I was talking with one of my best friends today, and he was asking for my opinion about SEP retirement accounts, and how he can reduce the taxes taken from the self-employed income he earns throughout the year. He does some public speaking and lectures that earn him some side income throughout the year, and he noticed that the money he made in 2008 was taxed at about a 30% rate. He was asking me if it was wise to open a SEP account and contribute the maximum amount to it in order to reduce his taxable self-employment income. There are a few things to consider here…
Why is he being charged a 30% tax rate for his self-employed income?
If you believe that you will owe more than $1,000 in taxes due to self-employment income, the IRS requiires you to file quarterly estimates for your taxes. If you do not file quarterly estimates and your tax liability from extra self-employed income exceeds $1,000, the IRS will impose an 8 to 9% tax penalty on top of the taxes owed. If he was in a 15% income tax bracket with 8% SSN and Medicare taxes and an 8% tax penalty, that that’s a 31% tax liability! Yikes!
If this is you, then you should file a 1040-ES form with the federal government by April 15th of the current year, June 15th, September 15th and April 15th of the following year. Estimate any tax deductions and credits that you think you will take for the year, then calculate your estimates quarterly tax based on your adjusted gross income after deductions and credits. If this is side business income, it shouldn’t be hard to do, but if your self-employed income is the main source of income in your household, you should definitely pay a good accountant to help you file your quarterly returns. Don’t worry though, if you overestimate, you can claim the remaining back in your refund the following year.
A SEP Account (Simplified Employee Pension plans), is primarily used for small business owners who want to set up a retirement plan for themselves and their small amount of employees at a reduced cost with less red tape. It’s a better solution for small business owners to start a SEP plan to contribute to their own account and offer an added benefit to their employees. My friend has an EIN number, so he had a good idea of opening up a separate bank account, placing all side income into that account, and then contributing “pre-tax” dollars to the SEP account before he files his quarterly returns. SEP accounts allow employers to contribute up to 25% of their income per account holder. I explained to him that this is a decent short-term solution, because it helps reduce the amount of his self-employed taxable income, but it should not be his primary retirement account. I like ROTH IRA’s, because they take after-tax dollars, and the withdrawals are not taxed at retirement. Any professional whose income will continue to rise as they age, should always try to set up retirement money so it is taxed early on in life at a lower tax bracket rather than later on in life when he or she could be in a much higher tax bracket.
I am not an accountant, so please consult a qualified CPA before you make any tax decisions about self-employment income.