Lowering pesky tax burden (US Version)

[DrewMcGunn]

I'm porting this data from that other forum. As I do a little house cleaning over there, I didn't want to lose this.


Of note, this thread speaks specifically to US-based authors. In the spirit of some earlier posts that talked about the high level of taxation that self-employed folks face, I wanted to share information about a few ways to get your taxable income a bit lower. There are still a few months before the end of the year, so if you're looking to find ways to reduce taxable income between now and the end of the tax year, there is time to consider your options before the 2018 tax season.

So, you’ve found a modicum of success and you’ve read horror stories about taxation issues and you’re wondering what to do next. First, you’ve probably seen other authors say, “you need to talk to a tax professional.” That’s a solid idea and I encourage the same. Let me give the standard caveat, that I’m not a licensed investment professional and nothing discussed below should be considered advice.

I want to discuss a few options that are available for reducing taxable income and explain where and when they work best, as I see it.

Scenario 1, you’ve broken free of your prawny status and over the past year, you’ve earned more than $5,000 profit. You are allowed to set up an IRA. If you’re under 50, you can reduce your income by up to $5,500 or $6,500 if over 50. You’re not allowed to reduce your income below 0, but if you’ve got the money in the bank, an IRA is a good way to reduce your taxable income.

It's also worth remembering that if you're still working full-time for an employer offering a 401(k) plan, and you're increasing your writing income, it could be easier to increase your contribution into your employer's plan. Something to keep in mind, though is that participating in an employer’s retirement plan may reduce your deduction if your adjusted gross income is over a certain threshold.

Scenario 2, you’ve done even better, and you’ve made upwards of $20,000 profit for the year. If you’ve got a fulltime job, that 20K could be taxed at 25% or even higher, and that’s before you calculate your own self-employed tax, which adds another 15% or so. That $20,000 could result in an $8,000 tax burden. While an IRA is certainly still available, you might want to consider a SIMPLE IRA or SIMPLE 401(k) Plan. These plan types allow you to fund up to $12,500 and take all of it as a tax deduction. A nice thing about contributing to one of these plan types is that if you’re contributing to your employer’s 401(k) plan, the SIMPLE plan isn’t aggregated with your employer’s plan regarding the deferral limits. For instance, if you’re doing well enough to maximize your deferral with your employer, you can still fund the $12,500 if your self-employed income is at least $12,500. Also, SIMPLE IRAs are not subject to the same level of regulatory oversight as 401(k) plans and thus, are not as expensive to administer.

Scenario 3, let’s talk about SEPs. These are simplified employee pension plans which allow you to defer up to 20% of your business’ profits, minus a deduction of 50% of your self-employment tax or a maximum in 2018 of $55,000. SEPs can be very useful in reducing your income by the amount of your contribution. It also doesn’t impact the amount you can defer in your employer’s 401(k) If you still work for someone else. Let’s say that your profits are $50,000, you could defer around $9,200.

Scenario 4, my personal favorite is a Solo 401(k). There is a bit of a setup cost to establish a 401(k) plan for your sole proprietorship. But it allows an author to set aside up to 18,500 in “deferrals.” That amount is a direct reduction in your income. So, if you made $50,000 after expenses in royalties, and you fully contributed the 402(g) limit of 18,500, then your income becomes $31,500. But it gets better. In addition to making a deferral from your income, you are also allowed to make a profit sharing contribution. The formula for calculating the amount of profit sharing is the same as for a SEP. This is where SOLO 401(k) beats a SEP: You get to put a “deferral” into a 401(k), which allows you maximize your SOLO 401(k) with less income than is necessary for a SEP.

So, what’s the most income you can shelter from tax in a retirement plan? In 2018 that amount is $55,000 if you’re under the age of 50 and $61,000 if over 50. How much does it take to make this size of a contribution? In a SOLO-K, that limit can be hit with $190,500 (approx.). To hit the limit in a SEP requires more than $280,000.

Most of us can stop here. But for those who hit that level of success where $55,000 doesn’t shelter enough income, I’d like to discuss Scenario #5. That little sole proprietorship that you have has now netted you a chill quarter million in profits in 2018 (from my keyboard to God’s ear). A defined benefit plan can help you shelter a substantial portion of your income. The formulas that drive the amount you can fund are driven by how many years separate you from your “normal retirement age” and are calculated by an actuary, but it’s possible to fund well more than $100,000 per year if your income is high enough.

My goal is to raise awareness that whether you make $5,000 in profit or a million, there are sections of the tax code that will allow you to lower your taxable income.

[HSh]

I concur that it's much easier and better to work with a tax professional, and not one of those places that set up in the mall and offer you guarantees about your rebates.  You might not get a rebate as an author; you might owe extra and have to pay a fine on top of it!  It's very reassuring to have someone in your corner who understands the ins and outs of tax law and can guide you through the details.

Look for a local small business tax professional, someone with a good reputation who isn't too big to give clients personal time and help.  Worth their weight in gold and NOT highly expensive. 

[DrewMcGunn]

There was an excellent question from JC Kang, to which I responded on that other forum.
Her comment is in the spoiler:

Spoiler: ShowHide

I'm not a tax professional, but I do my own taxes on my own business.  Here are a few things to consider:
If you set up a 401(k), you still have to pay payroll taxes (the same as self-employment tax on schedule C); half from the business, half from you.  On a Traditional IRA or 401(k), you will pay taxes when you withdraw funds (and a penalty if you withdraw those funds before age 55).  With an IRA, you can also opt for an employer match, though I can't remember what tax liability that match incurs.

