Side gigs, freelance work, and independent contracting jobs are popular ways for people to add to their income.
The main drawback with each of these income generating methods is that no matter how much income you earn, you must report it to the Internal Revenue Service (IRS), and you must pay any applicable income and self-employment taxes.
Many first-time contractors are shocked at year’s end when they realize they could owe the IRS nearly 30 percent of their side gig earnings.
How an IRA can help
The IRA was developed during the 1970s to allow working people who were not covered by a pension fund or employer-sponsored retirement plan, such as a 401(k), to build savings for their retirement years.
A tax incentive was built into the plan, allowing contributions to reduce the individual’s taxable income up to a limit set by Congress. While many workers have a 401(k) plan available to them, for those who don’t, an IRA is still an excellent way to postpone a tax liability for any earned income that’s reportable on a 1099 form.
It’s important for independent contractors to understand there are two distinct types available to individuals – the traditional IRA and the Roth IRA – and each one defers taxes in its own way.
The traditional IRA offers a tax deduction for the year contributions are made. Earnings grow tax-deferred until retirement, when you pay taxes on disbursements. By contrast, you contribute to a Roth with post-tax dollars.
Earnings in the account grow tax-free and distributions from the account aren’t taxed when they’re taken upon retirement. A Roth also offers tax-free withdrawals for qualified events such as retirement, disability or the purchase of a first home after five years.
Setting up an IRA
IRA accounts can be opened with very little money at most financial institutions, or online with a brokerage. An individual can contribute up to $6,000 to an IRA account every year, or they can make catch up contributions of $1,000, on top of the $6,000, for a total of $7,000 if they are age 50 or over.
Contributing the maximum amount could reduce a contract employee’s taxable income significantly. However, a traditional IRA does not change a contractor’s self-employment tax liability. Self-employment tax is the contribution that is normally withheld from an employee’s paycheck to cover Medicare and Social Security, plus the share of those taxes that are normally paid by an employer.
The self-employment tax rate for the current year is 15.3 percent: 12.4 percent goes toward Social Security and 2.9 percent funds Medicare. A contractor may choose to make these payments to the IRS on a quarterly basis or to make a lump-sum payment annually after filing their 1040 form.
Working a side job, contracting, and consulting all offer the benefit of increased income as well as the emotional satisfaction of earning money from your talent. Keeping more of this income and reducing tax liability makes it even more gratifying.
Building wealth using a traditional or Roth IRA could help make a side gig pay even more.