The "be your own boss" tax

Being your own boss can be fun and rewarding.  But, whether you own a small business, run a custom quilting operation from your home or write editorial articles for fun, taxpayers need to be aware of the self-employment (SE) tax.  

The SE tax is imposed on taxpayers that report SE income on their individual Form 1040.  The purpose of the SE tax is to recoup Social Security (FICA) and Medicare taxes from taxpayers that do not pay these through paycheck withholding.  When a taxpayer is an employee, it is their employer's responsibility to withhold these taxes from their paycheck and remit them to the government.  But, since self-employed taxpayers do not receive a "paycheck" per se, they must pay these taxes when they file their individual Form 1040.  

What types of income are subject to the SE tax?

Before calculating SE tax, the taxpayer must first determine how much SE income they have.  Common types of SE income include:

• Rental income
• Net profit from sole-proprietorship or single-member LLC (reported on Schedule C)
• Nonemployee compensation received and reported on Form 1099-MISC, such as contract labor, commissions, or bonuses.

Note that rental income is included above.  If rental income is passed through to the taxpayer on a Schedule K-1, then the K-1 should indicate whether the activity is passive.  If it is passive, then it is subject to the SE tax.  

How much is it?

As mentioned above, the purpose of the SE tax is to recoup Social Security and Medicare taxes.  The Social Security rate is 12.4% on all SE income up to $113,700, and the Medicare rate is 2.9% with no upper income limit.  The total amount of tax will be reported in the "Other Taxes" section of the Form 1040, but 50% of the amount reduces the taxpayer's AGI as an adjustment to income on page 1 of the Form 1040.  Here's an example:

Marty makes and sells custom coffee cups at his home.  He is not incorporated, and his net profit for the year was $75,000.  He will pay total SE tax of $11,475, made up of $9,300 in FICA (75,000 x 12.4%) and $2,175 in Medicare (75,000 x 2.9%).  He will get an adjustment to income in the amount of $5,738 ($11,475 x 50%)

But what if Marty makes really awesome coffee cups?  

Marty had the most successful year of his coffee cup career, showing net profits of $200,000.  Marty will pay total SE tax of $19,899, made up of $14,099 in FICA (113,700 x 12.4%) and $5,800 in Medicare (200,000 x 2.9%).  Notice how the FICA taxes are capped at $113,700, but Medicare is charged on the full amount.

Options to reduce or eliminate SE tax

Taxpayers can reduce their SE tax burden in various ways.  One way is through business structure.  Taxpayers that have substantial business income, such as Marty above, can consider incorporating and filing an S election.  As an S-corp, Marty could pay himself a reasonable salary for the year which would have the required payroll taxes withheld, and the remaining profit would be passed through to him on a Schedule K-1 as ordinary income not subject to SE tax.  If his salary was $100,000 and the other $100,000 was passed through to him on a K-1, Marty would save almost $10,000 in SE taxes.  Marty could also elect to be a normal C corporation, and all the profits from the business would be taxed at the corporate level.  Although this would eliminate the SE tax for Marty, corporate rates are not as favorable as individual rates and the taxpayer could end up paying more in corporate taxes.  

Taxpayers that generate SE income from their home should consider the Home Office Deduction.  The IRS now offers a simplified calculation for smaller operations, but taxpayers with a significant home office should go through the full calculation to reduce their SE income.  

Taxpayers can also reduce their regular tax burden associated with SE income by making contributions to retirement plans.  A traditional IRA is the easy way to go, but taxpayers with higher amounts of income and cash flow should consider a SEP (simplified employee pension).  The SEP will allow contributions up to 25% of SE income, with a maximum of $51,000.  However, the retirement contributions reduce the amount of taxable income, but not the amount of SE income.  In Marty's case above, he would have regular taxable income of $50,000 less after making a SEP contribution, but his SE tax would not change.  