Another option is incorporation, or having an LLC be taxed as an S-corp. This way, you can pay yourself a fair salary, on which you will pay both payroll tax and income tax; but then you don' t have to pay income tax on the profit.

These are good points, JC. While the self-employment tax does get collected on all “active” income, your income is reduced for income tax purposes for any eligible deferral/profit sharing you fund to your retirement account.

That raises a point that folks may not be thinking about. When the IRS takes our hard earned money, it’s useful to think of that money funding several buckets. The first bucket that we pay into is income tax. This is the bucket that was subject to so much discussion in the news recently with the new changes in the tax code. These deferral tactics are designed to lower your exposure to that tax rate. Under the new rules, it gradually increases to 37.5% tax rate. The second bucket of money is your self-employment tax (generally the same as FICA, but twice as much, because you're paying both the employee and the employer portions). It is 12.4% towards Social Security and 2.9 toward Medicare. Sometimes it is helpful to think of the self-employment tax as two buckets because the SSN tax caps out at 128,400 in 2018. But there is no cap on the Medicare portion.

For people who are making well above the average author income, JC’s comment about incorporating (referred to a C-Corp) or setting up an LLC that is taxed as an S-Corp makes a lot of sense, because with a C or S corp, you pay yourself a salary and issue yourself a W2 for your active income. All income on a W2 is subject to the above-referenced taxes. The rest of your income gets characterized a dividend income or passive income. The upside is that under the new tax rules, your passive income is taxed at a very favorable rate and isn’t subject to income tax or self-employment tax. A word of caution is that the IRS (bless their pea-pickin’ hearts) provide scant guidance about how much of your income should be characterized as active and reported on your W2 and how much is passive/dividend. You’re on your own to consult with your tax professional about how much should be reflected into each income source. If you’re an S-Corp and If you’re unlucky enough to get audited by the IRS, they will decide if they agree with you. If they disagree, their correction can get a little pricey.

I’ll repeat my earlier caveat, I’m not a tax or investment professional and so this shouldn’t be taken as advice. If you’re making good money from your book royalties an S-Corp can be a pretty sweet deal. In this example, let’s say you just netted a $100,000 in 2018 and you are taxed as an S-Corp. You pay yourself a salary of $50,000. You can defer $18,500 from your salary. While your profit sharing can only be 25% of your w2 wages (12,500), it can be paid from the profits of the business and not the salary. So, your $50,000 dividend/passive income is reduced by 12,500, and doesn’t come from your salary portion.

I can’t emphasize enough, answers to these kinds of questions rely very heavily on the facts and circumstances of your own business. Rules for C-corps and S-Corps are different from sole-proprietors, which are also different from partnerships, which I haven’t mentioned.  Also, working with a tax pro to determine what makes the most sense for you is very important. But it doesn’t hurt to talk to several before making up your mind. In the course of my own work day, I work with accountants and other tax professionals, advising them on retirement plan design. I have learned that quite a few tax professionals have a limited knowledge about which option works best for a given scenario. A tax pro who will do the research, or bring in an expert to consult with, is worth a lot more to a successful writer than one who sells the same standard retirement option to their customers.


*JC, if you do not want me to quote you, PM me and I'll remove your quote.

[LD]

Of you want an LLC taxed as an S-corp, does the LLC have to bed set up that way from the get-go?  Or can you wait until you hit that income range before changing it?

[DrewMcGunn]

Of you want an LLC taxed as an S-corp, does the LLC have to bed set up that way from the get-go?  Or can you wait until you hit that income range before changing it?

Your business and tax structure can change as your writing career develops. Nearly all of us are taxed as sole-proprietorships when we start writing. This simply means we fill out the schedule C when we file our 1040 at tax time. For the vast majority of writers, we'll never take it beyond that, because our revenue isn't high enough to mess with the higher cost of managing an S or C corp.

So, the short answer is, you can change when it makes sense to you.

As with all things financial, it doesn't hurt to discuss your financial situation with a competent financial person. I agree with Hsh, most of the tax prep places in malls or strip centers are not where you want to start your research. Most of those places are designed to quickly help basic tax prep issues, and to help connect low-income filers with quick refunds for EIC credits. If it were me, I'd check out a local CPA who handles business tax filings. They're more likely to have good ideas about when it would make the most sense to incorporate.

[Lex]

Don't forget HSAs (health savings accounts). You have to have an "HSA eligible" insurance plan, and the money can only be used for "qualified medical expenses" (prescription drugs don't count, for example), but it's tax free. The limit for individuals for 2018 is $3450.

[DrewMcGunn]

Don't forget HSAs (health savings accounts). You have to have an "HSA eligible" insurance plan, and the money can only be used for "qualified medical expenses" (prescription drugs don't count, for example), but it's tax free. The limit for individuals for 2018 is $3450.

Good point. But only folks who are enrolled in a high-deductible plan qualify for an HSA account.
You may want to confirm about prescription drugs. According to the IRS website, non-prescription drugs are not covered, but prescription drugs are. Most of the money that goes onto my HSA card each payroll goes to cover my wife's prescriptions.

One thing I like about the HSA account is that my provider allows me to transfer money from my bank account to it (so long as I don't exceed the limits). At the end of the year, they'll send me a 1099 that will reduce my income by the amount I fund (in addition to whatever I fund through payroll withholding).

[Lex]

You may want to confirm about prescription drugs. According to the IRS website, non-prescription drugs are not covered, but prescription drugs are. Most of the money that goes onto my HSA card each payroll goes to cover my wife's prescriptions.

You're right... not sure why I thought that.