Freelancers, Here's How To Save, Pay Down Debt, Retire And Splurge

This is the third in a series of articles on managing your finances as a freelancer. Read part 1, on budgeting for freelancers, part 2, on taxes for freelancers, and part 4, on ways to protect and structure your business.

If you’re a freelancer, you’re probably already well aware that you lack much of the financial apparatus that surrounds full-time employed folk: health insurance, a 401(k), automatically withheld taxes and more.

In the first two articles in this series, I covered how freelancers should tackle two of the biggest financial hurdles they face: managing an irregular income and paying their taxes themselves. Today, we’ll go over a number of other financial tips, including how to accumulate your retirement nest egg, how to handle emergencies and when to splurge.

Emergency Savings

Because the financial life of a freelancer tends to be less predictable than it is for full-time employed people, it’s imperative that you have extra savings to cover any times that you can’t work, or even to help smooth out gaps between checks. Sophia Bera, a certified financial planner and founder of Gen Y Planning, recommends that freelancers have three to six months’ of essential living expenses — housing, transportation, groceries, utilities, debt payments — in emergency savings. (Only essential living expenses are included since, presumably, during a real emergency, you wouldn’t be allocating money toward savings or spending it on going out or shopping.)

If you have more, such as a year’s worth (the emergency savings amount often recommended for freelancers), she says that that is a lot of cash to just have sitting in a bank account earning little to no interest. (If you’re in the market for a better bank account, here’s what to look for). Plus, she says, “With freelancers, you’re not at risk of job loss. In small ways you are, but because you have multiple income streams, you’re not losing 100% of your income.” If that did happen, it would likely be because of a medical emergency, so at that point, your health and disability insurance benefits would kick in.

However, if you do have a year’s worth of essential living expenses saved up, she recommends you keep six months in cash for easy access and then put any surplus into an investment account. (Read here to find out how to invest that money and how not to invest that money.) Then, if you ever had an emergency, you would have six months to sell any securities if you did need that extra savings.

If your partner has a full-time job, you may be able to stretch your savings. For instance, six months’ worth of savings if you were single could be stretched to cover nine months.

A “Curveball” Fund

Bera also recommends freelancers maintain a small savings account for small financial shocks, such as an unexpected car repair or a vet visit for your sick pet, separate from the savings you keep for true emergencies. (If you don’t already, get a savings account that allows you to sub-divide your money into separate savings goals such as travel, emergencies, taxes, curve balls, etc.) Keep $1,000-$2,000 in this curveball fund, and if you can’t fully fund it now, transfer $100-$200 a month, or however much you can afford, into it for the next several months.

Retirement

One of the biggest challenges of the freelance life is amassing a nest egg substantial enough to retire . As I went over in the budgeting article, you want to devote a significant portion of your income, such as 10% or 20%, toward retirement.

If that amount seems daunting to you, start small. Open a Roth or traditional Individual Retirement Arrangement (IRA) and contribute up to the limit, $5,500 (or $6,500 if you’re 50 or older). For many, especially those decades away from retirement, a Roth is more advantageous, as you will pay taxes on your contribution now, but you will not be taxed on any of the earnings when you withdraw the money in retirement. Also, you can withdraw your contributions at any time (not the earnings) without being penalized, because you’ve already paid taxes on them. So if need be, it can serve as a second emergency stash. (With a traditional IRA, you will get a tax break on contributions now, which could help bump you down to a lower tax bracket, but you’ll pay taxes on the withdrawals. If you expect to be in a lower tax bracket in retirement, then the traditional IRA may be more appealing to you.)

While many people would consider the Roth more favorable, it is subject to income limits. If you file taxes as single and your modified adjusted gross income (MAGI) is $129,000 or more, you are ineligible to contribute to a Roth. If it's less than $114,000, you can contribute the full $5,500, while those with a MAGI in between can contribute but not the full $5,500 (or $6,500). For those married filing jointly, if you have a MAGI of $191,000 or more, you are ineligible, and those with MAGI below $181,000 can contribute the full amount. If your total MAGI is in between, you can contribute a reduced amount.

If you have more money to contribute to retirement than $5,500 (remember — 15% or 20% of your income is the ultimate goal), then you’ll want to save more in another retirement vehicle, such as a Simplified Employee Pension Plan (SEP IRA) or solo 401(k) (also known as solo-k or one-participant 401(k)). You can set up a SEP IRA on your own at any brokerage firm. Contributions are limited to the lesser of either 25% of your total compensation or $52,000 for the tax year 2014 and are pre-tax, offering you a tax break now. So, if you do it in conjunction with a Roth IRA, then you’ll pay taxes on your Roth contribution and avoid taxes on your SEP contribution.

