By Gary A. Hensley
A Plan for Sole Proprietors to Reduce Income Tax
So, you have had a great year in the publishing world and even after maxing out your operating expenses, you are still showing a tidy profit. What to do? Consider reducing that profit further by funding your personal retirement account and taking a tax deduction for it.
Simplified Employee Pension (SEP)
SEPs provide a simplified method for you to make contributions to a retirement plan for yourself and your employees (if any). Instead of setting up a profit-sharing or money purchase plan with a trust, you can adopt a SEP agreement and make contributions directly to a traditional individual retirement account or a traditional individual retirement annuity (SEP-IRA) set up for yourself and each eligible employee (if any).
More good news! Suppose 2012 is a very profitable year, even after taking all available deductions. You can actually set up the SEP plan after your tax year closes (in this case, calendar 2012) and fund it until the due date of your return (including extensions). For calendar 2012 sole proprietors, the normal due date of your return would be April 15, 2013 but with an automatic 6-month extension (using Form 4868), you would have until October 15, 2013 to set up the SEP and fund it for 2012. This is one of the few opportunities to lower your tax bill after your tax year (in this case, 2012) has ended and still get the deduction on that year’s return (2012).
With an extension filed (only if you cannot create the SEP plan and fund it by the normal due date), you would have a total of 9 1/2 months after December 31, 2012 to create and fund the plan. That’s a lot of flexibility! Caution: Even after you take the SEP deduction on your return, if you still owe a balance due (based on other income such as wages, interest, dividends, etc.), that amount would need to be paid with the initial return or paid with the extension request to avoid late payment penalties and interest. The extension only allows you an extra six months to set up the SEP plan and fund it.
A sole proprietor is treated as his or her own employer for retirement plan purposes. For a self-employed person, compensation means “earned income.” Earned income is net earnings from self-employment from a business in which your services materially helped to produce the income. Net earnings from self-employment is your gross income from your trade or business minus allowable business deductions (including the deductible portion of your self-employment tax, shown on page 1, line 27 of your Form 1040).
Other Interesting Points:
- A SEP-IRA cannot be a Roth IRA.
- Employer contributions to a SEP-IRA will not affect the amount an individual can contribute to a Roth or traditional IRA.
- Unlike regular contributions to a traditional IRA, contributions under a SEP can be made to participants over age 70 1/2. If you are self-employed, you can also make contributions for yourself even if you are over 70 1/2.
For 2012, contributions cannot exceed the lesser of 25% of the employee’s compensation or $50,000. Special rules apply when figuring the maximum deductible contribution for the “owner-employee.” Let me illustrate with an example.
EXAMPLE: You are a sole proprietor with no employees. The terms of your plan provide that you contribute 25% (.25) of your compensation to your plan. Your net profit from line 31, Schedule C is $40,000. Your deductible self-employment tax (taken on page 1, line 27 of Form 1040) is $2,825. Subtract this amount from the $40,000 to get net earnings from self-employment of $37,175. Next, you multiply this amount by 20% (yes, 20%, not 25%, see Footnote below) to get $7,435. This is your maximum deductible contribution. You would enter this amount on Form 1040, page 1, line 28 as an adjustment (reduction) to your income. Although this adjustment goes on page 1 of the Form 1040, it does reduce the Schedule C profit of $40,000 which also gets reported on page 1 of Form 1040. Notice that the deductible portion of your self-employment tax ($2,825) and the SEP contribution ($7,435) have reduced your $40,000 Schedule C profit down to $29,740. This amount gets further reduced by your personal and dependency exemptions and your standard or itemized deductions before you actually reach taxable income, the amount used to determine your income tax due. You will still be required to pay self-employment taxes on the $40,000 on Schedule SE (approximately $4,913 for 2012). [See my earlier post on “Writers and the Self-Employment Tax“].
I know, for many of you in the early stages of your career, that any profit is a solid achievement. However, this is a worthwhile strategy for all to consider once profitability is attained. As a self-employed person, it is up to you to put funds away for your future. This is a great way to do it while lowering your current income tax bill. The sooner you start, the longer your retirement funds will have to compound.
Your bank, credit union or broker will be happy (eager) to help you set up your SEP-IRA plan with forms that comply with the IRS requirements. You will complete the paperwork (a few pages) and open your SEP-IRA at that institution and be on your way!
Helpful Resource: Pages 22, 23 and 24 of IRS Publication 560 illustrate the deduction worksheet for those self-employed and also include a rate table conversion chart for the self-employed.
Footnote: In order to arrive at a 25% contribution in the above example after the contribution is allowed as a deduction against your profit, it is necessary to do the following: take the contribution percentage you want to use, such as 25% or .25, and divide it by 1.25, which then gives you the 20% figure to multiply the profit by before any SEP deduction. In the above example, if you take the net earnings from self-employment, $37,175 and subtract the contribution of $7,435, you get $29,740. Now, when you take that contribution of $7,435 and divide it by $29,740, you get 25%. Therefore, you actually took a 25% contribution of your business profit after subtracting or allowing for the contribution. As a self-employed person, this is your unique formula to arrive at the maximum deduction allowed.