Retirement Planning – Freelancers Have A Secret Weapon, The Solo 401(k)

Retirement saving for freelancers and contractors

Rebalance IRA’s Managing Director, Scott Puritz writes about an underutilized retirement planning tool for freelancers — the Solo 401(K).

An amazing 40 percent of American workers will be classified as freelancers by 2020, according to the Bureau of Labor Statistics. Once the province of recent graduates and those “in between” jobs, the wave of the future seems to be contract work as a long-term career for millions of Americans.

And because of this trend, the most fundamental of workplace benefits, healthcare and retirement, are turning into stand-alone, customer-driven industries.

Take healthcare reform. Despite its rocky start, buying individual coverage through an exchange will soon become the norm. Many people continue to be covered at work, but as time passes workplace plans are expected to more closely resemble the health exchange offerings.

Likewise, expensive employer 401(k) plans are giving way to simpler, cheaper and, frankly, better run “solo” 401(k) plans that are portable by design, and almost anybody can set up. This is an option that should be given much consideration by freelancers and sole proprietorship business owners.

Not so crazy

“Start my own 401(k)?” you might be asking right about now. “Are you nuts?” Interestingly, because of the high costs of typical employer plans and their limited, costly investment choices, it is increasingly clear that a personal 401(k) is the far better option, and one any committed freelancer should investigate, pronto.

Most people have never heard of a solo 401(k). That’s because it is relatively new. In 2001 Congress created a way for self-employed individuals to access a 401(k) style retirement platform, now known as the solo 401(k). One huge benefit is that you can put away more money at lower income levels.

Many accountants and advisers will suggest that small-business owners consider a SEP IRA or, if they have employees, a SIMPLE plan.

But often these professionals say that only because they are more familiar with the older, more commonly used plans.
If you are a single entrepreneur and expect to have no employees other than perhaps a spouse, however, a solo 401(k) is the way to go. A SEP, for instance, won’t let you defer both the standard $17,500 plus a slice of tax-deferred income.

In a solo 401(k), you can save the same annual limit enjoyed by a participant in a workplace plan, which for 2014 is $17,500 a year in pre-tax savings, plus an additional $5,500 if you are over the age of 50. But unlike your cubicle-bound former compatriots, sole proprietors (that’s people who operate a small business with just one employee, themselves) can put away up to 25 percent of their income, up to $52,000.

Finding a write-off

Sure, you have to make a lot of money to hit those limits, but that is the point: If you turn in a great year, there is no reason to pay more taxes – turn that extra money into a write-off and put it into your retirement account and let Uncle Sam pay a big chunk of the tab.

And, if you happen to employ your spouse (be sure that he or she actually does work), it’s possible to double those numbers.

How can an entrepreneur sock away more with a solo 401(k) than with a SEP IRA?

Take a 51-year-old sole proprietor who earns $100,000 in wages. If the proprietor used a SEP IRA, he or she could invest only 25 percent or $25,000. But the same proprietor could put $23,000 in a solo 401(k), plus 25 percent of wages for a total of about $48,000 of annual retirement investing. That’s $23,000 more. Plus, unlike a SEP IRA, you can borrow against your solo 401(k).

Inevitably, the concern becomes how to invest your money once you save it, and there a solo 401(k) has your back, too. Since you run the plan, you choose the investing options.

Here’s the best part.

Most people think a big company plan can save them money. In fact, the opposite is true. Compared to a standard small-company plan, the cost differences are staggering. Many workplace plans charge 1 percent to oversee your retirement investments, and then buy “actively managed” mutual funds on your behalf that cost an additional 1.5 percent or more.

“All in” fees of 2.5 percent per year are not uncommon.

What that means on an account with $100,000 is that a retirement saver ends up paying $2,500 a year for what often turns out to be a disappointing investment performance. Those fixed costs compound, just like credit card interest. With this kind of fee burden, over 20 years the fund company can take up to 30 percent of your potential return.

As a freelancer, however, you can run your solo 401(k) for about 70 percent less in fees. Just open our own 401(k) and populate it with a well-considered portfolio of index funds or index-style ETFs.

Rather than paying 1.5 percent for active mutual funds, you can build a really great portfolio for only 0.2 percent per year. If you have an adviser, you can have them periodically rebalance those funds for an additional 0.50 percent. With this approach you will generate the kind of steady, reliable outcomes that usually are only found in the biggest retirement plans used by big, blue-chip companies, state pension plans and university endowments.

As for running the fund, as a solo 401(k) owner the management cost is zero (no reason to pay yourself) and the administrative costs are quite modest. Increasingly, too, you can find great investment advice on building and maintaining a solid retirement portfolio, advice which should cost no more than half of what typical investment advisers attempt to charge.

Ultimately, a correctly built and managed retirement investment portfolio gives you freedom: Rather than sweating individual stock selections, you simply own the markets in an intelligent, inexpensive way.

Knowing that you can maximize deferral in years when business is good is a tremendous advantage. But, the biggest plus may be the freedom to concentrate instead on building your business into a long-lasting, rewarding career, with the comfort that your retirement investment plan is on track.