Pension info every indie should know.

June --

I am from Long Island City (Queens), NY I am an Information Architect/Interaction Designer (web development) I have been independent (1099 sole proprietor) less than one year.

I am wondering if you could advise me on issues surrounding a retirement fund. I am interested in the Freelancers Insurance 401k plan. The limit for contribution is $16,500 but there is a profit sharing option which allows you to contribute as much as $49,000. How do I determine if I am eligible for profit sharing?

Daniel


Dear Daniel.

Here's a simple view of how pensions work for self-employeds:

You have a net income. Depending on your income and how much of that income you don't need for immediate living expenses [sometimes called discretionary income] you contribute money to your pension.

You can choose a pension that allows the contribution to be deducted from your income thereby reducing your current income tax. Years from now, when you withdraw the money from your pension you will pay tax on the amount withdrawn.

Or you can choose a pension that does not allow a deduction from income now. So there is no immediate tax deferral. And that means you will not have to pay tax on the money when you withdraw it years from now. These are ROTH versions of a pension account. For instance, you've probably heard of an IRA. This would be a ROTH IRA.

When you are 59 1/2 years old you may start withdrawing from your pension with no penalty. If you withdraw before age 59 1/2 you will have to pay a 10% penalty. There are some exceptions.

There are many different types of pension plans that a self-employed may have. The most flexible and the one that allows the largest contribution is a UNI-K, also know as a SOLO-K or one-person 401-k.

In 2009, if your income is high enough, you may contribute $16,500 plus 20% of your net income. This is not a requirement, this is a maximum. As long as you have a net income you may set up a UNI-K. There are additional contributions allowed if you are 50 years old or older.

To qualify for 2009, the plan must be set up before December 31, 2009. However, you have until you file your 2009 tax return to make the contribution. That could be as late as October 15, 2010.

You set up the plan at a brokerage house, for instance Raymond James or Schwab. Should cost about $ 75 or $100 per year. Be sure to use a brokerage house that allows complete flexibility in investment products. Some houses limit the investments for UNI-Ks.

There are other plans that allow for much greater contribution amounts and cost much more to set up and maintain. They are called Defined Benefit plans. I suggest them to clients who are at least 45 years old and who make a lot of money.

Here are a few other posts I've done on pensions.

Best,
June

"The Web" is not a recognized expert.

June --

Government Consultant. Indie for 3 years.

What are your thoughts on opening a SEP vs. a solo 401k. Since the SEP is limited by my net income I'd like the increased contribution limit of a solo 401k.

However, my understanding is that a solo 401k requires an indie to incorporate first?

F Rome


I so wish that F Rome and everyone else who says "my understanding is" would give me just a hint of where they get all this misinformation.

When indies send me an email I ask for some information. One of my questions is "Where do you get your tax info?"

Do you know what many of them answer? "The Web."

Well, "the Web" is not a recognized expert. Who on the Web? What on the Web?

I'd rather they tell me they got the info from Aunt Tillie. At least that's a source. A bad source but one you could put your finger on.

Anyway, F Rome has it wrong. You do not have to be a corporation to have a UNI-k, Which also goes by the names: one-person 401-k, a solo-k, an individual -k.

And a UNI-k does allow flexibility and a greater contribution than a SEP. I recommend it over a SEP.

Caveat: You may open a SEP up through tax return filing time in October for the previous year.

A UNI-k must be opened by December 31 of the year for which you will make the contribution. You do have until October of the following year to actually make the contribution.

-- June Walker

Hobby or Business? If it's fun, be careful.

Well, here I am making another exception and taking on a unique situation. But since 2009 is to be the year of change, why not? And, I do think that there is enough in Guren's situation that many of you will get something from my answers. My response is in orange.
-- June


Hello June,

My wife and I are avid travelers and, although we have settled down and each work full-time as employees at different companies, we plan to start a travel blog with the goal of making enough money to fund even more traveling.

We will file a dba and work as a partnership. A partnership is the least tax advantageous structure for a husband and wife business. For some basics on that, read these posts payroll -- spouse as employee .

1 - it seems too good to be true that we could deduct the cost of our travel and other expenses against our blogging profit and, if there are losses (and I'm sure there will be in the first few years), deduct those losses from our regular employee incomes. If the losses are great enough, it would be like the IRS paying us to travel. Or am I dreaming? Your dream may become a nightmare unless you show a true profit motive. Your goal cannot simply be to save enough in taxes to pay for your travel. That very much has the ring of a home-made tax shelter to me and I'm sure would make the same sound to the IRS.

Your profession -- travel blogger -- falls into the same genre as skiing and photography and other activities that people do for fun and so the proof that you are in it to make a profit must be stronger than for other professions such as massage therapy or IT consultant.

