Retirement Saving and Taxes as a Freelancer

Taxes and saving for retirement are notoriously baffling for freelancers. 

The good news is that freelancers have way more options than full-time employees when it comes to saving in retirement accounts. 

What are your options?

  1. Contribute to an Individual Retirement Account (IRA). This is the option most freelancers are presented with when they visit their tax preparer each year. 
  • Pros:  easy to fund and maintain; wide range of investment options; portable; Roth version allows for after-tax contributions and potential for growth that will never be taxed again
  • Cons:  IRAs only allow you to save $6,000 pre-tax (in 2022); IRAs are not ERISA-backed plans and are NOT protected from creditors or lawsuits; you can not take a loan out on an IRA
  1. Contribute to a Simplified Employee Pension IRA (SEP).  In this plan, you are the employer and make pre-tax contributions based upon your net compensation.
  • Pros:  easy to fund and maintain; wide range of investment options; portable; possibility of higher contribution than a traditional IRA, flexible contributions
  • Cons:  If you report your earnings on IRS Schedule C, the contribution is 25% of your “adjusted net earnings” or your net profit minus one half of the Social Security and Medicare taxes you pay, meaning, with the goal as a self-employed individual to minimize profit for tax purposes, the SEP hobbles your contribution limits; SEP IRAs are not ERISA-backed plans and are NOT protected from creditors or lawsuits; you can not take a loan out on an SEP IRA
  1. Contribute to a defined benefit plan (an example, Profit Sharing Plan). This plan type has the highest contribution options for high-income individuals.
  • Pros:  allows high earners to fund large pre-tax sums for their retirement; flexibility (assuming you work with an advisor who understands the plan type); ERISA-backed and protected from lawsuit and creditors; can take large loans against the plan and pay yourself back instead of a bank
  • Cons:  extra administrative and reporting requirements; feasible only for very high income individuals; more difficult to find custodians and advisors who are adept at working with this plan type
  1. Contribute to an Individual (or “Solo”) 401k. The Individual 401k is one of the best options available to freelancers for socking away a bunch of money for retirement.  
  • Pros:  allows high earners to fund large pre-tax sums for their retirement; ERISA-backed and protected from lawsuit and creditors; can take large loans against the plan and pay yourself back instead of a bank
  • Cons:  extra administrative and reporting requirements

Let’s look at an example of how freelancers can use the Individual 401k to maximize tax savings and retirement savings.

First, what is an Individual 401k plan?

An individual 401k actually consists of two parts: the first, an elective deferral, or the employee’s contribution (which has the same contribution limits you’d see in an employer-sponsored plan); and the second, an employer nonelective contribution which can be up to 25% of your compensation.

Individual 401ks are easy to set up and maintain and are offered by most large custodial firms. And, as it turns out, are one of the best ways for freelancers to reduce their tax bill dramatically.

Let’s run through two scenarios side by side. First, the assumptions:

  • Both freelancers have an Individual 401k
  • Both freelancers gross $120,000 per year
  • Both freelancers’ businesses have no other employees
  • Both freelancers are employed by their own business, likely via an LLC
  • Both freelancers have $30k of deductible business expenses

Freelancer #1 has an LLC but files her taxes as a sole proprietor, accounting for expenses each year on Schedule C.

Freelancer #2 has an LLC that is taxed as an S-corporation, and so files 1120S each year.

Freelancer #1 pays around $13,000 in taxes each year.

Freelancer #2 pays a bit less than $2,000 in taxes each year.

Both freelancers are able to contribute at least $34,000 to their Individual 401k each year (Freelancer #1 can contribute an extra $1,500 or so).

Freelancer #2 has to file an extra tax return each year, and has some extra expense for the administration of an S-corporation.

At the end of the day, Freelancer #2 has about $10k more in their pocket. 

Every year.

Why is this the case? Each is doing the same amount of work, paying the same amount in business expenses, and saving roughly the same amount of money for their retirement.

In a nutshell, our tax code is written to penalize the hired gun and to favor corporate structures. The self-employment tax liability Freelancer #1 faces by itself accounts for a large chunk of her tax bill.  And even with the added expense Freelancer #2 has, the savings Freelancer #2 can realize are dramatic.

While this a somewhat simplified example, if your business nets more than $40,000 of income, the benefits of changing the tax classification of your LLC could be substantial.