Self-Employed Tax Deductions

The IRS Goes For a Cuddlier, Fuzzier Image

Part I of II

Setting sail from the safe harbors of being an employee and sailing into the unknown waters of self-employment can be intimidating. One of the biggest hassles is complying with the incredible amounts of government regulation; all of the sudden you have sales tax to collect, payroll taxes to pay, estimated federal and state income taxes and a plethora of other regulations. But every thorn has its rose, as they say. Well, maybe they don’t say that but in this case it’s true. If you do it right then as a self-employed businessperson you can take advantage of a number of tax deductions that are not available to your chained-to-the-cubicle, W-2 receiving brethren.

Tax-Deferred Retirement Plans

As a newly self-employed person, one of your biggest preoccupations will be replacing your old 401(k) plan with another retirement plan, right? No more relying upon the employer for administrating a plan and providing or matching benefits, now the onus is on you! The easiest option is the plain-vanilla IRA or a Roth IRA, which can be a very sexy option for some. The problem is the relatively low limit on the amount that you can contribute, $5,000 in 2009. So, to provide the self-employed with a carrot to help them save for their retirements, your rich Uncle Sam has decided to make a plethora of other options available, including the Simple IRA, the SEP IRA, and the Solo 401(k). The right choice for you will depend upon a number of factors, including whether or not you have employees and how generous you want to be to them. Most self-employed will probably opt for an IRA, whether traditional or Roth, and, when they really start making the big bucks, change to a Solo 401(k), which gives you maximum deferment power. Bank Rate offers a great comparison of the plans available.

Health Insurance Deduction and the Health Savings Account

Unless you practice a total media blackout, in which case you wouldn’t be here reading this blog, you are aware of the fact that health care is expensive, especially in the USA, and difficult to get if you are self-employed. Well, Uncle Sam has generously offered to help out by allowing you to deduct the premiums that you pay for health insurance for you and your family on your tax return! Also, you can usually include premiums for long-term care as well. Beware! you cannot deduct premiums if you were eligible to participate in a plan subsidized by your spouse’s employer. Also, your business actually has to show a profit for the year greater than the amount of the deduction, or you get nothing. Mmm, the more you look at this one the less attractive it becomes. More detail on the health insurance deduction is available on the IRS web site.

In addition to deducting health care premiums, you may be eligible to participate in an Health Savings Account (HSA) that allows you to contribute “pre-tax” money (tax speak for money that you don’t have to pay taxes on, like any other expense of your business) into a special savings account that can be used for medical expenses not covered by your insurance or to pay the deductible before your insurance kicks in. It can’t be used to pay the insurance premiums but, as a self-employed person, you don’t care about that because you already get a deduction for health insurance. Usually your bank can help you set up your HSA and more information is available on the IRS web site.

Self-Employment Taxes and the Self-Employment Deduction

Self-employment tax is the biggest “Gotcha!” that gets the newly self-employed in trouble. Employment taxes are contributions to Social Security and Medicare that, as an employee, are paid in half by the employer and in half by the employee. They are taken right out before your net pay and most employees don’t think about them much. However, as a self-employed person, you had better think about them because all of the sudden you are responsible for 100% of them, not just the employee half, and they are due when you pay your taxes, that is, by April 15th for most of us. This means that your April 15th tax bill is going to be for both your income taxes, which you hopefully have budgeted for, and your Social Security and Medicare taxes, which too many don’t budget for.

Thankfully, your benevolent Uncle Sam has decided to extend a helping hand and gives you the self-employment tax deduction which allows you a deduction before net income of half of the amount of your employment tax. Now, most taxpayers grumble because they have to pay any self-employment tax at all and don’t really see the silver lining that is the self-employment tax deduction but they are wrong, it is a really fantastic deal for the self-employed. Why? First, because you were already paying employment taxes before, as an employee, only it wasn’t so transparent back then because half of it never made your pay stub (the half that your employer paid) and the other half was buried in with all of the gobbledygook that no-one (except nerdy accountants) ever reads anyway. Second, because the deduction doesn’t change the amount of credit you get with Social Security at all, it only allows you a tax deduction on its payment, and therefore will allow you to get the full amount as a benefit with Social Security for when you reach the retirement age. Ergo, you’re paying in, let’s say $1,000, in self-employment taxes and getting $500 back as a tax deduction before net income. If you are in the 25% tax bracket that’s like getting $125 bucks back, right? But you get the full $1,000 as a credit toward your Social Security benefits! Doesn’t that just make you ecstatic?! No? Well I love saving $125 bucks! Play around with Self-Employment taxes and figure out what you owe here at Dinky Town.

Note: this is Part One of a two-part series

As the WebCPA and the author of WebBizFinance.com, my job is to help you have more time and more money!

Tyler

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