I’m self-employed (with regular freelance work) in my late 20s, and I don’t plan on changing this due to the regularity of my contracts. My toughest challenge has been knowing how to invest my money since I’m not part of a company, and therefore don’t have a 401(k). I have a traditional IRA that I max out contributions to every year, but I don’t think this will be enough if I live another two decades (or hopefully more) beyond my 60s. My only current debt is my student loans, which will be paid off in eight years. Apart from this, I have $20,000 cash that I don’t know how to invest — or if I should. People have recommended buying a house, but I (a) don’t want to go into more debt, and ( b) feel like the timing is wrong.
As the “gig economy” becomes more popular, what do you suggest for a self-employed person in my position — with standard debt and a chunk of liquid assets? Should I think more about buying a house? Is there another investment opportunity I’m missing? Or should I just keep saving my cash until I reach a certain amount? Any advice is appreciated.
When I read your question, I thought, “Easy!” Which is always a sign that the answer is trickier than I anticipated. The short version: You should open a SEP-IRA, which is a special type of retirement account for self-employed people — basically the freelancers’ equivalent of a 401(k). The longer version: Determining how much to put into it will require advance planning and potentially some accountant-level math.
As for your $20,000 stash: Most experts recommend that freelancers keep about six months’ worth of living expenses at the ready, just in case. This is often referred to as an emergency fund, a fuck-off fund, or a “cushion” — its purpose is to keep you afloat in a worst-case scenario. Once you’ve calculated the right amount for yourself, put it in a high-yield savings account (you can find some good options here) and don’t touch it unless financial disaster strikes — you lose a major client, get an unexpected medical bill, break your thumbs in a freak accident and can’t work, etc. From now on, whenever you’re lying awake at night stressing about invoices, remember those reserves and let them cradle you to sleep.
After you stock your emergency fund, whatever money remains (plus the chunks you continue to save) is for investing. I agree that a house is not the smartest choice for you right now. Real estate is a big, emotional commitment, and if you’re feeling meh about it, there are much simpler ways to grow your nest egg — like the aforementioned SEP account.
As a seasoned freelancer, you’re probably well-acquainted with the quest to maximize your earnings by dodging as many taxes as possible. If you picture your gross income — the amount that your clients pay you — as a pizza that the IRS wants 30 percent of, then it behooves you to stuff as much of that pizza in your face as possible before the IRS sidles over to your table (30 percent of a half-eaten pizza means 15 percent more pizza for you). In tax terms, those pre-IRS bites are known as deductions, and you only pay taxes on the leftovers.
Like a traditional IRA, a SEP-IRA or SEP plan (an acronym for Simplified Employee Pension) is a great vehicle for siphoning your pizza-slash-income away from the IRS and into a long-term investment account; both allow you to save pre-tax dollars and chop down your taxable income. However, for your purposes, a SEP is superior because it has a much higher contribution limit than the $5,500 cap on a traditional IRA (for 2018, the SEP limit is either $55,000 or 20 percent of your adjusted net earnings, whichever is less) and therefore allows you to save more for retirement — which, as you wisely pointed out, will be essential for spoiling your grandkids and living happily into your 80s, 90s, or beyond.
Going forward, you could have both a SEP and a traditional IRA, but it makes more sense to reduce steps — why make this boring process more complicated than it already is? You can consolidate the accounts by rolling your existing IRA savings into your SEP after you’ve opened it. It might be simpler to keep your SEP at the same investment company that’s currently managing your traditional IRA, but if you feel like switching, go wild. (Personally, I keep my retirement savings at Vanguard, which I recommend.)
Now for the annoying part: Calculating your SEP contribution, assuming it’s less than the $55,000 cap, takes some arithmetic. You could do what I do and just ask an accountant to figure it out for you, if you have one. But if you’re less lazy and/or better at math than I am — a strong possibility — you can determine the numbers by taking the following steps.
First, determine your net earnings before taxes — what’s left over after you deduct all your business expenses (internet costs, receipts from “business dinners,” a portion of your rent if you work from home, and so forth). Then, for annoying reasons I won’t go into, you must subtract half of your self-employment tax (for Social Security and Medicare, totaling 7.65 percent) from the remaining amount. The “shortcut” is to multiply your net earnings before taxes by 92.35 percent. Then, take 20 percent of the remaining amount, and voilà — your SEP contribution limit.
To guard against miscalculations, it’s best to err on the conservative side — contribute a little bit less to your SEP-IRA than you think you need to, and save some cash to catch up at the end of the year if you’re under your limit. Alternatively, if you over-contribute by mistake, it’s not the end of the world — the extra money will carry over into your contributions for the following year, and create a bit more paperwork. Or you can hire professional help.
A weird note: If you Google SEP accounts, many websites will tell you that you can contribute 25 percent of your “salary.” Don’t be confused: This only applies to people who work for small companies that offer SEPs to their employees — not a self-employed individual like you.
Finally, you might also consider opening a Roth IRA in addition to a SEP, just to diversify your savings. Like a traditional IRA, a Roth has a $5,500 annual contribution limit, but it’s unique in that you contribute post-tax dollars, so you won’t get taxed on your withdrawals (an advantage if you suspect you may be in a higher tax bracket later in your life). Another upside to a Roth is that you don’t have to wait until retirement to take distributions from it — the money only has to sit there for five years, so you could potentially use it for mid-term goals as well as long-term ones.
Speaking of timing: It’s completely normal to be unsure about how you should sprinkle your savings around. IRAs are a good way for self-employed people to save money for retirement, but I imagine you have other financial goals that predate your 60s. Take this opportunity to start mapping them out. If you do want a house someday, how much do you want to spend on it, and when? Do you want to open your own business someday? Have kids? Take a trip to Antarctica? Finishing off your loans is probably part of this picture, too — if you have an opportunity to pay them down faster, you may want to take it. But remember, it’s your pizza, and you get to eat it the way you want.