The Right Way to Save for Retirement as a Contractor
by Maurie Backman | April 4, 2019
Retirement can be a daunting prospect if you're unprepared. After all, it's hard to go from earning an income to living off of savings and Social Security. But if you build a large enough nest egg, you'll minimize your chances of running out of money later in life, or struggling financially when you should be enjoying your golden years.
You'll often hear that you should set aside at least 15% of each paycheck you receive for retirement, and that's generally good advice. But what happens when you don't have a steady paycheck? If you're an independent contractor, your earnings might vary quite a bit from one month to the next. As such, 15% of your earnings one month might be a decent retirement plan contribution, while 15% of another month's earnings might be a pittance.
Further, if your earnings fluctuate, you may find it difficult to part with any amount of money in a given month. For example, if you're used to earning something in the ballpark of $5,000 per month, but you have a slow period in which your monthly income drops to $3,500, then your retirement savings may fall by the wayside -- and your future self can't afford to let that happen. Here's how to save steadily for retirement as a contractor -- even if your circumstances make that more difficult.
1. Create a budget that emphasizes long-term savings
Following a budget is a good way to ensure that all your financial goals are being met. Most people create budgets by mapping out their different expense categories and ensuring that their total monthly spending doesn't exceed their monthly earnings. When your income varies, that's tougher to do. Your best bet, therefore, is to review your earnings over the past 12 months to come up with an average.
Once you have that average, base your monthly expenses (meaning, what you can afford to spend) on it, assuming you have a little money in the bank to tide yourself over during slower earning periods. At the same time, create a line item in your budget for savings so that it's part of your monthly expenses. If you don't call that line item out and instead assume that you'll just take whatever money isn't already spent and allocate it to retirement, then you're apt to neglect your long-term savings, even if unintentionally.
2. Choose the right retirement plan
The good thing about being an independent contractor is that you can invest through a number of powerful retirement savings accounts. First, there's the traditional IRA, which, in 2019, lets you contribute up to $6,000 of your earnings if you're under age 50, or up to $7,000 if you're 50 or older. Your contributions will be made with pre-tax dollars, lowering your tax bill for the year, though your withdrawals will be taxed as income in retirement.
You can also contribute to a Roth IRA, which has the same limits as the traditional IRA. The main difference is that Roth contributions are made with after-tax dollars, so there's no immediate tax savings. However, withdrawals in retirement are completely tax-free.
Additionally, you might look into an SEP IRA. As with traditional IRAs, SEP contributions go in tax-free, and you can contribute up to 25% of your self-employment earnings (your earnings minus your work-related expenses, SEP contribution, and half of your self-employment taxes) for a maximum of $56,000 in 2019. There's also the SIMPLE IRA, which currently lets you contribute up to $13,000 if you're under 50 or $16,000 if you're 50 or older -- all pre-tax.
Finally, you can look at a Solo 401(k), which works just like a regular 401(k) only with higher annual contribution limits. For the current year, you can contribute up to 25% of your net self-employment income for a maximum of $56,000 if you're under 50, or $62,000 if you're 50 or older.
The retirement plan you choose will depend on how much you're looking to save and what sort of tax benefits you're looking to reap. That said, you don't have to limit yourself to a single plan if you don't want to.
3. Pay yourself first
Once you have money earmarked in your budget for retirement savings and you've chosen a place to put those savings, you'll want to make sure you're staying on track. A good way to do so is to set up an automatic transfer so that money is sent into long-term savings right off the bat, before you get a chance to spend it. Some retirement plans allow for automatic transfers, while others don't. If yours doesn't, then set up an automatic transfer to your regular savings account, and from there, manually transfer money to retirement savings at regular intervals.
4. Bank your extra earnings
As a contractor, you're apt to have some months when the work just doesn't stop -- and your income increases because of it. When that happens, it's a great opportunity to boost your retirement savings, so take advantage of those periods by socking away that extra money instead of spending it. It'll also buy you some wiggle room so that if you have a period where work slows down and you're forced to cut back on retirement plan contributions, it won't hurt you as much in the long run.
Retirement is a milestone all workers should save for. Though doing so might be tougher as a contractor with variable income, if you make it a priority, you're more likely to reach your goals. That's something your senior self will be grateful for.
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