By John Benedict
As an independent contractor, you fall under the category of self-employment, which sets your career apart from those who receive W-2 income. While the freedom and perks of being your own boss has its advantages, being an independent contractor comes with its own set of financial obstacles.
But rest assured because you are not alone in dealing with these challenges. In 2023, the independent workforce reached record numbers, with 58 million Americans joining its ranks, and this trend is expected to continue its upward trajectory.
Given this fact, it’s more vital now than ever for independent contractors and other self-employed professionals to stay informed about the most effective strategies for constructing their portfolios in order to optimize their financial well-being. In this article, we explore the top 3 financial planning challenges experienced by independent contractors and offer insights on how to overcome them.
Perhaps the biggest financial challenge for independent contractors is planning and saving for retirement. Since you are not eligible for the traditional retirement benefits that W-2 employees receive, it’s crucial that you 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.
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 $66,000 (or $73,500 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.
- 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.
Work With a Trusted Professional
If the idea of managing your finances as an independent contractor feels daunting, rest easy. At J2 Capital Management, our goal is to help you craft a customized plan that caters to your specific financial needs, placing a strong emphasis on your long-term goals while keeping your plan flexible as your circumstances evolve.
Today we provided a snapshot of key financial planning considerations for independent contractors; for a deeper understanding of how these factors align with your financial strategy, please get in touch to schedule a meeting online or reach out to us at email@example.com or 248-641-4444.
About John Benedict
John Benedict is CEO, investment advisor representative, and portfolio manager at J2 Capital Management, a boutique financial advisory firm specializing in in-house custom financial planning, tax, estate, and investment management. With over 20 years of experience, John is passionate about helping clients navigate uncertain markets, reduce risk, and plan for a sound future. John combined his talents and passion in statistics and technical analysis to create J2’s tactical strategies, managing them since the beginning of the organization. He is known for being a visionary and continually looking for ways to improve J2’s services and strategies to better serve his clients. John graduated from Central Michigan University with a degree in business administration and finance, and his thoughts on markets and technical analysis have appeared in The Wall Street Journal, Investment News, and on Moneyshow.com. He was also a contributor to the book The StockTwits Edge: 40 Actionable Trade Set-Ups from Real Market Pros.
When he’s not working, you can find John boating or participating in water sports and spending time with his wife, Janine, and his three children, Jack, Alexis, and Saraphina. To learn more about John, connect with him on LinkedIn. You can also register for his latest webinar on What Makes J2 Capital Management Different From Other Financial Advisors.