Taxes Made Simple

Lisa (realtor) asks:

I've been working as a realtor for a couple years now, and am just starting to make some good money.  I know that there are several retirement plan options for independent-contractor types such as myself, but I can't really tell the difference between any of them.  What would you suggest?

Answer: 

Great question, Lisa. One of the greatest tax benefits of being self-employed is that there are more/better retirement plan options available to you than there are to most other taxpayers.  In addition to the standard IRA/Roth IRA options that everybody has, there are two excellent retirement plan options available only to self-employed taxpayers:

1) Savings Incentive Match Plan for Employees (SIMPLE IRA)

2) Simplified Employee Pension (SEP)

Most of the IRS literature comparing the two options is rather complicated. Luckily, most of it is completely irrelevant if you have no employees.  In that case, the primary difference between the two types of plans is that they have different contribution limits.  If you set up a SIMPLE IRA you can contribute (for 2007) up to $10,500 on a pre-tax basis, or $13,000 if you are 50 or over.  However, if you have a SEP you are allowed to contribute on a pre-tax basis the lesser of:

1) 20% of your net earnings from self-employment

2) $44,000

What you probably noticed already is that, generally, unless your earnings from self-employment are less than $50,000 and you plan on contributing more than $10,000, a SEP is the better option.

It's important not to make contributions beyond the deductible limit, as you will end up being penalized for them.  As such, there are two key things to remember to deduct when calculating your "net earnings from self-employment"

1) The deduction for one half of your Self-Employment tax

2) The deduction for your SEP contribution.

Now, you're probably justifiably confused at this point, wondering how it's possible to determine your maximum contribution, when, in order to figure it out, you have to already know how much you're going to contribute.  The answer is that the IRS gives you a cheatsheet to simplify the calculation.  You can find it toward the end of IRS Publication 560. 

One final point to make on this topic: Unfortunately, the deduction for contributions to a SEP or a SIMPLE IRA do not count as business expenses.  They are deducted on your form 1040 rather than on your Schedule C.  As such, your contributions do not help to reduce your Self-Employment tax. 

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