Taxes for the Self-Employed can be Steep!

In addition to regular income tax rates business owners are responsible for an additional “self-employment” tax.

Consider that if you are married and earn $200k in 2018, your income puts you in the 24% federal tax bracket. Add self-employment taxes and you’re looking at almost 40% of your income paid in taxes – before considering state taxes. If you live in one of the US states with rates 9%+ you are likely paying almost half of your hard-earned money to the government in the form of income taxes.

But did you know there is a way to defer taxes on up to $55,000 of your income as a self-employed person or small business owner?

I’m referring to the Simplified Employee Pension Individual Retirement Account, or SEP IRA, which I’ll explain further below.

Self-Employment Tax

What’s up with this “self-employment tax” situation?

The so-called self-employment tax is actually just your contributions to Social Security (12.4%) and Medicare (2.9%). This is always paid whether you work for someone else or for yourself. But when you work for someone else your employer pays a large part of that tax for you. Since self-employed people are “their own business” they have to cover both the employee and employer parts of these taxes.

What is a SEP-IRA?

A SEP IRA functions essentially like a regular IRA. You open an account type of SEP IRA, make your allowed contributions, and decide how to allocate the funds.

The easy part is opening and funding the account; picking the appropriate investment portfolio for your needs is more complex of a decision. If you aren’t comfortable weighing the various factors and managing the account yourself you might want to speak with a fee-only financial advisor about how they can help.

RELATED:
How To Create A Triple-Tax-Free Million Dollar Retirement Plan

Contributions to a SEP-IRA

If you are self-employed, or a small business owner with less than 100 employees, you are likely eligible to make contributions to a SEP-IRA.

If you work for someone else, THEY would need to establish the SEP-IRA and make contributions for you. That would be an uncommon arrangement – for the reasons mentioned below.

How Much Can You Contribute to a SEP-IRA?

Per IRS rules, you can contribute the lesser of $55,000 or 25% of your income to a SEP-IRA plan.

How you reach the maximum contribution (for 2018) of $55k is a common point of confusion for business owners.

To be able to contribute the maximum you need eligible earned income of $275,000.

Why?

Because the contributions are deductible from your income. If you make $275,000 you deduct the $55,000 from your income – giving you a taxable income of $220,000. Taking 25% of the $220k gives the $55k contribution amount.

When Does it Make Sense to Contribute to a SEP-IRA?

If you make less than $30,000 per year in your business, you likely won’t be able to contribute more to a SEP-IRA than you would a standard IRA. But once you start earning more, the ability to save on current year taxes justifies more consideration.

What is Your Tax Rate?

But consider this: If you are married filing jointly in 2018, and have a household income of $77,400, your federal income tax bracket is just 12%.

You’ll need to consider whether income tax rates might be higher, lower, or the same in the future.

Remember, with retirement accounts (IRA, SEP IRA, 401k, etc) you aren’t avoiding the need to pay taxes on that income. What you are doing is deferring the need to pay taxes on that income. Money put into a retirement account today is taxed when it is withdrawn in the future.

If you believe that the tax rate you’ll pay today is lower than it might be during your retirement – perhaps you should just pay the taxes now and put your savings into a standard brokerage account.

On the other hand, if you believe your tax rate will be lower in the future, deferring taxes from the current year to be paid in the future might make sense for you.

RELATED:
How To Make Sense Of Tax Brackets

A Decent-Sized SEP-IRA “Catch”

One big point to understand about SEP-IRAs: The IRS has built-in a rule to make sure employers don’t benefit from this option disproportionately to their employees.

So if you have employees you pay, you’ll need to contribute the same percentage for them as you do yourself.

To max out the benefit for yourself you might want to make the maximum 25% contribution. Just remember that it will increase your total payroll costs by 25% since each employee will get the same benefit level.

Getting Started with Your SEP-IRA

With research and a little effort, you can educate yourself on SEP and other IRA options to determine which retirement plan makes the most sense for you.

If you are a DIY investor you can then open an account with a brokerage like Fidelity, TD Ameritrade, or similar. They’ll explain which paperwork to complete and how to get the account both opened and funded. Then you just need to decide how best to invest then execute the steps for your retirement investing plan.

But, if you are like many business owners who prefer to focus on running and growing their business, letting professionals help in other areas that make sense, you might want to engage with a fiduciary financial advisor to talk about your retirement planning needs.

Do you want to talk about this or other financial planning topics? Use my online scheduler to set a time for us to chat on the phone about creating a plan to maximize your money.

The post How to Defer Taxes on up to $55k when Self-Employed appeared first on Maximize Your Money | Fee-Only Financial Planning.