To ease the pain of the 15.3% self-employment tax, you get an income tax deduction for 50% of the tax you pay. Suppose you have $50,000 of self-employment income. The self-employment tax would be $7,065 and that generates a $3,533 income tax deduction. In the 28% bracket, that saves you almost $1,000. You claim the deduction as an adjustment to income on Form 1040. This means you get the benefit whether or not you itemize deductions. TaxCut automatically enters the write-off on the appropriate line after figuring your self-employment tax on Schedule SE.
See Self-Employment Tax (Schedule SE) for more information.
Self-employed taxpayers can now deduct 100% of the cost of health insurance for themselves and their families as an adjustment to income. That's extremely valuable because, otherwise, the cost would simply be added to other medical expenses and written off as an itemized deduction only to the extent that total medical costs exceed 7.5% of adjusted gross income.
Here's how it works: If you qualify and paid $3,000 for a family health policy, you could write off the full $3,000 without worrying about the 7.5% floor. That guarantees a $840 tax savings if you're in the 28% bracket.
Your medical-insurance deduction under this rule can't exceed the net income of your business. Also, this deduction is out of bounds if you are eligible for health coverage offered by your employer—if you had a job as well as your own business—or by your spouse's employer.
Money you contribute to a Keogh is deductible, and earnings inside the account grow without interruption from the IRS until you withdraw the money, presumably in retirement. In these ways, Keoghs are like IRAs, but there are many differences and most benefit the taxpayer.
For example, rather than an annual $4,000 limit on IRA contributions, the most popular Keogh plans permit deposits of up to $44,000 in 2006. Payouts are taxable, but there are special methods to ease the tax bite. Also, Keogh plans are not affected by the restrictions on regular IRA deductions. Deductions aren't restricted by how high your income is or whether you or your spouse is covered by another retirement plan.
If you have employees, establishing a Keogh plan requires that you make contributions for them as well as yourself. The discussion here, however, focuses on taxpayers who don't have employees and who therefore are the only participants in the retirement plan.
To qualify for a Keogh plan, you must have self-employment income — money you earn working for yourself rather than someone else. Investment income doesn't count.
This is the most flexible plan and lets you decide each year how much to contribute. You can even forgo deposits altogether if you decide to skip a year. The maximum annual contribution to a profit-sharing plan for 2005 is 20% of net self-employment income, up to a top pay in of $42,000.
You may read that you can contribute up to 25% of your self-employment income to a Keogh. That's true, but misleading because of the way the IRS defines income here. For this purpose, net income is income reduced by the Keogh contribution itself. Let's say you have $50,000 of self-employment income. Twenty five percent of that is $12,500. But, $12,500 is 33.3% of $37,500 — your net income after subtracting the $12,500 deduction. But, if you use the 20% factor — 20% of $50,000 is $10,000 and $10,000 is 25% of the remaining $50,000 — you get the right number. Whew.
You think that's complicated? Well, things get worse because taxpayers can deduct 50% of the self-employment tax they pay. That deduction also reduces "net" self-employment income for purposes of figuring the top Keogh contribution. So, to find the maximum contribution to a defined contribution Keogh, you really have to reduce self-employment income by the self-employment tax deduction and multiply the remainder by 20%.
Fortunately, the IRS has prepared a special table for calculating maximum Keogh pay-ins. It appears in IRS Publication 560, Self-Employed Retirement Plans, available at www.irs.gov. Even better: It's built into TaxCut.
The primary difference between this version of the Keogh and the profit-sharing variety, is that with a money-purchase plan, you're required to make the fixed-percentage-of-income contribution each year. If your plan calls for a 20% annual contribution, you have to deposit that much even if things are tight. Before 2002, there was a bonus for accepting this requirement, the contribution limit for money-purchase plan was higher than for profit sharing (20% versus 13.0435% of self-employment income). But now both versions have the same limit: 20% of income up to $42,000. If you set up a money-purchase plan in the past (or if you had established both kinds of plans to give you both flexibility and the maximum saving potential) you may want to switch or consolidate to a single profit-sharing plan.
This third variety is the most demanding plan, but it also offers the greatest potential tax shelter. With it, you decide how much you want to receive from the plan each year after you retire. Your contributions — up to 100% of your self-employment earnings — are based on how much you must set aside each year before retirement to build a fund sufficient to pay the desired level of benefits.
There is a restriction on how big the Keogh retirement benefit you're shooting for can be, though. In 2005, the limit is the average of your self-employment earnings during your three highest-earning years or $170,000, whichever is less.
Defined-benefit plans are particularly attractive to older taxpayers — age 50 and older, say — who want and can afford to build up a big retirement fund quickly. Because this type of plan involves complicated actuarial computations, you'll probably need a lawyer or an accountant to help you set it up and figure the required contribution each year.
You can have a Keogh plan in addition to an IRA. However, a Keogh counts as an employer provided retirement plan for purposes of the IRA deduction restrictions. Basically, if you have a Keogh plan and your adjusted gross income for 2005 is more than $60,000 on a single or head of household return or $80,000 on a joint return, you can't deduct IRA contributions.
Keogh plans are offered by the same types of sponsors that handle IRAs—banks, savings and loans, mutual funds, insurance companies and brokerage firms—and the same kinds of investments are available. Unlike trustee fees for IRAs, which are deductible only if you pass the 2%-of-AGI threshold for miscellaneous deductions, trustee fees for a Keogh plan are deductible as a business expense, assuming you pay the expense separately rather than have it deducted from the account.
As with IRAs, your Keogh contribution can be made as late as April 15 of the following year. (Keogh contributions can be made even later, in fact, if you get an extension for filing your tax return.) There is an important difference on the issue of timing, however. The Keogh plan to which the contribution is made must be set up by year-end for you to claim a deduction. Even if you're not certain exactly how much you can put in the Keogh, the plan must be established by December 31. Any contributions made as late as the filing deadline could then be deducted on your return. With an IRA, you can set up a new account as late as April 15 and still get a deduction on the return for the previous year.
Just as the tax benefits can be greater, there's more paperwork involved with a Keogh plan than with an IRA. The general rule demands that you must file an intimidating Form 5500 each year, but there's an exception for owners of small Keoghs. You don't have to file at all if your account balance is $100,000 or less. This break applies only if you qualify for the 5500EZ, which you do if your plan covers only you or only you and your spouse.
If you have more money in your account, or if you can't use the 5500EZ because your plan covers employees other than you and your spouse, you have to file a 5500 annually. And if you have a defined-benefit plan, you must also file a Form 5500 Schedule B, a complicated two-page form showing how you arrived at the required contribution. That schedule must be signed by an actuary attesting to the accuracy of the information.
One bright spot: The Keogh report for the year isn't due April 15. The deadline is generally July 31 for the previous year.
Although designed as an easy-to-administer retirement plan for small businesses, you can also open a SEP if you have self-employment income from a sideline business or free-lance work. As with a Keogh plan, if you have full-time employees, you must make contributions for them as well as for yourself. This discussion, assumes no employees are involved.
Sometimes called SEP-IRAs or Super IRAs, these plans are a hybrid between Keogh plans and traditional individual retirement accounts. You must have self-employment income to use an SEP, and for 2005, the contribution limit is 20% of self-employment income up to a top pay-in of $42,000. With a SEP you can change the percentage of income deposited in the SEP each year or skip contributions altogether.
Contributions go into a special individual retirement account at a bank, mutual fund, brokerage or other sponsor. You have the same investment and transfer options as with a regular IRA. When you set up the account, be sure the trustee knows it is a SEP instead of a garden-variety IRA. Otherwise you might run into resistance if you try to deposit more than $4,000 a year.
SEPs are covered by many of the same rules that apply to regular IRAs. Your contributions are deductible, and earnings compound tax-deferred. The 10% early-withdrawal penalty generally hits payouts before age 59 1/2 and distributions are required starting the year you reach age 70 1/2. The big differences are that you can sock much more in a SEP and you can write off SEP contributions without regard to the restriction on regular IRA deductions for high-income taxpayers who are covered by company retirement plans.
SEPs are not burdened by the annual reporting requirements that apply to Keogh plans. All you have to do is claim the deduction for your contribution. Another advantage is that, unlike the December 31 deadline for opening a Keogh plan, taxpayers who choose this plan can open the account as late as April 15 and still deduct contributions for the previous year. If you miss the deadline for opening a Keogh, you can use the SEP as a last-minute tax shelter.
Note this, too: The SEP is considered an employer-provided plan for purposes of the regular IRA-deduction restriction. If you have such a plan and your AGI for the year is over the IRA income thresholds, you won't be able to write off contributions to a regular IRA.
This is yet another way Congress encourages self-employeds to save for retirement. SIMPLE stands for "savings incentive match plans for employees" and these plans were really created by Congress as a simplified retirement plan for small companies. Only firms with fewer than 100 employees can use a SIMPLE. But the definition includes self-employed workers with no employees. Whether your business is full-time or you do freelance or consulting work on top of a full-time job, you can have a SIMPLE. And you can have one even if you have a job that offers a pension plan. But you may not have both a SIMPLE and a Keogh.
There are actually two kinds of SIMPLE plans—a SIMPLE IRA and a SIMPLE 401(k). It’s likely that the IRA version will be best for a self-employed person with no employees, so that’s what’s discussed here.
The advantage of the SIMPLE IRA is that you can stash up to $10,000 a year into the plan—even if that’s 100% of your self-employment income. The $10,000 limit is for 2005. Also, for workers age 50 and older, "catch up" contributions will boost the limit even higher. For 2005, for example, the SIMPLE limit for someone 50 and older is $12,000. (For 2006, the basic contribution limit will be unchanged, but the catch-up bonus will be $500 higher, allowing maximum contributions of $12,500.) With the 20% of income cap that applies to Keogh plans, you need net income from your business of at least $50,000 to make a $10,000 contribution. So, if your business income is under that amount—and you can afford to set aside $10,000 a year for retirement—a SIMPLE is an alluring tax shelter. (Actually, the SIMPLE can be a winner even if your business income is higher because you may be able to boost the amount contributed to the plan with an employer "match" to the plan. The match can be 2% or 3% of your income.)
Contributions to a SIMPLE IRA can be deducted on your return and earnings inside the account are tax-deferred. As with traditional IRAs, there’s usually a 10% penalty if you withdraw funds before you reach age 59 1/2 but the penalty is a whopping 25% if you pull money out before 59 1/2 if you’ve been in the plan for less than two years. Rollover and required distribution rules are basically the same as for traditional IRAs and 401(k)s.
You have until the filing deadline to make your SIMPLE contribution for the previous year, but there is a catch: The plan must have been opened by October 1 of the year for which the contribution is being made. Thus, to make a 2005 contribution, your plan must have been be opened by October 1, 2005. (An exception to the October 1 deadline if the business is started after that date.) As with Keoghs, SEPs and IRAs, SIMPLEs are offered by banks, brokerage firms and mutual funds.
Thanks to rule changes in 2002, it is now practical for self-employed workers to use an individual 401(k) plan for retirement savings. Using the 401(k) can allow you to stash a much higher percentage of your income in the plan than with a Keogh or SEP. If you can afford to do so, check out the individual 401(k). Basically, contributions are limited to $14,000 ($18,000 for those age 50 and older by the end of 2005) — assuming you have at least that much profit — plus 20% of self-employment income up to a maximum of $42,000.