Do you pay taxes on the money you earn from your side hustle? If so, then he’s a hack you’ll want to know: Contributing to a SEP IRA can help lower your taxes as well as allow you to stash away more money for retirement!

For years I’ve enjoyed making money on the side from blogging.  But in the eyes of the government, that money is “business income”, and therefore taxable.  So while it was fun to earn several thousand dollars per year, it wasn’t so great having to pay roughly a quarter of that money back into taxes every year.

Just like all the steps I’ve taken to reduce my personal taxes down as much as possible, I knew there had to be a way to do the same with my business income.

That’s when I discovered the SEP IRA. By maxing out your SEP IRA contribution each year, you can offset your taxable business income and save roughly one-fourth of what you would normally owe in taxes.

At its peak, that’s been a reduction much as $1,000 in the amount of taxes I owed for the year.  But over time, these savings can really start to add up!  Perhaps into the tens of thousands of dollars!

If that wasn’t great enough, the benefits don’t stop there!  If you’re also in the unique situation where you’re already maxing out your 401(k) and IRA, then a SEP IRA can also be your tool to save even more money for retirement tax-deferred.

Yes, I get to contribute to all three accounts!  By doing so, I get to maximize my efforts towards reaching financial freedom and put the power of compounding returns to work making money for me!

If you’re a money-making blogger or even someone with a hobby that earns them some extra income on the side, then you’ll definitely want to know how contributing to a SEP IRA could benefit your retirement savings as well as lower your taxable income. Read on to see what a SEP IRA is exactly, how it’s different from the other types of IRA’s, and how it could be used to potentially save yourself thousands of dollars in taxes this year!

What is a SEP IRA?

Chances are that unless you’re self-employed (or really into personal finance strategies like I am), than you’ve probably never heard of a SEP IRA.

A SEP IRA is short for a “Simplified Employee Pension Individual Retirement Arrangement”.  Basically it’s another style of retirement plan designed for people who are either work for themselves or have a very small number of employees.

Keep in mind: You can be both employed by someone else AND self-employed.  My situation is a good example of this.  I earn a regular salary from my day-job and from blogging.  Therefore I am both.

Without getting carried away on the technicalities, you can think of a SEP as the same thing as a regular traditional IRA.  They carry the same rules for deductions, tax-sheltered investment growth, investment options, and no early withdrawals until age 59-1/2.  However, there’s one BIG difference to note: You get to contribute to a SEP IRA as two different people, 1) the employee and 2) the employer.

The employee part. 

Contributing to your SEP IRA as an employee is really no different than when you contribute to your regular IRA.  You can invest up to $6,000 for the year in ANY combination of the IRA’s you choose.

Example: If you wanted to put $4,000 in a Roth IRA and $2,000 in a SEP IRA (as an employee), you could do so.  Since I already max out my Roth IRA every year, my SEP IRA employee portion is $0.

The employer part. 

Now here’s where it starts to get interesting!

Because you’re declaring business income (from your blog, freelancing, whatever) on your tax filing, the government treats you like you’re self-employed (again, even if you’re also a full-time employee for someone else).

Therefore, as your own employer in this regard, the IRS says that you have the opportunity to pay yourself a nice big bonus to put towards your retirement savings.

How much exactly?  Employer SEP IRA contributions can’t go over the lesser of:

• 25% of the employee’s total compensation.  (Note: If you’re like me, the actual math works out to 20% of your Adjusted Profits.  I’ll show you can easily calculate this yourself in the section below.)
• $57,000 for the 2020 tax year.

How This Ends Up Saving You Money in Taxes

If you’ve been questioning up until now how this is all supposed to benefit you, here is the part you were waiting for: Your SEP IRA employer contributions are deductible as a business expense.

Basically that’s like saying if you made $20,000 last year, you could choose to pay taxes on the whole $20,000 OR you could give yourself $4,000 for retirement and only pay taxes on the remaining $16,000.

Which one would you rather do: Pay the government or keep more of your hard-earned money for yourself?

I know which one I prefer …

Just in case you’re feeling curious, here’s an example of how to actually calculate how much you could stash in a SEP IRA according to how the IRS calculates it.  Fidelity has a good worksheet that helps guide you through the steps that you can download here.

