Those who are self-employed enjoy lots of intangible perks by being their own bosses, but they also encounter uniquely vexing financial challenges. A classic example of what I mean is often experienced by real estate agents and loan brokers who work on commissions and operate as independent contractors. Ironically, because they are self-employed, it can be especially hard for them to qualify for a mortgage loan to buy a home.
Some challenges self-employed individuals face is a lack of a retirement fund and affordable health insurance. Tens of millions of self-employed parents couldn’t afford to provide health insurance for themselves or their families until the Affordable Care Act came along. These are the types of things employees in the corporate sector typically take for granted.
The ranks of the self-employed are growing every year, too, as companies look for clever ways to trim overhead. By hiring contracted professionals, companies are often able to save money and only pay workers for the specific hours they are needed instead of keeping them on permanent payrolls.
Here are three tips to help this growing industry of self-employed individuals.
Use a Mortgage Broker
Self-employed home buyers used to rely heavily on low-documentation and no-documentation mortgages, but after the housing crisis of 2008 those types of deals are non-existent.
The difficulty is that self-employed individuals usually write off as many expenses as possible to offset their taxable income. You may make $100,000 a year, but show virtually no net income on your tax forms, which makes lenders reluctant to approve your mortgage. Lenders also worry that your income may fluctuate since you work for yourself, which they perceive as a risk factor. For these reasons you should be ready to provide two years’ worth of tax returns in addition to other documents such as recent bank statements to verify your income.
If you are buying a home, it is a good idea to use a mortgage broker instead of just shopping around for a loan independently at various banks. Find a broker experienced with making loans for the self-employed. They’ll be able to package the loan in a way that is most favorable to you while also having the ability to reach out to a diverse network of lenders who are eager to loan to you. Those who have moderate income and don’t live in a heavily populated part of the USA can also apply for a USDA guaranteed loan. Self-employment is not an obstacle for those mortgages, and you can buy a home with little or no money down, low closing costs, and a very competitive interest rate.
Open a ROTH or SEP Account
If you are self-employed you will need to create your own retirement savings account and a Simplified Employee Pension (SEP) Individual Retirement Account is one great option. Contributions into your SEP IRA are tax-free until you withdraw them in retirement, which is usually when most Americans enjoy the perks of being in a lower tax bracket. The contribution limits for SEP IRAs are higher than they are with many IRA plans, which is another advantage for those with a rather high income.
Meanwhile if you want to lower your taxable income you can pump more cash into your SEP IRA to lower your tax base and pay less to Uncle Sam for that particular year. For 2014 you are allowed to contribute up to 25% of your total income or 20% of your adjusted income, up to a maximum annual contribution of $52,000. Contributions can be done at the last minute, too. Additionally, you cannot withdraw funds without a 10% penalty until you reach age 59 and a half, but you can grow your wealth by investing your SEP IRA funds in mutual funds, stocks, bonds, or real estate investments.
Calculate Social Security Differently
When it comes to retirement, you also need to think about when to start withdrawing your Social Security payments. Most financial advisors emphasize waiting as long as possible, because the longer you wait the more the money will grow (about 8% a year). That yield is nearly impossible to match through other investments in today’s sluggish investment climate. Your monthly payments may be $700 if you take your benefits starting at age 62, for example, whereas waiting until the full retirement age of 65 or 66 will put your checks closer to $1,100 a month. Wait until the latest year which is age 70 and the monthly checks will be around $1,500.
If you are self-employed you probably pay about 15.4% a year toward Social Security out of your own pocket. Traditional employees only pay half that much. Once you quit working, retire, and start withdrawing your benefits, you won’t have to pay that tax any longer -keep that in mind as you approach retirement. Consider how much income you’ll be able to keep after taxes in order to get a more accurate picture of the bottom line. Consider, for example, someone with a lower income can expect to collect a Social Security check of $500 a month by taking early withdrawals at age 62. If they wait until age 65 or 66 though, they will likely reap payments of around $700 a month. They won’t have to pay Social Security tax if they start taking payments early, though, which puts that 15.4% back into their pocket. If they are paying $3,000 a year in Social Security taxes that is $250 a month. For example, if they stop working and take early Social Security they receive $500 a month (using our example) plus $250 a month in tax savings. That’s $750 a month without waiting until age 65.
Everyone’s situation is unique, but the advice here is that if you are self-employed you need to crunch the numbers and also consider the implications of paying versus not paying additional Social Security tax. Keep in mind that if you continue working while drawing social security you will be liable for Social Security taxes, which can skew the equation in another direction.