Idea$ 2014 - February: Retirement accounts

During the month of January, it seemed as if everyday I went to the mailbox or checked my email, there was some kind of document related to my finances waiting for me.  On Monday I got a 1099 from my bank for interest earned during the year.  On Tuesday American Express sent me my "Annual Summary" which shows how much money I spent during the year and in what categories (which can be a great tool to use when making a Budget).  Then on Wednesday, I got my W-2, Thursday brought my 1098 mortgage statement, and on Friday I got a Form 5498 showing contributions to my Roth IRA.  The irony is, the 5498 also discloses the fair market value of the account at the end of the year, to which I responded "hmm, I figured it would be more than that....I wonder what I still own in there?"  

Between packing up holiday decorations and getting together tax information, retirement accounts don't carry as much priority this time of year.  But, this is a great time to go over your retirement accounts and analyze contribution amounts and investment allocations.  

Investment allocations

The investment allocation of your retirement portfolio is simply how you have your portfolio diversified between different types of investments.  There is a wide array of investment options out there, including common stocks and exchange traded funds (ETFs), to mutual funds and bonds.  There are even different allocations within some of these families.  For example, a mutual fund can own large-cap growth stocks or small-cap international stocks.  Determining how to allocate your retirement portfolio between these different types of investments is usually tied to your age.  A 30-year-old worker will want to have their portfolio allocated more to higher-risk investments like growth and international stocks, whereas a 60-year-old worker will want to have more of their portfolio invested in less risky assets such as dividend stocks or bonds.  This is true for two reasons: 1) as an older worker nears retirement, their risk of loss of principal is greater because they will be withdrawing the funds in the near future, and 2) an older worker does not have as much time to make up for losses in a broad market decline as compared to a younger worker.  A simple Google search will produce a number of links to investment allocation calculators where you can input your age, how long until you retire, and the amount you expect to contribute, and the calculator will suggest an investment allocation for you.  One of my favorites is from CNN Money, and can be found here.

Contributions

Another aspect of a retirement account to consider is how much to contribute.  The common response to this is 10% of gross wages, but that figure is debatable given certain circumstances.  First, a young worker might not be able to contribute 10% because they have other liabilities such as student or car loans that must be serviced.  A young worker just starting out, living on their own and providing for themselves might also not have the cash flow to put away 10%.  In this case the worker should put away something that they are comfortable with.  On the other hand, take an older worker (55) that makes a very high wage, let's say $250,000/year.  The 2014 contribution limits to a 401(k) are $17,500, and workers over the age of 50 can defer an additional $5,500 as catch-up contributions.  In this case, if the older worker put away 10%, they would exceed the allowable amount of contributions.  One other consideration is the employer match.  If your employer matches all contributions made by the employee up to 3% of their income, then it is beneficial for the worker to defer at least 3%.  This way, the worker will be saving something, and will be getting full benefit from their employer.  The match is in effect free money and should not be passed up.    

Company stock

I live in Little Rock, and we have a handful of publicly traded companies located here, one of which is Windstream Communications.  Dividend investors love Windstream because, even with a stock price below $10, they pay a $1 per share annual dividend.  This is a pretty good return, especially on common stock.  But every once in a while I will hear a friend of mine that works at Windstream say "I dumped all of my 401(k) into Windstream stock...can't beat that dividend!"  Although this mindset seems smart, ("I work there, it's a great company, and it's a great dividend) it is a very risky move.  Several employees at Enron did the same thing, and ended up with no retirement savings after the company went belly-up.  I'm in no way suggesting that Windstream will have a similar fate, but the lesson is investing all of your retirement account in one asset, including company stock, is very risky.  The key to having a retirement account that grows and can weather the ups and downs of the market is diversification, and investing all of your contributions in one asset prevents even the smallest form of diversification.  