A solo-k may require additional cost and paperwork compared to a SEP IRA, but nowadays, firms like Vanguard and Fidelity offer options for sole proprietors who want to open a solo 401(k). (The Vanguard one even offers a Roth 401(k) option, which allows you to save up to $17,500 per year in after-tax money, so you won't pay taxes on the earnings when you withdraw the money in retirement.) The advantages of a solo 401(k) are first, that it allows you to take out loans on the money, and second, that it allows you to save even more money than a SEP in two ways. First, it allows so-called "catchup contributions," which allow those 50 and older to contribute up to $23,000 a year toward retirement instead of $17,500. Second, it has a feature called profit sharing,  in which you can contribute two types of money to your account -- one is $17,5000 (or $23,000 if you're 50+) out of your wages. The other is a contribution of 25% of the profits of your business (or 20% if you're paying your taxes as a sole proprietor LLC). "This allows people to sock away a ton more money due to the profit sharing component when combined with the employee deferrals in the solo-401(k)," says Bera.

So if you’re looking to stash the most money away and may want to use the loan option, the solo 401(k) may be worth it for you despite extra paperwork. (This calculator allows you to compare how much you can contribute to a SEP vs. a solo 401(k).) Bera says that if you’re in a top tax bracket, the 401(k) can allow you to save more, but you should talk with your accountant to make sure it’s the right move for you.

Debt

If you’re paying down debt on an irregular income, keep at least one month’s worth of emergency savings  while you pay it down. Although you may feel like shoveling as much as you can toward your debt and not letting money sit in savings, once you put money toward debt, you can’t get it back . And if you have a financial emergency but no financial cushion, then you’ll end up putting it on your credit card, adding more debt onto your load — and it’ll be at a high interest rate.

If you have several debts, rank them from highest to lowest interest rate. Pay the minimums on all the debts except for the highest interest rate debt. After creating a workable budget, put as much as you can toward the highest interest rate debt every month until you’ve paid it off and then repeat the strategy for your next highest interest rate debt and so on until your debt is gone.

If you’re trying to figure out how quickly to pay down debt against the priority of saving for retirement, Bera recommends prioritizing debts with interest rates higher than 5%. “If your student loans are at 6.8%, that’s a guaranteed rate that you’re [paying] which you’re not guaranteed in the market,” she says. But if your student loans have an interest rate of 4%, then it may be worth it to put that money in the market for retirement instead of paying off your debt as quickly as you can. If all your debt is high interest rate debt, Bera still recommends you put what you can toward an IRA, preferably maxing out your contribution if you can. “Just getting $100 or $200 a month started to that Roth IRA is really important, because then it’s easier increase it by $50 and then the next year another $50,” she says. “So it’s a good habit to get into.”

When To Splurge

Finally, many freelancers live with enough anxiety about paying the bills or saving for retirement that some of them struggle with the question of when to splurge and when to save.

Create a budget that has your “splurges” built in so you never feel guilty  for what you might otherwise consider a splurge, says Bera. “Travel is important for a lot of people. It’s a value or financial priority, so you have to work it into your monthly budget. It can’t just be, ‘Oh, I’m going to go to Vegas with the girls next month and it’s $1,000!’ You need to be saving a couple hundred dollars each month so you can go on those trips if that’s important to you, and then it’s not a splurge. It’s a planned expense.” So hopefully now that you know how to budget on an irregular income, and now that you know you won't get a surprise tax bill, you can leave room for all the fun stuff.

Check out these other stories for freelancers:

• Freelancers, Here's How To Budget Your Money
• Freelancers, Here's How To Do Your Taxes
• Freelancers, Here's How To Protect And Structure Your Business
• Freelancers, Here's How To Set Your Rates
• Freelancers, Here's How To Negotiate Raises With Clients
• Freelancers, Here's How To Protect Your Personal Assets From Liability
• Freelancers, Here's How To Protect Your Business Assets From Liability
• From Full-Time To Freelance: How To Make The Leap
• How a Freelancer Manages Her Time, Money, To-Do List And Despair
• The 50 Best Cities For Freelancers
• Freelancers, Here's Why You Need A Tribe To Succeed

Update 10:10am, July 21, 2014: The original version of this article stated that a solo 401(k) requires a plan administrator. It has been updated to reflect that a number of brokerage firms, including Vanguard and Fidelity, are making it easier to set up your own solo 401(k), and to state the different types of contributions one can make to a solo 401(k).