Self-employment has its perks. You can set your own schedule and be flexible with when and where you work, and you generally have more independence, control, and freedom over your time and work. As an independent contractor, you get to enjoy the freedom and benefits that come with being your own boss. As with any job, however, there are some challenges—especially when it comes to finances.
The good news is that you are not alone in this struggle. The independent workforce grew to record numbers in 2021, reaching 51 million Americans, (1) and it’s projected to continue growing in the years to come. (2)
Given these statistics and the changing economy, it’s more important than ever to stay on top of the challenges facing independent contractors and make sure you have a solid financial plan. So what are the top 3 financial planning challenges for independent contractors and what can you do to overcome them? Read our guide to find out more.
Perhaps the biggest financial challenge for independent contractors is planning and saving for retirement. Since you are not eligible for the traditional retirement benefits W-2 employees receive, it’s crucial to take an active role in creating and sticking to a retirement plan. As a self-employed individual, there are several steps you should take to get your retirement plan in order.
What’s Your Retirement Number?
The first step is to calculate how much money you will need to retire comfortably. Fortunately, there are several online calculators, including this one from NerdWallet, that can help you determine how much money you will need in retirement.
The amount needed for a comfortable retirement will vary for each person and depend on a number of factors, including your current level of income and what you want to do in retirement. Perhaps you want to downsize your family home and travel more. Or maybe you plan on retiring in a warmer climate where the cost of living is higher. These factors all contribute to what your personal retirement number will be, but as a general rule, you will need at least 80% of your pre-retirement income to live comfortably. (3)
Which Retirement Plan Works Best for You?
Next, you will have to pick a retirement plan that makes sense for you. There are several different options available to self-employed individuals, including:
- Solo 401(k): This retirement account closely resembles a traditional 401(k) and allows you to contribute up to $61,000 (or $67,500 for those who are age 50 or older) to the plan pre-tax. You can only add employees to this plan if they are spouses of the owners. (4)
- Cash balance plans: These retirement plans are helpful for independent contractors who are advanced in their careers and may not have much saved toward retirement because they allow for higher contribution limits that increase with age. Self-employed people between the ages of 60 and 65 can contribute significantly more to their cash balance plans than younger plan participants.
- IRAs: Traditional or Roth IRAs are also great options for independent contractors. With a Roth IRA, you contribute after-tax dollars and your investment grows tax-free. With a traditional IRA, you can contribute either pre-tax or after-tax dollars to the account and the investment grows tax-deferred. Withdrawals are then taxed as income after the age of 59½. Another IRA that is ideal for self-employed individuals is the simplified employee pension (SEP) plan. The SEP-IRA offers tax breaks for self-employed individuals and business owners, but it requires proportional contributions for each eligible employee if you contribute for yourself.
Once you have determined how much you need for retirement and which plan works best for you, consistent contributions and periodic monitoring are the next steps to ensure your retirement plan stays on track for the future.
Risk management is another important financial planning consideration for independent contractors with a few key categories to keep in mind.
Since health, life, and disability insurance policies are commonly obtained through employer benefit packages, it is essential that independent contractors and other self-employed individuals take steps to find insurance policies to protect themselves. Failing to plan ahead can lead to catastrophic consequences down the line. Finding affordable coverage can be challenging, but it’s always better to err on the side of safety.
Diversification is another aspect of risk management not to be overlooked. This applies to both your retirement investments and your business investments. As a self-employed individual, it can be tempting to reinvest all of your income back into your business. While that is a commendable goal, it’s important to diversify your investments and ensure that not too much of your personal wealth is tied to your business. This helps reduce your overall exposure to risk.
Lastly, independent contractors should prioritize building a sufficient emergency fund as part of their financial planning strategy. A good rule of thumb is to set aside enough to cover 3-6 months of necessary living expenses, including mortgage or rent, utilities, groceries, transportation, etc. If you have variable income, or your household only has one source of income, consider saving closer to 12 months of expenses.
However much you save, be sure this money is held in a highly liquid account. It needs to be readily available and easily accessible, but it should also be in an account that offers a competitive interest rate so you don’t lose out on potential growth.
One of the biggest financial challenges for independent contractors is navigating and minimizing tax liability. Since income tax is not automatically withheld as it is for W-2 employees, self-employed individuals must keep track of, save, and pay their income taxes on their own. Here are some tips to help you manage your taxes as an independent contractor.
1. Pay Estimated Quarterly Taxes
Income taxes must be paid as you earn or receive your income during the year, either through withholding by your employer or by making estimated tax payments. Self-employed taxpayers are responsible for paying estimated tax payments quarterly for both income tax and self-employment taxes. The penalties and interest incurred for late or missing payments or underreporting your income are costly and entirely preventable with an organized system for staying on schedule with quarterly payments.
2. Deduct Business Expenses
Business profit or loss is reported as additional income on your tax return and is used to calculate self-employment taxes. Therefore, the benefit of claiming all your allowable business expenses is significant.
Some common examples of business expenses include:
- Legal and professional fees
- Office expenses, including costs related to the business use of your home
- Business use of your vehicle
- Continuing professional education
- Memberships to professional organizations
Tax-deductible business expenses need to be ordinary and necessary to operate your business. Consult your tax professional for more details on qualified business expenses.
3. Save on Self-Employment Taxes
A notable difference in taxation between a self-employed professional and an employee is the FICA tax, which funds Social Security and Medicare. Paying FICA taxes is mandatory for employers and employees. Independent contractors are effectively both employer and employee, so they must pay both portions as self-employment taxes. Reducing your net earnings by deducting all allowable business expenses can result in significant savings in self-employment taxes.
4. Don’t Overlook Additional Tax Deductions
Self-employment presents an opportunity for additional tax deductions, whether you itemize deductions or not, which include:
- Self-employment taxes
- Retirement plan contributions
- Health insurance premiums
- Qualified business income
These deductions can help reduce your tax liability and offset the burden of self-employment tax.
Are You Experiencing Some of These Financial Challenges?
As an independent contractor, you have a lot on your plate. Navigating your finances can be especially complex when you don’t know where to start. That’s why it’s important to have a trusted financial advisor on your side to help support you and make sure you have a sound financial plan.
At 1on1 Financial, our goal is to exceed your expectations. We offer planning, guidance, and sophisticated investment management designed to meet your specific needs and goals. For more information on how we can help you overcome your specific financial planning challenges, call our office today at 909-981-1720 or simply click here to schedule a free 15-minute introductory phone call!
About 1on1 Financial
1on1 Financial is an independent financial advisory firm specializing in guiding working and retired professionals, executives, and business owners along the path to financial well-being. Founded in 1997, we use a team approach to help our clients accumulate wealth, generate income, preserve their life savings, and strategically plan for the distribution of their estate. With more than 50 years of combined experience in the financial services industry, we remain true to our fundamental mission: to provide personalized guidance, treatment, care, and service so our clients can gain control of their future and feel confident in their financial life.