In conclusion, take some time this month to look over your retirement account statement.  Calculate how much you have invested in each asset class, and if there is too much or too little consider rebalancing the account.  Because the assets are in a retirement account, you won't be taxed on any gains or losses generated transferring funds between investments.  During this process, consider how much you have invested in stock of the company where you work, and take some off the table if it seems too high.  Also look at your contributions and see if they are too high or too low.  If you find yourself having excess funds each month, it might be wise to up your contributions, but if you are struggling to make ends meet or have other obligations it's okay to lower the contributions, as long as you don't sacrifice your company's matching provision in the process.  

What is myRA?

After President Obama's State of the Union address this past week, there has been quite a buzz about "myRA" accounts.  More details were released in a press release from the White House the following day.  But, with 401(k)'s, 403(b)'s, and IRA's already in existence, why do we need another retirement savings vehicle?

In simple terms, the myRA is essentially a Roth IRA offered by an employer that has very low initial investment requirements and where the principal is guaranteed.  Here's how it would work in practice: an employer that does not currently have a plan in place can offer a myRA to their employees.  The employees make after-tax contributions to the account, as low as $5 to $25.  These contributions are deposited to the same government securities investment fund that only federal employees had access to before, meaning the principal is backed by the US Treasury.  The employer has no cost because they will not administer or contribute to the accounts.  

Married couples making up to $191,000/year and single individuals making up to $129,000/year can contribute to a myRA account.  Fittingly, these are the same income limits to make contributions to a Roth IRA for 2014.  Another catch is that the account only exists for a finite amount of time - the earlier of when contributions reach $15,000, or 30 years.  Once these are reached, the account holder will be required to roll their money to a "private sector retirement account", i.e. a real IRA.  

The pros of this approach are 1) employees that work somewhere without a retirement plan now will have an option, 2) contributions are guaranteed by the US government, which eliminates the majority of the investment risk, and 3) with very low initial investments, people in middle and lower income brackets will find it easier to participate.  The cons are, well, only one: the 1-year return on the government securities investment fund last year was 1.47%.  

The President has urged the Treasury to start making these accounts available to the public by December 31, 2014.  

IRA tax on MLP earnings

Investing in a publicly-traded Master Limited Partnership (MLP) can be a savvy move for some investors.  This is because the MLP, unlike a common or preferred stock, is taxed as a partnership.  In doing so, the earnings of the MLP are distributed to its members on a Form K-1, instead of through dividends or capital gains.  What's even better is that most MLP's make a distribution on a regular basis.  This distribution might appear to be a dividend, but it is not, because the taxpayer is paying tax on the earnings, not the distribution.  Here is an example:

Randy owns 100 units of ABC MLP, a publicly-traded partnership.  The taxpayer receives four quarterly distributions of $100 each, for a total of $400.  At the end of the year, Randy receives a K-1 from ABC which shows $50 of ordinary income.  On Randy's tax return, he will report $50 of passive income on his Schedule E.  The $400 from a tax perspective is basically forgotten, to be deposited into Randy's brokerage account for other investments or reinvested in more units of ABC MLP.

MLP's are also commonly known to have high distribution yields, such as in Randy's situation above.  He received $400 of cash during the year for his investment, but only had to report $50 on his tax return.  How do they do it?  Many MLP's take advantage of tax deductions such as depreciation and domestic production activities in order to reduce their taxable income below their book income.  These deductions are not cash expenses, which allows the MLP's to distribute high amounts of cash even though their taxable income is low.  Good for the MLP, and good for the investor.

Because of their high distribution yields, many investors choose to hold MLPs in their retirement accounts.  From a tax perspective, this is where the situation gets a little dicey.

Retirement accounts, such as IRAs and 401(k)s are technically considered tax-exempt entities.  There is a little known rule that if these entities earn something called Unrelated Business Taxable Income (UBTI) over a certain threshold, they are required to report that income to the IRS and pay tax.  The threshold is $1,000, and the tax rate is 39.6% (gasp)!

