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Tax Strategy for Self-Employment Income, Part 3: The Major Options

Contributed by mm | August 28, 2005 1:17 AM PST

So far I have explained the tax situation I am expecting to improve, and the four conceivable strategies I can consider, namely tax deduction, income deferral, income transfer, and shift of income timing. It is time to find out what are the available tactics I can deploy to carry out these strategies.

Two days of serious research allowed me to categorize my major options to two layers:

As a starter, just as traditional IRA, Roth IRA and 401(k)/403(b) plans are popular among those making a living from a regular job, various retirement plans have been made available to people earning self-employed income. Such plans include Individual 401(k) (a.k.a. solo 401(k)), SEP IRA (Simplified Employee Pension Plan), SIMPLE IRA (Savings Incentive Match Plan for Employees) and Keogh Plan.

Each of these plans is different from one another, but in general, they allow higher amount of annual income to be deferred (up to $42,000 in certain plans plus $4,000 catch-up for people over 50), and none of them posts an income cap like that of an traditional IRA or Roth IRA. To map back to the tax-saving framework, these retirement plans shall all help to defer much of the self-employment income.

One level higher, more tax efficiency can be achieved by setting up a business entity. By default, people earning self-employed income are classified as solo proprietors. By forming a business entity, it is possible to execute the strateges like tax deduction, income transfer and income time shifting.

Available options include a partnership, an LLC (limited liability company), a corporation, or an "S" corporation. Each of these forms of doing business has different tax consequences that might be explored to maximize tax savings to the full extent of law. Plus, some of the business forms limit owners' liability, and provide certain level of privacy, which is certainly appreciated in the personal finance blogsphere.

What makes this series of tax discussion more interesting is the fact that these two layers of tools can be used at the same time. For example, a solo proprietor can set up an individual 401(k) plan without forming an LLC or corporation, but forming a high-level business entity and setting up the 401(k) plan on top of it may be more tax favorable under certain circumstances.

Therefore, I will discuss the above-mentioned options one by one in more details. To illustrate the tax impact of various options, I'll use a hypothetical example, in which my wife and I will each achieve $20,000 in self-employment net profit (Line 31 of Schedule C). Note this $20,000 is already after deducting normal cost of running business -- most of business deduction can be made without forming an advanced business entity like LLC or corporation.

Below is the expected tax impact of extra $40,000 self-employment income, if we don't change a thing. That is, reporting all income as solo proprietors without an active retirement plan. The result does not look good: $14,091, or 35% of the total income will be assessed.

  Me Wife Total
Total Self Employment Income - Net Profit  $     20,000  $     20,000  $     40,000
Tax Bracket     28%
       
Solo Proprietor      
  Me Wife Total
Schedule C: Net Profit  $     20,000  $     20,000  $     40,000
Schedule SE:      
  Net Earnings from Self-Employment (92.35%) (*)  $     18,470  $     18,470  $     36,940
  Self Employment Tax (**)  $         536  $      2,826  $      3,362
Form 1040: Deduction (1/2 of Self Employment Tax)  $         268  $      1,413  $      1,681
       
Form 1040 Impact (as increments to earned income)      
Business Income (Line 12)      $     40,000
Self Employment Tax Deduction (Line 30)      $     (1,681)
Total Taxable Income (Line 42)      $     38,319
Income Tax (Line 62)      $     10,729
       
Total Tax Effect      
Federal Income Tax Paid      $     10,729
Self-Employment Tax Paid      $      3,362
Total Tax Paid      $     14,091
% of Total Self Employment Income Taxed     35%
       
(*) After deduction of employer's share of self-employment income.
(**) 2.9% for me because I maxed out social security tax from my job income; 15.3% for my wife.

So much for the background and baseline, Let's start our comparison shopping with individual 401(k).

This post is part of the Tax Strategy for Self-Employment Income Series, please also read the rest of the series:

Part 1: The Tax Exposure
Part 2: The Framework
Part 3: The Major Options
Part 4: Individual 401(k) Introduction
Part 5: Individual 401(k) Analysis & Resources
Part 6: SEP IRA and SIMPLE Plans
Part 7: Forms of Doing Business
Part 8: LLC and S Corporation
Part 9: C Corporation
Part 10: The Conclusion

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