Example:

Suppose your profits for the year were $20,000 after you subtract away Self-Employment Tax.

Take $20,000 divided by 1.25 = $16,000.

Then take $16,000 x 0.25 = $4,000.

There you have it!  $4,000 is what you get to contribute to your SEP IRA for the year.

(Mathematically this also works if you simply go $20,000 x 20% = $4,000.  But who am I to argue with the way the IRS does things?)

If you’re in the 25% tax bracket, that’s $4,000 x 0.25 = $1,000 you just saved in taxes!

My Vanguard SEP IRA

I think anyone that reads this blog knows that I always prefer to deal with Vanguard over pretty much everyone else.  However when it comes to my SEP IRA, they go ahead and get some extra credit.

It was actually a phone call with Vanguard’s customer service where I first learned about my eligibility to contribute to one.  Not only did they explain how one works and the rules for contributing to one, they also let me know that the account is completely free of administration costs.

Again this year I’m happy to make another big contribution to my Vanguard SEP IRA and watch it grow even further.  I invest very simply using my favorite low-cost, balanced fund Wellington.  If you’re not familiar with this one, it’s a fund that contains about 65% stocks and 35% bonds.  The long-term annualized return rate is 8.33% which is pretty great in my opinion.  You get the added stability of bonds in your portfolio for almost no compromise in returns when you compare this to a 100% stock market index fund.

Hypothetically if someone were to contribute approximately $4,000 each year over the next 10 years into their SEP IRA investing in this fund, their balance would grow to over $70,000!  I don’t know about you, but that’s money I’d gladly accept on my path to financial freedom!

Readers – Do you have a SEP IRA or some other type of self-employment retirement savings account?  What are some other tricks like this that people should know about to help save themselves thousands of dollars in taxes for the year?

Photo credits: Unsplash, Pexels

The post How We’ve Saved $1,000’s in Taxes By Contributing to Our SEP IRA appeared first on My Money Design.

This year I found out there is a dark side to earning a decent amount of passive income.  While making money outside your job is absolutely great, you have to remember that at some point you have to report it all to the IRS.  And that means paying a whole lot of extra income taxes!

While the concept of having to paying taxes on your earnings is no secret to anyone, the way you have to go about it is a little bit more complicated than simply waiting until February and then paying in a thousand bucks one time.  In fact because of the mistakes I made, I’ll likely have to pay a penalty for my negligence.

If you’re someone who freelances or makes a decent amount of extra income (perhaps from blogging or some other activity on the side), then listen up!  Don’t make the same errors I did and help yourself avoid the headache.

What Did I Do Wrong?

2014 was a GREAT year for my passive income generation efforts.

• My retirement funds were maxed
• My investments grew.
• I received dividend payments every month.
• Best of all: Blogging income was phenomenal – more than ever before!

All the right kinds of things you’d WANT to hear, right?

Of course.  But there’s a flip side to all of that.

You see in the past whenever I made any extra income on the side, there was never an issue when it came to my taxes.  My withholding I had already paid on my employment income was so large that the extra taxes I owed on my side income would simply offset them by some small amount (since they were pale in comparison).  For example: If I was usually expecting a tax refund of around $4,000, perhaps I’d only receive $3,000 instead.

Up until last year this was never an issue.  Then in 2013 something new happened – I actually had to PAY IN a tax payment as opposed to receiving a refund check.  Though it was awesome and all to have made so much side income that year, I was realizing that I was entering into uncharted territory (for myself) when it came to business / self-employment taxes.

Then last month things got even heavier …

What I Should Have Done for My Extra Income Taxes:

Recently as I was adding up the figures of my blog income records, I realized something: I had actually earned about twice as much money as I did last year!

Combine that the larger volume of capital gains and dividends we had received and I became suspicious that I was going to owe a lot more in taxes than last year.

That’s a big problem.  And here’s why:

The IRS expects that when you earn a significant portion of income that isn’t withheld right away (like the way they do with your paycheck) that you’ll make regular quarterly estimated tax payments to them.