Let's go back to Randy, and now he owns 5,000 units of ABC MLP in his IRA.  He receives $20,000 in distributions during the year, and his IRA receives a K-1 with $2,500 of ordinary income.  The IRA is the partner in the MLP, not Randy, so the IRA will have to file a Form 990-T and pay tax of $594 ($2,500 - $1,000 exemption = $1,500 x 39.6% = $594).  It is not Randy's responsibility to file this return; the custodian of the account will do the filing and use money from the IRA to pay the tax.  This scenario shows how a tax-savvy investment in a tax-exempt account just became taxable.

In summary, individuals that hold MLPs in retirement accounts should monitor their positions to ensure that they are not losing any of their retirement savings to taxes.  Those that are interested in making significant investments in publicly-traded MLPs should consider doing so in taxable accounts, the main reason being that the individual tax rate will most likely be lower than 39.6%.

Give yourself a raise

With Halloween having come and gone and stores now ramping up to sell Thanksgiving turkeys and other holiday treats, 2013 is quickly drawing to a close.  This brings colder weather and the inevitable task of raking leaves, but it also presents an opportunity to take a moment and analyze employment benefits, spending for the year, and a budget for 2014. I am joining a group of financial writers to encourage people to increase their savings in 2014 by 1%.  One of the easiest ways to increase savings is through a retirement account, the most common of which I have discussed previously.  The related benefits to increased savings can be demonstrated using the grade school theory of the "5 W's".

WHO needs to increase their savings by 1%?

Anyone that wants to retire or anyone that pays taxes.  Everyone has an idea of what they want to do in retirement.  Whether they want to travel the country in an RV, play golf everyday, or move to Italy, all of those activities require money.  Since it is rare for people to work and earn an income in retirement, those dreams require a nest egg to become a reality.  Employees that participate in a 401(k) plan or similar arrangement can enjoy tax benefits by increasing their retirement contributions.  Contributions are not included in taxable income, so for a taxpayer in the 25% tax bracket, every dollar contributed saves approximately 25 cents in taxes.

WHAT money should be used to increase savings by 1%?

This is the biggest challenge for most people trying to increase savings.  "I want to save more, but I also want to keep my subscription to HBO!"  Instead of looking at the savings goal in total, break it down into monthly or weekly amounts.  A goal to increase savings by $1,000 for a year is only $83/month and $19/week.  That equates to not eating lunch out 2 days a week, one less round of golf a month, or no more lattes on the way to work.  Taxpayers that typically receive a refund on their taxes can also consider adjusting their withholdings in order to keep more of that money during the year.  By decreasing tax withholdings and increasing retirement contributions by an equal amount, the taxpayers net take-home pay does not change.  But, the taxpayer will not receive a large refund on their tax return, and that money will have been saved towards retirement.

WHERE should savings be increased by 1%?

As discussed above, a qualified retirement plan offered through an employer is the easiest place to start.  If that's not available, a Traditional or Roth IRA can accomplish similar objectives.  There are also a variety of options available for the self-employed.  IRA accounts can be opened at almost any brokerage such as Vanguard, Fidelity, or TD Ameritrade.

WHEN should savings be increased by 1%?

As soon as the opportunity presents itself.  Several large employers use November and December as "benefits season", giving their employees the opportunity to adjust their benefits, including retirement plan contributions.  Taxpayers contributing to IRA's can make contributions for 2013 by the date their 2013 tax return is filed or 4/15/14, whichever earlier.

WHY should savings be increased by 1%?

Aside from the reasons already listed above, increased retirement contributions align with the time value of money concept.  In short, the time value of money means $1 today will be worth more in the future.  For example, $1,000 today, growing at an average rate of 5% annually for 40 years will be worth $7,040.  These calculations can be made here.

The savings rate in our country has dropped from 5% last year to 4.6% this year.  From an accounting sense, that indicates that current obligations are being met, but future obligations are likely to not be met.  So, I encourage you to put pencil to paper and see where you can adjust your finances to give yourself a raise in 2014 by increasing your savings by 1%.  If anything I have given you a reason to put off raking those leaves for another day.

This post encouraged by the Financial Duckmail blog - see their site and other works here.