. Roth IRAs, on the other hand, are pre-taxed, which means you’ll be taxed the year you make the contribution. On the flip side, withdrawals you make are generally tax-free.
Traditional Versus Roth: Which One to Contribute To?
So the big question is when you’ll want to be taxed. If you’re just beginning your freelancing career and aren’t making a huge amount of money, Beatty recommends that you start a Roth IRA. “If you’re just starting out, your income should be low, which in turn will keep your tax bracket low,” says Beatty. “If you end up in a higher tax bracket at retirement, it’ll make paying taxes now a better choice. Plus it’ll keep your taxes diversified for retirement.” In addition, because income taxes are so low right now, it might make sense to contribute to a Roth IRA and get taxed on your contributions now.
Shane Mason, a CPA/PFS and CFP® at Brooklyn Fi, a financial planning services company for professional creatives, agrees. If you’re in the lowest-two federal tax brackets and earn $38,700 or less, Mason recommends contributing to a Roth IRA. And if you’re in a higher tax bracket, then contribute to a traditional IRA.
What to Do If you’re on the Fence
Unsure whether to contribute to a Roth or traditional IRA or are on the border of two tax brackets? If that’s the case, consider divvying up your investments so you’re contributing half to a Roth IRA and half to a traditional IRA, says David Zaegel, a CFP®, CPA, and founder of CWOs for Hire. That way, when you’ll be paying taxes will be spread out.
Focus on Tax Diversification
Besides how much you contribute, you’ll also want to diversify your taxes. Nobody can predict the future, and you aren’t entirely sure what tax bracket you’ll fall in when you hit retirement age. And as your finances don’t live in a bubble, changes in tax code and policies will affect how much you’ll be taxed and when.
That’s where tax diversification comes to the rescue. In a nutshell, tax diversification is having a mix of pre-tax and tax-deferred investments so that you aren’t taxed on everything in the same way or all at once. One of the reasons why you should diversify with different types of retirement accounts is that, you can manage where your income is coming from, and manage your taxes based on that, explains Zaegel.
It’s important to think about the big picture when it comes to tax diversification, and come up with a plan to reduce how much you’re paying in taxes, explains Zaegel. “A lot of people reduce taxes now, which is understandable, but you’ll need to consider the total tax impact in the long term.”
For retirement savings, it’s often a good idea to have a mix of pre-tax (i.e., 401[k], traditional IRA) and after-tax funds (Roth and taxable accounts), explains Henry-Moreland. “Because all of that pre-tax money will become taxable income once you withdraw it in retirement,” says Henry-Moreland, “it’s a savvy move also to have some money available that you’ve already paid taxes on.”
Consider the “Bucket Approach”
Because many freelancers begin their careers with a modest income that gradually bumps up as they establish themselves, Henry-Moreland suggests a “bucket” approach to retirement savings. You start with the smallest bucket—a traditional or Roth IRA, which are easiest to set up and administer. And when you reach the contribution limits to those plans, you spill over into the next bucket.
Whether to choose the traditional or Roth, IRAs are a great way for freelancers to save for retirement. And when devising a game plan to save for your nest egg, make sure to do your homework and take tax-saving strategies into account. Your future self will surely thank you.