Freelancing is not just for writers and designers anymore. More than one-third of the American workforce is doing freelance work, according to a 2014 survey published by the Freelancers Union, an advocacy group for independent contractors.
With an increasing number of people making a career out of freelance work, it’s important that they continue to focus on retirement and savings, and to address the challenges of long-term personal-finance goals. Unlike most salaried income, freelance income can be irregular and doesn’t include a company-sponsored 401(k) plan. But these tips can help anyone get on the path to better personal-finance management.
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Set a budget based on your average income.
Typical budgets use the same number each month for the income and expense categories. However, freelancers are quick to learn that income can be unpredictable or seasonal, with some months consistently stronger than others. With no steady paycheck, it’s important to adjust a budget to match. This means freelancers should look at their average income each month rather than actual income each month.
“I recommend taking your previous year of income and dividing it by 12, so you can come up with your estimated monthly income,” says Deacon Hayes, a personal-finance blogger at Well Kept Wallet. “That way, you can pay yourself each month and know that you can cover your bills. If you make more money one month, put it in savings for the months where less money comes in.”
Save for retirement using a percentage of income.
In most cases, company employees can automatically invest a percentage of each paycheck into a 401(k) or similar retirement account. While freelancers can’t count on an employer to make that transfer for them, they can still save a fixed percentage of income each month toward their nest egg.
At a large company, saving 6 percent is common—and an employer often matches dollar-for-dollar toward that first 6 percent, which helps build savings for salaried workers.
There’s no rule of thumb for freelancers because each person’s financial situation is different. To be safe and build savings comparable to what they might receive at a large company, freelancers should take a close look at their annual income and current savings.
For example, consider Josh, a 34-year-old freelancer living in New York City who already has $15,000 in retirement savings. He is now earning $68,000* as a writer and saving $8,000 per year for retirement.
With that savings rate, he can expect to have $43,000 per year in spending money in retirement after age 68.** If he saves $12,000 per year, his retirement spending increases to $54,000 per year. Whatever amount he decides to save, he can use a SEP-IRA, or a combination of a SEP-IRA and Roth IRA. (More on these plans below.)
Choose the right retirement plan for your needs.
Once you’ve determined the amount to save, you’ll need a place to put all of that money to grow for the future. There is no perfect investment account for everyone, so you will need a good handle on your income and savings goals. You should always consult your tax professional to determine what plan or plans may be best for your circumstances.
Your options include a simplified employee pension (SEP) plan, as well as traditional and Roth individual retirement arrangements (IRAs). The SEP-IRA is a tax-advantaged account for retirement and aimed at self-employed workers such as freelancers. Contributions to a SEP are tax deductible, and savers do not pay taxes on investment growth.
“Don’t jump right to a traditional [IRA] or SEP-IRA,” says Alex Benke, CFP, director of advice products at Betterment, an automated investing service. Benke says freelancers and other self-employed workers get hooked on business deductions and go right for a deductible IRA contribution. But a tax-advantaged Roth, for which contributions are not tax deductible, may be better, if a freelancer’s income level qualifies.
“If you think your current tax bracket is lower than it will be in retirement, do a Roth,” Benke advises. “A Roth IRA also has an added benefit, which is that contributions can be withdrawn tax and penalty free in the case of an emergency.” However, beware that any gains withdrawn will be taxed and penalized by the IRS, Benke adds.
Early withdrawals are generally not recommended because they can set back your retirement savings; however, the option can come in handy in a cash crunch caused by variable income.
One reason to use both types of IRA is to spread the tax benefit across this year and the future.
For workers who can and want to save more than $5,500 ($6,500 if you’re 50 or older) in 2015—the Roth IRA contribution limit—the simplest option is to use a SEP-IRA, which has no special plan setup or filing requirements. SEP-IRAs also make sense for higher earners who don’t qualify for a Roth. They have much higher contribution limits than traditional IRAs.
Speaking of contributions, Benke suggests making IRA contributions throughout the year, not only at the end (or around when you pay your quarterly taxes), in order to maximize time in the market.
Create an emergency fund.
Emergency savings is a fundamental part of managing money well, and it can be extra important for freelancers because their cash flow can be irregular. “Money won’t always flow in as it does some months,” says John Rampton, a freelancer for online invoicing tool Due.com.
There are two key decisions for saving for a rainy day: (1) how much to save and (2) where to save it.
To figure out how much to save, first determine how many months you might be out of work, says Benke. It’s recommended by most financial experts that full-time employees have three to six months’ worth of expenses saved, but it could be more for freelancers. Adjust this amount based on work history and experience.
Next, estimate the smallest amount you’d be able to live on month-to-month. This includes expenses related to housing, food, clothing, transportation, health insurance and essential liabilities (utilities, loan payments, etc.). Add these up to get the sum of your monthly expenditure, and multiply by the number of months determined in the first step.
Finally, consider where to save this money. It shouldn’t be in a place where you could spend it (like a checking account), but where it can be accessed easily should the need arise. One option is a safety net fund, designed as a low-risk investment for money earmarked for emergencies. Another option is keeping money in an interest-earning savings account.
If you think you will only have a very temporary cash flow shortage, it can also be useful to have an available line of credit to be used only for emergencies.
Hire a CPA if you need more peace of mind.
Personal finance matters can get complicated, and you might not want to try to manage everything yourself. Outsourcing complex financial tasks like bookkeeping and quarterly tax payments saves you time and mental energy—and could save you money as well.
“Make sure you spend the time to learn the tax rules or hire a certified public accountant (CPA) who specializes in your area of practice,” says Lance Cothern, a finance expert from Money Manifesto. “The money or time spent will be well worth it when you make the correct estimated tax payments and you don’t have to worry about a surprise tax bill because you didn’t fully understand what you would owe on tax day.”
Freelancing can offer a new kind of lifestyle—one that isn’t inhibited by the strict schedule of a traditional 9-to-5 job. Perhaps one of its bigger disadvantages is it requires you to pick up many of the financial responsibilities that an employer typically provides. But with the right planning and financial tools in place, you can enjoy the flexibility a freelancer’s lifestyle while still feeling confident and secure about your future.
* The mean annual income for a writer in 2014 according to the Bureau of Labor Statistics.
**This example is based on Betterment’s RetireGuide advice model. It assumes a retirement age of 68 and longevity of age 90, 3 percent inflation and a portfolio allocated according to Betterment’s advice for someone age 34. It assumes $15,000 in existing savings and that $19,000 a year will come from Social Security benefits.