Even though these estimated quarterly payment amounts can be based on a lot of different factors, the way I should have approached this was to estimate my total side income for the year and then make quarterly payments on them throughout the year.

Who knew doubling your revenue would come with such a headache!

As it turns out, the IRS doesn’t take kindly to waiting a whole year to pay them the money you owe.  And so if you fail to do so, there will be penalties to pay!

Darn!  Penalties are the worst.  It’s basically just throwing your money away due to ignorance.

Could there be any redemption?  I decided with only 4 weeks left as 2014 was coming to a close, it was time to get down and dirty and crunch some numbers.  I fired up Microsoft Excel and started estimating the extra income taxes I’d likely owe this year.  As it turns out, they were a lot! I came up with a figure close to $10,000!

Yikes!

It Pays to Work with a Professional:

As I found out last year when I needed some help with my SEP IRA, seeking the advice of a tax professional is well worth the cost.  Not only can they give you piece of mind that you’re finally doing things correctly, but they can also help educate you on things you could do differently to help save even more money in the future years.

After going back and forth with my advisor, his estimates came in closer to us owing $6,000 as opposed to the $10K I initially thought I we did.  Together we worked out a modest figure for how much I should pay now before the last tax quarter ended.

It turns out my penalty won’t really be too bad (less than $100).  At our next meeting we’re going to discuss a few strategies for how I can avoid tax penalties in the future as a result of the money I’m making on the side.

How You Can Get Your Taxes Right:

If you make any significant income or even planning to (whether it be from your blog or whatever), then you need to do the following:

1. Work with a tax professional. Again, don’t be penny wise and pound foolish.  When it comes to navigating your taxes and knowing the rules, seek the advice of someone who knows what they are doing.  Its fine and all to ask questions and try to understand things for yourself.  But don’t do open-heart surgery on yourself.  Get the right kind of help.
2. Be realistic about your extra income. My big blunder here was that I didn’t anticipate making so much blogging income in 2014.  Although the extra revenue was great, I should have been better prepared to handle the tax end of the earnings.  In 2015 my tax preparer and I are going to work a quarterly income tax payment schedule that I will pay in to avoid penalties and end of the year shock.
3. Budget your tax payments. Another big disaster on my part was not to budget for the taxes I knew I would eventually have to pay in.  No matter what my tax pay-in ended up being, I should have been ready to handle it.   Going forward I’m going to have a rule about saving a minimum of 25% of my blogging income simply to cover the quarterly taxes I will owe.
4. Contribute to a SEP IRA. What would you rather do – give your money to the IRS or invest it for retirement?  Hard choice, right?  Last year I discovered that as my own employer I was able to contribute 25% of my profits to a SEP IRA which ultimately ended up saving me about $500 in taxes.  This is where working with a tax professional can be valuable.  Together the two of you can discuss strategies such as this and avoid mistakes like I made with my extra income taxes.

Readers – How many of you make quarterly income tax payments?   Has anyone else ever found out the hard way about penalties (like I did)?

Image courtesy of Flickr | Ken Teegardin

The post Extra Income Taxes – How I Messed Mine Up and What You Can Do to Get It Right appeared first on My Money Design.

I think I may have found another good one.

A few weeks ago when I laid out my ultimate plan for becoming financially independent, I thought I had really done a pretty good job of optimizing every single angle of my retirement savings options.

My 401k.  My IRA.  Is there anything else I’m possibly missing where I could find even MORE tax-deferred savings?

Apparently there is!

And as it turns out it has a lot to do with this blog.  So all of my blogging friends or people earning any kind of side income may want to listen up …

Another Helpful Phone Call with Vanguard:

Over the Christmas holiday, I offered to help my sister explore her options for retirement savings.  Since she is a freelancer and basically self-employed, I knew the rules would be slightly more involved than the more conventional options that I am used to.

With nothing more than a few ideas in mind, I decided to call the people who would probably know best – Vanguard – and see what I could learn from them.

After only a few short minutes, I was chatting with one of their retirement specialists and our conversation seemed to focus on the subject of a SEP IRA (Self Employed Pension IRA).  (There will be a lot more info below on just what the SEP IRA rules actually are.)

