Are you self-employed or a partner in a small professional practice? If so, you're probably very familiar with all the different challenges of running a business. Ultimately, you're responsible for attracting and retaining customers, providing them with quality services or products, getting paid for your work, and then paying your employees and vendors-all before ever paying yourself a penny.
Then, from the remaining profits, the government wants their "fair share" of your success. Fortunately, with some knowledge and planning, you can take steps to minimize the taxes you end up paying. Here are five ways that self-employed individuals and Realtors® can cut their tax bill.
1. Employ your child
While you get to deduct the wages you pay to your son or daughter as a business expense, your child doesn't pay any federal income taxes on the first $5,350 of wages earned (in 2008). Plus, if your business is a sole proprietorship or a two-person partnership consisting of the child's parents, wages paid to your child under the age of 18 are exempt from social security and Medicare taxes as well.
Using the wages paid to your child to fund a Roth IRA is another perk of employing your child . The maximum IRA contribution is $4,000 in 2007, increasing to $5,000 in 2008. Imagine 60 years or more of tax-free growth within your child's Roth IRA.
For example: Let's say you're in the top tax bracket, and you pay your child who is under the age of 18 wages of $5,000 in 2008.
Cost | No cost if you're a sole proprietor. Otherwise, the cost is $765 for social security and Medicare taxes |
Benefit | A tax savings of $1,895, plus the opportunity to contribute to your child's Roth IRA |
2. Employ Your Spouse of Other Family Member
If your practice has a 401(k) plan or SIMPLE IRA in place, consider paying your spouse or other family member over the age of 21 enough in wages to max out their allowable salary deferrals, provided he or she isn't already doing so through another employer. For 2007 and 2008, a person can contribute up to $15,500 ($20,500 if 50 or older) into a 401(k) plan, and up to $10,500 ($13,000 if 50 or older) into a SIMPLE IRA. Remember, money contributed into these plans grows tax deferred and is usually protected from your creditors too.
Note: Be aware that there are some costs to you. Expect to pay social security and Medicare taxes at a rate of 15.3 cents for every $1.00 of wages paid to your spouse or family member. You'll generally owe unemployment taxes and workers' compensation insurance on their wages as well.
For example: Let's say you're in the top tax bracket, pay your spouse $17,000 in wages, from which your spouse contributes $15,500 into a 401(k) plan through salary deferrals.
Cost | $2,601 in social security and Medicare taxes |
Benefit | A tax savings of $5,918, plus $15,500 growing in a tax-advantage, creditor-protector 401(k) account |
3. Consider an HSA
With the rising cost of health insurance, high-deductible plans are becoming more attractive to healthy professionals. The rules now allow you to combine a high-deductible plan with a tax-advantaged Health Savings Account (HSA).
Here are the basics about HSA's:
- Your practice can make pre-tax contributions into an HSA on behalf of you and your family members.
- Money can be withdrawn tax-free from your HSA at any time to pay qualifying medical expenses.
- Any money remaining in your HSA upon your reaching the age of 65 can be withdrawn penalty-free to help fund your retirement.
For 2008, people with family coverage can contribute up to $5,800 into their HSA, while people with individual coverage are capped at $2,900. The government really wants HSAs to succeed, so you should be able to find an adequate high-deductible health insurance option within your state.
For example: Let's say you switch to a high-deductible health insurance plan and contribute $5,800 into a Health Savings Account.
Cost | Higher out of pocket costs associated with the high deductible health insurance plan |
Benefit | Tax savings of $2,030, plus $5,800 growing tax-deferred within your HSA to fund your family's medical expenses now and/or your retirement later |
4. Incorporate Your Business
Once the profits in your business exceed $230,000 (in 2008) per owner, you could save some taxes by incorporating. That's because you avoid paying the 2.9% Medicare tax on money withdrawn from your practice as S-Corp dividends instead of as salary.
Why is $230,000 the magic number? That's the maximum amount of salary that you can use to calculate your retirement plan contributions in 2008.
Beware of the costs of incorporating, however, including having an accountant prepare your corporate tax return, additional payroll taxes and worker's compensation insurance now that you'll be on the company's payroll, and a variety of minimum taxes and filing fees assessed by many states.
For example: Let's say you change your business structure from a sole-proprietor to an S-Corporation, earn $330,000 in profit, from which you take a salary of $230,000 and S-Corp distributions of $100,000.
Cost | $1,000 or more in additional fees and taxes |
Benefit | Save $2,900 in Medicare taxes on your S-Corp distributions |
5. Set up a More Sophisticated Retirement Plan
From what I've seen, most practices have relatively basic retirement plans in place, such as a SIMPLE IRA or a Safe-harbor 401(k) plan. While these plans are generally more than adequate, you should be aware that there are more sophisticated plans that you can establish that allow for increased annual contributions for you and your partners, without requiring you to contribute more money into the plan on behalf of your staff. You'll want to find a retirement plan specialist to help you design the best type of plan to fit the specific needs of you and your practice.
Cost | Potentially higher retirement plan contributions on behalf of your staff |
Benefit | The ability to contribute more money into your retirement account each year. |
Five Ways To Save
Check with your Tax Professional to see if it makes sense to institute any of these five tax-saving strategies early in 2008. By investing some time now, you could earn substantial dividends in the form of reduced taxes down the road.
