Freelancers face a number of challenges that retirement savers who work for a company do not. For starters, they don’t have access to employer-sponsored retirement plans. They also are on the hook for self-employment taxes, equal to 15.3% in 2021, which can hamper the flexibility to save.
These challenges are tough for any freelancer, but they can be particularly onerous for freelancers who are part of the FIRE, or financial independence/retire early, movement. Some wonder, then, whether changing their business structure would offer tax advantages that can help them boost their savings.
Specifically, does it make sense to organize your freelance business as a single-member limited liability company? The answer: It depends.
“There’s no tax advantage in simply being a single-member LLC over a sole proprietor,” says Brian Thompson, a tax attorney and financial planner in Chicago. That said, an LLC that elects to be an S corporation can save money on self-employment taxes, and self-employed workers have access to tax-advantaged retirement accounts every FIRE freelancer should know about.
The benefits of becoming an S-Corp: As a freelancer, you are a sole proprietor by default. As such, there is no legal or financial separation between you the person and you the business entity. The money you earn from your services is all personal income and will be taxed as such. And lawsuits targeting your business can put your personal assets in jeopardy.
When you organize as a single-member LLC, your business income is taxed as personal income, just as under a sole proprietorship. However, you separate your personal assets from your business assets, limiting your potential liability and providing some protection for your savings should your business be sued. This separation will hold up in court only if you keep your business and personal finances separate in practice.
Potential tax savings come into play if, as a single-member LLC, you elect to be taxed as an S-Corporation. This tax designation allows you to divide the money you make from your freelance business into two categories: salary, which you earn as the sole employee; and distributions, which you collect as the sole shareholder. You pay the 15.3% self-employment tax only on salary—but that doesn’t mean you can pay yourself a tiny salary to avoid taxes. “You need to pay yourself a ‘reasonable salary,’” Thompson says.
What constitutes a reasonable salary is not always clear from Internal Revenue Service rules, Thompson adds. One guideline is the 60/40 rule, which suggests you pay 60% of your business income as salary and take the remaining 40% as a distribution.
S-Corp status comes with paperwork and other requirements that some freelancers deem too burdensome, Thompson says.
Tax-advantaged plans for freelancers: While favorable tax status can certainly save money, the tax-advantaged retirement accounts available to all self-employed workers can be even more powerful. Thompson recommends that freelancers consider a solo 401(k). “You can build your nest egg a lot faster than you would if you were just contributing to an IRA or a 401(k) through an employer,” he notes.
The solo 401(k) is open to freelancers regardless of their business structure. In these accounts, you can make tax deductible contributions as both the employee and the employer, effectively increasing the 2021 contribution limit to as much as $58,000, depending on your income. And if your spouse works for you, even part time, they can open a solo 401(k) as well, further expanding your household’s saving power.
Freelancers might also consider Roth solo 401(k)s. Contributions are not tax-deductible, but they can be withdrawn without penalty at any time, providing income flexibility.
Other retirement plans available to freelancers include the SEP IRA and Simple IRA. They typically offer fewer advantages and less flexibility, but may make sense in certain circumstances—say if you plan on hiring an employee besides your spouse.
The bottom line, Thompson says, is that smart decisions about where to park your savings can have a bigger impact on your FIRE plan than whether or not you incorporate. Rather than narrowly focus on taxes, he says, “FIRE is really about ensuring you have the resources to accomplish the things you want to do.”
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