From a self-employed perspective, this one really seemed to stand out among the other options.

But then the agent said something to me that I wasn’t expecting.  Something that was a game-changer.

“You know that you could contribute to one too ….”

One More Way to Grow My Money Tax-Free!

“I” could contribute to one to?

You see when we were talking about the actual mechanics of how this SEP IRA would work, I had mentioned that I too make a side income from my blogging efforts.

That’s when the Vanguard agent mentioned that you can contribute to a SEP IRA even if you participate in another retirement plan such as with another employer 401k.  I later independently verified this statement to be true.

So what does that mean?

It means that if you’re a full-time employee for some job (like myself) BUT you also receive some sort of income on the side, then you COULD contribute to a SEP IRA in addition to all your other retirement strategies!

That may not sound like a big deal.  But consider that the contribution limits can go as high as $52,000 in 2014!  That’s a lot of money you could potentially be stashing tax-free!

How Does This Benefit You?

Do you really like paying a bunch of taxes on your blogging income or passive income streams?  I sure don’t.  And I’d love to use any legal means out there I can to make that number as low as possible!

That’s what I like about this prospect!

Not only could I be lowering my overall tax bill, but it would mean that I would get to save more of my earned money.

Follow my logic.  If you’re like me, you probably:

1. Do something that earns you a side income (for me, it’s this blog)
2. You pay taxes
3. Save or invest whatever is leftover

Recall in my post about Tax Deferred vs Taxable Retirement Income Strategies, we learned that the tax deferred savings route didn’t just beat the taxable one, it beat it by A LOT!  In one of the examples, we made over $1.9 million dollars more in accumulated wealth!  That’s no small chunk of change to disregard.

So that’s what I like about the prospect of using a SEP IRA.  My process would then become:

1. Do something that earns you a side income
2. Save or invest a portion of your earnings
3. Pay taxes on whatever is leftover

That’s going to be a much better deal for me!

The SEP IRA Rules and Fundamentals:

Here is more of what I learned about the SEP IRA rules:

The Basics:

To summarize, a SEP IRA looks and acts just like a regular traditional IRA.

• (With Vanguard) There are no annual fees or establishment fees
• You can invest in whatever you would normally invest in with your IRA today – mutual funds, stocks, etc.
• Taxes are paid later in life when you retire rather than now
• You can’t touch it until age 59-1/2.  Otherwise you have to pay that 10% early penalty.
• There are required minimum distributions when you reach age 70-1/2

Contributions:

As it was explained to me, it helps to think of your SEP IRA in two parts:

1. The employer.
2. The employee.

If you are self-employed, then you are actually both and entitled to save on both sides of the fence.

As an employee, you get to save $5,500 per year in this SEP IRA.  HOWEVER, keep in mind that this does affect your ability to contribute to other types of IRA’s.  You can’t exceed $5,500 in any combination of IRA’s whether they be a Traditional, Roth, SEP, or anything else.  So if you’re already contributing to a Roth, then this part of the equation isn’t available to you.

Now on the employer side is where you reap the benefits!  As the employer of this self-owned business, you also get to make a total contribution that doesn’t exceed $52,000 (for 2014) or 25% of your income; whichever is less.

The definition of “25% income” is the tricky part, and the Vanguard agent advised that I seek the help of an accountant to assist with that.  Apparently the way that works is its 25% of your gross compensation.  So what exactly counts as “gross compensation”?  Is it Revenue – Expenses?  This is where you or I would have to speak to a true tax professional to figure it out.

So How Much Extra Money Would I Make?

To really illustrate how much extra money this strategy may or may not make me, let’s run through a simple real world example and see what the benefits would be.

So let’s say last year I added up all the revenue and expenses from my side income (my blogs) and decided (with the help of an accountant) that my gross compensation was $10,000.

My employer contribution to my SEP IRA would then be 25% x $10,000 = $2,500

That would leave me with $10,000 – $2,500 = $7,500 of taxable income.

If I’m the 25% tax bracket, that would be $1,750.

What if I hadn’t contributed to that SEP IRA?

Then my taxes would be 25% x $10,000 = $2,500

That means I got to keep an extra $2,500 – $1,750 = $750 by using the SEP IRA.