The IRS lists nine guidelines that will help determine whether you’re goal is to make a profit. No single item on the list settles or resolves the issue, and the list includes questions such as:

Do you carry on your work in a businesslike manner? Do you keep accurate records of income and expenses? Have you had success in carrying on similar or dissimilar activities? Have you taken a similar activity and converted it from an unprofitable to a profitable enterprise? Have you had general success in running other kinds of businesses? Did you write a business plan on how your blogging is going to make money over the next 5 or 10 years?

2 - As long as we have losses, are we forbidden from contributing to a SEP retirement plan? For a SEP, and any other pension for self-employeds, the contribution is determined by net income. That means what you are left with after deducting business expenses. A loss means no pension contribution for the sole proprietor. If your spouse is your employee, then a loss does not have that same relationship to the spouse's pension contribution.

3 - any idea of what a indie-friendly CPA should charge for an initial consultation? Between $150 and $350 per hour. Depends on the geographic location and expertise of the tax pro.

I hope you're able to help!
Thanks in advance!
Guren
St Louis, MO

A related comment: There are so many books and sites that tout self-employment as a way to pay no tax. This is a concern of mine. I'll say more about it in this month's eLetter Ways Through the Maze. If you are not already on the mailing list and would like to subscribe, you may do so here.

--June

An Indie Business Mindset Regarding Pensions

Hi June,

I'm a sole proprietor who has contributed to SEP IRAS for the past 10 years. Currently, I joined a credit union that doesn't offer SEP IRAs, but has some attractive CD rates for a traditional IRA. I was wondering if I could take some of my money out of my SEP IRA at the brokerage house [It is invested in a money market fund.] and roll it over to a traditional IRA at the credit union. [I would invest it in a CD.]

I would still continue future SEP IRA contributions to the brokerage account.

Frank
Franklin Square, NY


Dear Frank,

Very clever. Yes, you may roll over any kind of pension into an IRA. You can't mix and match ROTH IRAs with traditional IRAs, though.

If, as an indie, you are looking to contribute more to a pension, consider a UNI-k. Also known as a solo-k, individual 401-k or a solo-k.

Best,
June

Less Tax vs Higher Pension Contribution

June,

I am employed full-time but have been a part-time indie for the last 20 years (consulting psychologist).

My question is about my SEP IRA. One of the problems, as I see it, with a SEP IRA is that the more you deduct from your gross self-employment income, the LESS you can contribute because the allowable contribution is a percentage (20 or 25%?) of your self-employment income AFTER expense deductions.

It would seem that the less you deduct for expenses, the more you can save!

How does one crunch the numbers to see what the best way to go is?

By the way, how would you rate the SEP IRA vs the new Roth 401(k)?

Mark
Fairfax Station, VA


Dear Mark,

Good questions. You are into the "indie business mindset" way of thinking.

Let me overview here for some of my readers. The allowed contribution to any pension plan for a self-employed is limited by the net self-employed income. Therefore the more business expenses you have the less your net income and so the less you may contribute to your indie pension.

Here are some actual numbers to look at: Let's assume a 15% federal income tax and 15% SE tax. That means that deducting a $1,000 expense saves you $300 -- 30% X $1000.

In a SEP, because your self-employed income was reduced by $1000, you may contribute $200 less to your pension.

You are looking at a tax savings of $300 versus putting $200 less into your pension.

It makes more sense to take the tax savings and do one of two things:
1. Put the $300 into another kind of non-pension savings. Talk to your investment broker about what would be best.
OR
2. Change to a different kind of indie pension. There are many to choose from, and at my earliest opportunity I will write about the choices you have. Fort the interim, ask your personal tax advisor to explain your choices.

You can have ROTHs of any kind, e.g. SEP, 401-K. The younger you are and the less concerned you are about paying less tax NOW the more advantageous a ROTH.

Best,
June

Pensions for Indies

Hi!

I'm a bookkeeper off Long Island, NY. Work 1099 several jobs and also on the books for 2 other companies.

I have come into some money. I know I can pay into an IRA and I have up until tax due date 4/15 to put money in from the previous year. My question is: Does the IRA have to be set up in the year you are claiming?

Thanks for any help.
Dana


Hello Dana,

Of all the retirement plans available to indies -- and there's many!! -- the only two that may be opened for the previous year are IRAs and SEPs. All other must be opened by December 31 or earlier.

You may open and contribute to a 2007 IRA -- traditional or ROTH -- until April 15, 2008.

