It’s Possible to Work for Yourself While Still Building a Sound Financial Future
The current shut down is another reminder of how tough it is to plan for your financial future and retirement in the entertainment industry and self-employed freelancer world in general. However, it also gives you a perfect opportunity to put strategies in place to maximize your future when things start up again. Most Oscar winners think of themselves as artists, but they are also highly successful business owners. And the same goes for the legions of other successful, but less renowned, self-employed freelancers. If you work freelance and are self-employed, it is critical that you maximize the unique financial planning strategies available to you and your fellow self-employed business owners.
This is even more important in creative fields because of the unpredictability and volatility of the career trajectory. Even in normal times, we all know those who thought their phenomenal youthful success would last forever, and sadly it did not. Meanwhile, too often they paid far more in taxes in their high earning years than they should have done and did not use the planning vehicles available, then had nothing left when their careers got cut short. Do not let that happen to you.
Below we will discuss four strategies high-income, self-employed freelancers can use to prepare for their financial futures while also minimizing their tax burdens. We are going to start at the top of the income ladder and work our way down. So, don’t get dispirited if you are not earning the kinds of numbers we are talking about. Keep on reading and hopefully, there will be something for you:
Self-Employed Freelancer Strategy #1: Set-Up a Defined Benefit Plan
This option seems almost too good to be true. It enables you to fund your retirement plan with way more than you even pay yourself. Most retirement plans restrict you to 25% of your income, but not the Defined Benefit plan. You could put 200%, 300%, or more than your salary – untaxed – into your retirement plan. Let’s say your business is netting $900,000 after expenses, excluding your salary. You could pay yourself $300,000 and put double that – $600,000 tax-deferred – into your own personal pension. You can quickly build up several million dollars to take care of yourself in retirement, adding a little more predictability to your life.
You don’t have to fund it with such large numbers. It could still work just funding it with $100,000 a year. Either way, a Defined Benefit Plan is a great strategy for high-income earners, and even more so for those whose incomes vary greatly from year to year. If you take on a project that skyrockets your income in a particular year, you can contribute a great deal pre-tax to your Defined Benefit Plan and avoid a costly tax burden in the present. Your contributions will usually be deductible, and your distributions will be taxed as income in retirement.
These plans are somewhat complex, and you need an advisor experienced in setting them up. They have annual administrative needs and fees, and you need to have the ability to fund them and to do so relatively consistently. They work particularly well with highly-paid older business owners with few and younger employees – and even better, a Hollywood loan-out with only one owner-employee! Please contact us if you would like us to help you put one in place or simply discuss if it might be the right option for you. (Be warned, some insurance companies push plans that we do not think are optimal.)
Strategy #2: Opt for a One-Participant 401(k)
Some CPAs don’t tell their clients about this strategy, commonly called a solo 401(k), and yet it is one of my favorites. For the right client, I prefer it to its more commonly suggested cousin, the SEP (Simplified Employer Plan) for the following reasons:
A Solo (401(k) can be perfect for the film industry because self-employed freelancers in this industry often have high incomes and no employees. And whilst its rival, the SEP, is limited to 25% of your income, a Solo 401(k) sometimes enables you to contribute more. For instance, although both the SEP and the 401(k) are generally limited to $57,000 (2020), if you are over 50 you can contribute an additional $6,500 catch up contribution into a Solo 401(k) raising the limit $63,500. You cannot do this with the SEP. Moreover, with a Solo 401(k) you can contribute 100% of your salary up to $19,500 or up to $26,000 if you are over 50. So, there are ways to contribute more than 25% of your income with a solo 401(k).
A Solo 401(k) has another great benefit: you can make that employee part of your contribution as a Roth contribution up to $19,500 or $26,000 (for those over 50). What is a Roth Contribution? Most retirement contributions go in “pre-tax” i.e. they are tax-deductible and you don’t pay tax until you withdraw them in retirement. Roth contributions are the opposite. You pay tax now and never pay tax again. This is perfect if you have a low earning year and are in a lower tax bracket this year (COVID, anyone?) and expect to be in a higher tax bracket in retirement. This happens all the time in the entertainment industry.
This above point is a reminder that the value of contributing to a tax-deductible retirement plan is based on the premise that you will be in a lower tax bracket in retirement. If you think you will be in a higher tax bracket in retirement it may not make sense to contribute to a traditional tax-deductible retirement plan, remember to do these calculations carefully. We are happy to help you think through the best solution for you. Please contact us for a complimentary consultation.
Another benefit is you can put your spouse on payroll and have them contribute, too. However, if your spouse is contributing to another employer-sponsored 401(k), the contribution limits are shared across both accounts belonging to your spouse.
Self-Employed Freelancer Strategy #3: Open a SEP IRA
A simplified employee pension (SEP) IRA, mentioned briefly above, is an option if you’re a sole proprietor, which is the default business entity for freelancers who don’t form an LLC or a corporation. These tax-deferred accounts have the same investment options as traditional IRAs, but significantly higher contribution limits ($57,000 for 2020, but no catch-up contribution).
When you contribute to a SEP IRA, you do so as the employer and not as the employee. Tax-wise, you get the advantage of deducting the lesser of your contributions or 25 percent of your net self-employment earnings. You’ll contribute pre-tax, and your distributions will always be taxed in retirement, as discussed above. One advantage to a SEP IRA and a 401(k) that you won’t have with a Defined Benefit Plan is that you are not required to contribute every year, which can be advantageous if your income varies quite a bit from year to year.
One benefit of the SEP over the Solo 401(k) is that it requires less administration. Also, there is no annual reporting fee. If your savings ability is limited, this might make the SEP the right plan for you.
Strategy #4: Utilize a Traditional IRA or Roth IRA
An Individual Retirement Account (IRA) is a tax-advantaged retirement account that is widely used, and easy to set up for self-employed freelancers. It is funded with pre-tax dollars, like the options mentioned above, so you won’t pay income tax until you begin withdrawing funds in retirement. Typically, you can get a tax deduction on your contributions each year, too.
A Roth IRA works similar to the Roth Solo 401(k) described previously, except with lower contribution limits. Basically, you pay tax now but never pay tax again.
When compared to the above options, traditional IRAs and Roth IRAs often feel less complex to self-employed freelancers without much financial background. However, their low contribution limits make them a less desirable option for high-income earners. For example, in 2020, you can contribute up to $6,000, plus a $1,000 catch-up contribution if you’re 50 or older. While there are still clear advantages to them, especially if you begin to work less and earn less as you near retirement, they won’t allow you to save as much as the options above.
There are also income eligibility limits and restrictions, which you need to navigate with your CPA.
(Note: some CPAs mistakenly allow their clients to contribute to a Traditional IRA even though the client does not qualify for a tax deduction. We do not think this is a good strategy.)
What Are You Waiting For?
It’s always a good time to begin investing in your long-term financial security, especially if you’re a self-employed freelancer at the top of your game. At WellAcre Global Wealth Advisors, we can customize a strategy that helps you fund your retirement while also reducing your current tax burden as a high-income self-employed freelancer in an industry you love.
Please contact us today to schedule a complimentary discussion about your retirement planning goals and to learn how we can help you develop and implement a comprehensive financial plan to suit your individual needs. We look forward to hearing from you!
DISCLAIMER: We are not tax advisors. Please consult with your own tax professionals before taking action.