Tax Deductions are a much chased around topic all year round, and why should it not be! As a self-employed individual you work hard taking all the business risk only to realize that you have to pay a large portion of that in taxes.
In this article, we try to focus on tax deductions for self-employed individuals. The basic question first:
Do self-employed individuals have to pay taxes?
Yes, self-employed individuals and business owners have to pay taxes just like any other salaried employees. They typically have to pay income tax as well as the self-employment tax (SE tax), also known as FICA tax (Federal Insurance Contributions tax or payroll tax (in case of wage earners).
However, self-employed individuals have a greater control over their tax rate owing to a multitude of factors. A prominent factor is the way in which the business is incorporated and the tax election made. For example, a sole-prop and a partnership allow for pass-through income and avoid double taxation unlike corporations. The decision to incorporate as a particular type of entity has huge ramifications in terms of tax rates and the individual liability. It is advisable to spend much time on making this decision and consider an expert lawyers opinion in this regards. You can read the basics about business structures on the IRS website.
What is the self-employment tax rate?
Per the latest tax rates available on the IRS website, the tax rate for 2017 will be as follows:
Social Security: 12.4% on your first $127,200 of earnings
Medicare: 2.9% on all of your earnings.
Total FICA: 15.3% maximum
Since you are self-employed, you pay the entire tax and can deduct half of this on your tax returns as an adjustment.
What business expenses can I deduct?
The IRS defines deductible expense as an expense that is both ordinary and necessary. An ordinary expense is one which is common in your line of business while a necessary expense is one which is helpful and appropriate to run the business.
Typical Business expense are:
- Cost of goods sold
- Capital expenses
- Office expense
- Business Interest expense
- Federal, state, local, and foreign (in some cases) attributable to your business
- Deductible insurance premiums
- Business bad debts
- Pension expense
Which is the largest deduction for a self employed person?
The answer could vary depending on your business. If your business produces and sells a product, the largest expense would be the cost of goods sold. However, if you are a management consultant, the largest expense will probably be the taxes that you pay.
The largest non-business expense could be the amount you deduct for your pension plan if you select the right pension plan.
Are pension contributions tax deductible?
Yes, most of the pension contributions made to a 401(k), profit sharing, SEP IRA, and defined benefit plan will be tax deductible.
Which is the best pension plan for self employed person?
Typically, the answer will depend up on how much free cash flow you have to put aside in the pension plan. These are the options available:
Low Cash Flow: In this situation you can opt for the solo/individual 401(k) plan. People below 50 can make contributions of up to $18,000 and those above the age of 50 can make additional $6,000 contribution adding to a total of $24,000. These limits are adjusted annually by the IRS based on the cost of living increases.
Medium Cash Flow: Regardless of the size of the business, profit sharing plan is a good plan for a business with medium cash flow or inconsistent cash flow. It allows clients to contribute up to $54,000 annually and provides flexibility in choosing the amount of contributions in any given year. This plan can be beneficial if the company employs the spouse as well and contributions can be made for the spouse, thereby increasing the total amount of contributions.
Large Cash Flow: With a high cash flow, you can always go for a single life Defined Benefit Plan. a defined benefit plan is capable of generating a deduction of up to $200,000 and higher in some scenarios, making it an ideal choice for a self employed individual looking for a large tax deduction. One of the reasons why defined benefit plans find no mention is the complexity of the plan and that it requires the certification of an enrolled actuary. This is where we come in to mask the complexity for you and provide services for drafting plan document, actuary certification, annual administration and IRS filings (Read more about us). In the article below we will demonstrate how a defined benefit plan is simple, capable of providing a large deduction and how you can get one for yourself.
A defined benefit plan promises a certain monthly benefit to the plan participants after retirement. An actuarial valuation needs to be performed to estimate mortality rates of participants and the amount of money required to fund their retirements.
If you are a self employed individual, this is where the traditional definition ends, and the magic begins! Assuming a scenario with no employees, you are the owner of the company sponsoring the plan and the only participant as well. If you have employees you might want to read about a floor offset defined benefit plan). This effectively means you are having your company contribute for you, which makes the defined benefit plan very similar to a profit sharing plan. The major difference is that the IRS limits contributions to a profit sharing plan each year. However, the limitations on a defined benefit plan are determined by the plan design and are typically much higher. A self employed individual who has had a net income of over $200,000 in the past can contribute between $100,000 and $250,000 each year and claim a deduction on the income tax returns for this amount. (If you have employees and are looking to contribute an amount around $50,000 you might want to read about new comparability profit sharing plan here)
Instead of limiting the annual contributions the IRS limits the total amount of money that one can accumulate in the defined benefit plan at retirement. This amount is determined on the participant’s past compensation history, age, and the plan formula. The plan formula is arrived at after a consultation between the actuary and the client so that the plan provides enough flexibility regarding contribution amounts. Another thing the IRS limits is that the annual benefit after retirement cannot be more than $210,000 or 100% of the participant’s income. When we design the plan for you, we take all these limitations into consideration and tell you a minimum required contribution and the maximum permitted contribution. In any given year, the minimum required contribution can be reduced if your business experiences lesser cash flow.
You can use our defined benefit calculator to estimate the amount of contributions in the first year.
What is the deadline to make pension contributions for self employed?
A contribution to the 401(k) has to be made before the end of the year. Contributions to the profit sharing and defined benefit plans can be made after a financial year ends. However, it has to be done before the tax returns are filed or until 9.5 months after the close of the plan year, whichever is earlier.
Of course, contributions can be deposited in installments.
Can self employed people not contribute to a pension plan in a particular year?
Yes! A contribution can be skipped in a particular year if you have a pension plan and are having a tough year in your business. For a 401(k) or a profit sharing plan, this is a no brainer.
An issue of a minimum required funding would only arise if you have a defined benefit plan. In that case, you will need to work with your actuary in order to freeze the accruals for that particular year. It is advisable to talk to your actuary about the funding needs for the defined benefit plan early in the year. The performance of the plan assets in the past year will have an impact on the minimum required contributions in the defined benefit plan. So a decent estimate of the contributions for a particular year will be available early in the year.
If you are convinced that a defined benefit plan is an appropriate tax saving instrument for a self employed individual like you, feel free to reach out to us.