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There's more to contractor finances than finding work and bringing home the bacon. You can't forget about having to procure and pay for your own health insurance, deal with the complex tax issues of having your own business and manage your own retirement savings. While contractors are forced to focus on the more immediate needs of health insurance and taxes, saving for retirement languishes on the back burner for many. Word to the wise: Put the retirement issue front and center.
"There's a tension between providing income for today and producing for tomorrow," explains Bryan Williams, managing director of Rockwater Financial Service, a registered investment advisory in Newport Beach, California. It's hard to see the larger picture when you are worried about making enough to pay the bills, or building a practice or growing a clientele, Williams points out.
But it is important for contractors or self-employed individuals to actively and liberally invest in retirement. "It's really important to invest as much as you can," Williams says. "You don't have a corporate pension…the only thing you have is Social Security, and that's debatable," he says.
What Contractors Don't Get
Company pension plans, also called defined benefit plans, guarantee employees a certain income after retirement. The lucky workers who have these plans will receive a set amount of money each year after they retire until death.
The other type of plan available to company employees is the defined contribution plan. These plans take many forms, including money purchase plans, profit-sharing plans, employee stock ownership plans, 401k plans, 403b plans, cash balance plans and target benefit plans. None of these guarantee a specific benefit after retirement, but they do specify contribution limits and ensure that at least some money is set aside to grow for after retirement.
All these investment vehicles are tax-deferred in some way; either you don't pay taxes on the contributions you make, your contributions are tax-deductible, you contribute pretax dollars or the profits aren't taxed until you withdraw the money. The same kinds of tax-deferred accounts are available to contractors, but it's up to each individual to open an account and set money aside.
Accounts for Contractors
Perhaps the best-known account available for self-employed individuals is the Individual Retirement Account, or IRA. There are several variations on the central theme, but in general, they are available to anyone under 70½. Since IRAs are specifically intended for retirement, withdrawals are subject to penalties if taken before age 59½. Maximum annual contributions vary, but, in general, these are tax-deductible in the year in which they were applied to the account. In most cases, you contribute pretax money, meaning you also reduce your current taxable income.
Traditional IRA
You can invest up to $4,000 per year in an IRA ($4,500 if you're over 50). If you have more than one IRA, you cannot contribute more than this gross amount to the combined accounts. The contributions you make to your IRA grow tax-deferred, which means you don't pay any taxes until you withdraw funds. Contributions are also tax-deductible in most cases.
Roth IRA
The Roth IRA offers federally tax-free growth, which means you pay no taxes at all on earnings if you withdraw after age 59½ and have had the account for more than five years. You can place a maximum of $2,000 annually in a Roth IRA. Unlike a traditional IRA, you do have to pay taxes on the money you contribute. Remember though, you don't have to pay taxes on the money you earn on your investments once you've retired. This is considered a particularly good option for younger workers.
SEP-IRA
Simplified Employee Pension IRAs are designed for sole proprietors and those with any self-employment income. The employer or self-employed individual can contribute up to 15 percent of compensation, up to $25,500 annually.
SIMPLE-IRA
Savings Incentive Match Plan for Employees-IRA offers sole proprietors and small businesses with fewer than 100 employees a tax-advantaged retirement savings option. Employers contribute, and employees can elect to contribute if they wish. Employees must have earned at least $5,000 from the employer in two years preceding the establishment of an account and must be expected to earn $5,000 in the current year. The employee maximum annual contribution is $6,500, and employers can match that, or they can contribute a percentage of the employee's salary whether the employee contributes or not.
Keogh
A Keogh is not an IRA, but it is designed for small business owners and the self-employed. Of all the plans described here, the Keogh allows for the largest contributions: Up to 25 percent of your compensation, up to the annual maximum of $30,000. You can deduct what you contribute to your Keogh from your taxable income.