While that might not sound like a ton of money, consider that over a 10 year time frame with 8% inflation adjusted returns that $750 per year could grow into $9433!

No matter which way you look at it, I think we could argue that it would be worth it to at least speak to a professional accountant and see how I could go about taking advantage of this.

Readers – Does anyone already have or participate in a SEP IRA?  Were you aware that the SEP IRA rules allow you to invest a lot more than you may have previously understood it to?

Related Posts:

1)     Using a 72t Distribution to Get Early Access to My Retirement Savings

2)    Could Early Retirement Planning Be Ruining Me?

3)    Your Plan for How to Become Financially Independent

Images courtesy of FreeDigitalPhotos.net

The post Did I Just Find Another Great Retirement Saving Strategy? Understanding the SEP IRA Rules appeared first on My Money Design.

Just like back-to-school signs and Christmas decorations, you can almost pin-point the time from December on when a swarm of tax-filing hysteria starts to show up in our lives. But among the tax software and lists of documents we’re told to dig out of our file cabinets, financial advisors also like to argue one age-old debate:

• Should you wait to get your big tax refund check or take it throughout the year?

The difference of course is how many exemptions you file with your employer (if you don’t remember what you did, it’s in a little box on every one of your paycheck stubs). File a “0” and you will have more money taken out of your check which leads to a bigger end of the year return. File a “1” or higher and you will have less money taken out of your check, but your end of the year return will be much smaller.

So which side of the fence am I on? Well, I know I’m going to go against the grain, but here it comes:

• I prefer to file a “0”, have more taxes taken out, and get a larger tax refund.

Here are my reasons:

1. It really doesn’t make that big of a difference.

Let’s run some numbers using two extremes. Suppose you get a huge refund check every year, say $5,000. What would be the difference between pocketing the whole $5,000 all throughout the year ($192.31 for 26 pays) versus waiting until income tax season to get that big $5,000 refund check? At today’s 1% bank rates:

That’s right, about $23. Hardly seems worth the effort.

So what if you were an ultra disciplined saver and committed to putting that extra money away into an investment account (like your IRA or 401k) earning the historical average of 8% return?

$187 is a little better, but it still doesn’t break the bank. Plus, remember that this isn’t the same thing as “making an extra $187 each year” because you’re still going to get your big check at the end of the year. In other words, one is only behind the other by one year.

2. My income tax refund is my safety blanket.

I’m not perfect. Throughout the year, I budget and try to control my spending as much as possible. But things happen, opportunities come up, etc. It seems that by Christmas I always have to dip into my emergency funds to use money for less-than-emergency situations. That’s why when I get my income tax refund, it’s like a do-over or safety blanket. I can stash the entire sum away for the whole year and buffer my mistakes as move along. I know I “shouldn’t” need this, but it certainly helps.

3. You risk trouble.

It’s okay for the government to hold out on you for a year, but it’s not okay for you to hold out on the government. If you pay too little into your taxes throughout the year by claiming too many exemptions, you can be fined! So not only will you end up paying money back to the government, but now you have penalty charges on top of that. Why take the risk?

4. I learn to live on less.

Although this sounds like an insignificant reason, this is actually a very important one for me. By having more money taken out of my check each month, I learn to adapt my spending to a smaller paycheck. Basically it’s an “out of sight, out of mind” mentality. It is the same logic I use for having a high 401k contribution.

Learning to live on less is just as important for your short-term spending as it is for the habits you’ll have someday when you retire. Think about if wanted the income tax money now, filed more exemptions, and got bigger paychecks. You’d get comfortable with the extra spending money and it would be harder to break those habits later in life.

Like being a diet or training for a marathon, having a smaller paycheck helps me to keep my spending in moderation.

What do you prefer to do? Do you like to take the money now or wait for your big check at the end of the year? Have you just always done one or the other, or do you have specific reasons for doing so? Please share!

Related Posts:

1) Year-End Financial Checklist

2) 10 Tips for Saving More Money

3) Gambling at the Casino – Still Not Really Investing

Photo credit: Microsoft Clip Art

The post The Now or Later Tax Refund appeared first on My Money Design.