You may open and contribute to a 2007 SEP up to the filing deadline for your 2007 tax return. That could be as late as October 15, 2008. SEP stands for "simplified employee pension." Don't let the name confuse you. It's for the self-employed and you may contribute up to 20% of your net self-employed income.

-- June

Contributions from a Minor to a Pension or Retirement Account

June,

If a young person (under 18) earns money doing odd jobs (like mowing grass etc...) and then puts this money into a Roth IRA is he in any way exempt from having to file a tax return and thereby able to avoid paying self employment (social security) tax?

I realize that if he were going to use the money to buy comic books or something he would never even consider reporting the "cash" income, but I'm assuming opening the Roth IRA will put him on the IRS radar.

John in South Carolina


Hello John,

Regardless of how young the indie he may contribute to a pension only if he has taxable earned income. So, no he cannot hide the income and also put it into a pension.

If the grass cutter wanted to contribute, let's say, $4000 into a ROTH -- or any other pension/retirement account -- he must file a tax return showing that he had at least $4,000 taxable earned income.

Were he an employee that would be $4,000 in wages, for an indie that would be $4,000 net profit.

To establish a pension plan for a minor the account must be opened and held by an adult, as guardian, in the name of the minor. While the adult is the individual authorized to perform transactions on the account, the minor is considered the registered owner for tax purposes.

Although there is no minimum age, on various kinds of pensions there is a maximum age at which you may not longer contribute.

Best,
June

Hire your child and give him a pension, too.

Hello June,

I am an Independent Literacy Consultant. I am a sole proprietor who set up a SEP [simplified employee pension] last year for myself.

Now I am taking advantage this summer of hiring my 17 year old to work in my business (I only have to pay withholding taxes on him, not Social Security, Medicare or unemployment, via a special regulation with the IRS (outlined in Publication 15).

However, I want to do what is more advantageous for our family in terms of contributing to an IRA for my son, either directly as a employer-paid contribution or by asking him to contribute from his salary to a traditional IRA. Is that the only or best way to do it? Do I have other options?

Cathy in Huntsville, AL


Dear Cathy,

The following factors come into play when choosing a pension type:
** Your tax bracket
** Son's tax bracket
** Amount your son will earn this year
** Your business net income
** Whether now or in the future you plan to have other employees
** Your age

There may be a plan for you and your son that is more advantageous than a SEP but without a lot more info there's no way to tell.

Whether your employee is your son or a non-relative you must treat him fairly. That means all employees must receive the same benefits and that you cannot give yourself a better benefit than you give your employees.

With your current plan you need to complete a Form 5305-SEP and keep it with your records.

All SEPs are also IRAs. So the best way to use your current SEP depends on your son's income. An IRA allows for a $4,000 contribution. A SEP allows you to contribute 25% of his wages. Your contribution to his pension is a business deduction for you. Choose the method that gives you the biggest deduction.

Best regards,
June

If you are your only client ... you're not self-employed.

June --

As a forex day trader; may I open a self employed 401K account; fund it with whatever the allowable contribution might be - - - and then proceed to conduct the same day trading activity within the confines of the 401K account - - - realizing the tax deferral benefits on any gains?

Thank you. DD


Hello DD,

A 401-K is a pension or retirement account. A 401-k for a self-employed is called a uni-k or solo-k and is only one kind of pension plan available to indies.

In order to be eligible to have a self-employed pension you must be self employed. That's explained at this post Self-employed or Employee: It's more than a name . A day trader -- whether domestic or foreign -- who trades only for himself and does not have a commodities license is not a self-employed.

Good idea but it won't fly.

Best, June

To learn more about indie taxes and Self-employed Tax Solutions please visit http://www.junewalkeronline.com

Lower Taxes

June,

I have been self-employed in program and logistics management for a year and a half. Besides deductions and placing money into an IRA or 401K plan for the self employed, what are other ways to bring my tax burden down?

Thanks. Teresa


Hello Teresa,

If you want to be good at lowering your taxes you need to use the same method as you would to be good at anything else. You need to learn about the subject from the right sources and then act on the information that you get.

There are several different kinds of pensions for indies. The most flexible and least expensive for those under 50 years old is a UNI-K -- also called a solo-K. It's structured like a combination SEP plus 401-K.

In order to take advantage of every possible deduction you need to know what those deductions are. Click here for a complimentary copy of the Self-employed Business Expenses List and also read Is it a deductible business expense? on my website.

If you like what you read there, I encourage you to buy a copy of my book, Self-employed Tax Solutions, featured in BusinessWeek. The book will give you the basics for understanding how to lower your takes. It also tells you how to set up a recordkeeping system and prepares you for an audit -- all in the same easy-to-understand style you'll find in my columns.

I wish you much success.

Best regards,
June Walker