Thursday, May 28, 2015

1099 Income - A Potential Retirement Savior

You have likely seen reports about how financially unprepared the average American is for retirement. According to the Federal Reserve, the median balance of retirement accounts held by Americans who are saving for retirement totals less than $60,000. The same report states that the median value of retirement accounts for families whose head of the household is between ages 55-64 is $103,200, while the median value of retirement accounts for families whose head of the household is between ages 65-74 is $148,900.

Clearly, these median account balances are insufficient to fund a retirement. A 65-year old with a retirement account balance of $148,900 who is withdrawing 4% of that balance each year (a common withdrawal rate) is receiving less than $500 per month. Although most individuals will have Social Security and perhaps a pension to supplement this retirement income, it is likely that many people will need to significantly scale back their standard of living during retirement in order to not outlive their retirement savings.

So what is the best way to give your retirement accounts a boost? Obviously, the basic answer is to save more. However, this is easier said than done for most people.  First, many people simply don’t have money left to save after subtracting expenses from their income. Second, even those who have extra funds face a restriction on the amount of tax-advantaged money that can be saved each year because retirement accounts have contribution limits: individuals under the age of 50 can only contribute $5,500 per year into traditional or Roth IRA accounts (individuals over age 50 can save an additional $1,000). Similarly, employees under the age of 50 who have access to an employer-sponsored 401k plan can only contribute $18,000 to the plan each year (individuals over age 50 can contribute an additional $6,000). These 401k contribution amounts are in addition to any deposits made by the employer.

Due to both a lack of income and retirement account contribution limits, it may be hard for some people who feel behind on their retirement savings to get caught up. However, allow me to suggest a potential way to bump up your retirement account balances – 1099 income.

Income from self-employment is classified as 1099 income. Self-employment income can come from sources ranging from consulting, to providing a service in which you possess a unique skill, to driving for Uber. It is frequently a perfect second source of income in that by definition, you can earn 1099 income on your own schedule. While an employer can require you to work at a certain time, you can literally earn 1099 income whenever your schedule allows. Of course, assuming your expenses remain constant, a second source of income would create more money that can be saved for retirement.

More importantly, 1099 income allows you access to unique retirement plans such as a Solo 401k or a SEP (simplified employee pension). These retirement plans enable you to save a tremendous amount in tax-advantaged retirement accounts – up to $53,000 in 2015! This is incredibly useful, particularly to individuals who don’t have access to employer-sponsored retirement plans like a 401k or 403b. In these instances, the amount that can be saved in tax-advantaged retirement accounts suddenly increases from $5,500 (the IRA contribution limit) to as much as $53,000 per year.

A Solo 401k enables the person who generated the 1099 income to make a tax-deferred contribution to the retirement account as both an employee and an employer. Contributions as the employee are limited to the lesser of the amount of income earned by the individual or $18,000, the 401k contribution limit ($24,000 for people over age 50). Additionally, as the employer, the individual can contribute up to 25% of the employee’s compensation. Combined, the contributions as both the employee and the employer can’t exceed $53,000 in 2015.

For example, consider a 55 year-old that can’t afford to save any of the income from his primary job but also generates an additional $30,000 of 1099 income. This individual would be able to contribute $24,000 of this income to a Solo 401k as the employee, and would be able to contribute the additional $6,000 to the plan as the employer (as $6,000 is less than 25% of $30,000, the employee’s compensation). Consequently, this individual would be able to save the entire $30,000 earned for retirement in a tax-deferred account, which would prevent their tax bill for the year from increasing.

It should be noted that the individual would still need to pay the payroll tax, which consists of both the Social Security and the Medicare tax. Further, as both the employer and the employee, the individual would have to pay the entire amount of both taxes, which totals 15.3%. However, the point remains the same – the additional 1099 income created a significant amount of extra money, of which an unusually high percentage could be saved in tax-advantaged retirement accounts.

For those not looking to save such a large additional amount, a SEP may be sufficient. While a SEP doesn’t allow you to make the $18,000 employee contribution (or $24,000 for workers over age 50), you still have the ability to make the employer contribution of 25% of income. A SEP is slightly more simple to create and maintain than a Solo 401k. Additionally, for individuals who already have the ability to contribute to a primary employer’s 401k plan, a SEP may be a better choice. Such an individual could make the full employee contribution of $18,000 ($24,000 for individuals over 50) to the primary employer’s retirement plan, but still make the 25% of 1099 income contribution to their private SEP plan.

If you are looking to ramp up your savings rate and increase your retirement account balances, creating 1099 income may be an ideal solution. Of course, most people would welcome the second source of income, but the fact that the income can be generated on your own schedule makes this option particularly viable. Further, the access that 1099 income grants to unique retirement plans like a Solo 401k or a SEP, which have unusually high retirement account contributions limits, makes this type of income particularly appealing.

No comments: