You can deduct one-half of the amount of self-employment tax that you paid as an adjustment to income on Form 1040. This means that you can take the deduction even if you don’t itemize deductions.
If you’re self-employed, you can deduct 100% of the cost of health insurance for you, your spouse, and any dependents as an adjustment to income on Form 1040. However, your deduction can’t exceed the net income from your business minus the adjustment for one-half of the self-employment tax that you paid and the adjustment for your retirement plan contributions. You also can’t take a deduction for any month that you’re eligible to participate in a health plan offered by either your or your spouse’s employer.
You can deduct the amounts that you contribute to a retirement plan, such as a Simplified Employee Pension (SEP), a Savings Incentive Match Plan For Employees (SIMPLE), or other qualified plan as an adjustment to income on Form 1040.
Simplified employee pensions (SEPs) provide the simplest way of setting up retirement benefits for yourself. You can set up an IRA designated as a SEP at any institution of your choice. You can deduct the amounts that you contribute on your tax return.
Setting Up the Plan
You must have a written agreement that conforms to IRS requirements. The IRS provides a model form, Form 5305-SEP, that you can use if you want. This agreement must include a written allocation formula for contributions to be made. IRS approval isn’t required but you must maintain the original agreement in your records. You can start the plan at any time up to the due date of your return (including extensions).
Contributions
You can make contributions to a SEP at any time up to the due date of your return (including extensions). The amount of allowable contributions must be determined according to the allocation formula set forth in the plan. The contribution amount can be no more than the lesser of:
$45,000
20% of your compensation up to a maximum of $225,000 in 2007
Compensation greater than $225,000 for 2007 can’t be used for contribution purposes. Compensation for the purpose of your SEP contribution is your net self-employment income minus the deduction for one-half of the self-employment tax that you paid.
Example: You’re a sole proprietor, and your net self-employment income is $38,000. The contribution rate set in your SEP plan is 4%. The deduction for contributions to your own SEP-IRA and your net self-employment income depend upon each other. For this reason, you determine the deduction for contributions to your own SEP-IRA indirectly by reducing the contribution rate called for in your plan. The reduced contribution rate for your SEP-IRA is determined by dividing the contribution rate for your plan (4%) by one plus your plan rate (1 + 4% = 1.04). In this case, your contribution rate is 3.8462% (4 / 1.04 = 3.8462%). After subtracting the deduction for one-half of the self-employment tax that you paid ($2,684.62), your compensation for SEP purposes is $35,315 ($38,000 - $2,684.62). Your contribution to your SEP-IRA is $1,358 ($35,315 * 3.8462%).
Deductions
Any contributions that you make to a SEP-IRA for your employees are fully deductible on Schedule C. You deduct the amounts that you contribute to your own SEP-IRA, up to the maximum allowed, on Form 1040.
A Savings Incentive Match Plan for Employees (SIMPLE) is a more complicated type of retirement plan. You can set up a SIMPLE plan if you have no more than 100 employees who have at least $5,000 in compensation for the preceding year.
A SIMPLE can be set up as an IRA or a 401(k). If the plan is set up as an IRA, a separate account is set up at a financial institution. A SIMPLE set up as a 401(k) is considered a qualified plan with complex rules. For more information, see IRS Publication 560, Retirement Plans for the Self Employed.
Setting Up the Plan
You must have a written agreement that conforms to IRS requirements. The IRS has model forms available for your use. Use Form 5305-SIMPLE if all the accounts will be maintained at the same institution. As with the SEP plan, you don’t need to file the form with the IRS. The form must be completed, signed, and maintained in your records.
A SIMPLE plan must be set up between January 1 and October 1 of the year in which the plan becomes effective. If a new business is formed after October 1, a plan must be developed as soon as possible to become effective for that year.
Contributions
The maximum contribution to a SIMPLE is $10,500 for 2007. You must match at least 1% and up to 3% of the employee’s compensation. The matching amount paid by you applies to your contributions as well.
Example: Your net income from your contracting business is $35,000, and you choose to contribute 10% of your earnings to your SIMPLE ($3,500). In addition, your plan calls for employer-matching of 3%. This means that your matching contribution will be $1,050:
$35,000 (Net income) X .03 (3%) = $1,050
Matching contributions must be made by your tax return’s due date (including extensions).
Qualified plans are the most complicated types of retirement plans available to you. There are two types of plans:
Defined-contribution plans. There are two types of plans classified as defined-contribution plans:
Profit-sharing plans. A profit-sharing plan is based upon business profits, which are based on formulas or systematic and substantial contributions.
Money purchase pension plans. A money purchase pension plan allows for contributions based on a percentage of compensation without regard to profits.
Defined-benefit plans. A defined-benefit plan is any plan that’s not a defined-contribution plan. Amounts contributed are based on amounts needed to produce a certain amount of benefit to participants.
Most plans that are set up by small businesses are defined-contribution plans. A defined-contribution plan requires an individual account to be set up for each participant.
Setting Up the Plan
A written plan must be produced. Most follow a standard form approved by the IRS. However, the IRS doesn’t provide its own form for this type of plan. Many banks, trade or professional organizations, insurance companies, and mutual fund companies have a standard form available for use. A plan may be designed to suit individual needs, but it requires IRS approval. Included in the plan must be an arrangement that establishes how the plan will be used to build assets.
Contributions and Deductions
The amount of contributions and deductions that may be made vary by the type of plan. Contributions to a defined-benefit plan may be the lesser of:
$180,000
100% of a participant’s average compensation for his or her highest three consecutive years of employment
Contributions to a defined-contribution plan may be the lesser of:
$45,000
100% of actual compensation
A plan administrator or employer who maintains a qualified plan or a SIMPLE 401(k) must file Form 5500 or Form 5500EZ with the IRS each year. SEPs and SIMPLEs set up as IRAs are not required to file these forms if the plans were established using the IRS-provided forms.