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This is the first year my income has been almost exclusively derived from my self-employment/sole proprietorship and I have never been so furious in my life at our tax code. The assumption built into the system appears to be that within two years of being self-employed you should be raking in sufficient gobs of cash that you can just afford to pay professionals to take care of all retirement and tax issues.
Well, I make a hell of a lot less money now than I did before I became self-employed, so CPA's and CFP's are not in my near future.
Which reminds me of the absolute most infuriating thing about the tax code, which is that everybody is so freaking terrified of actually giving anyone any advice. They have to recite the entire goddamn tax code chapter and verse to make sure they're not leaving anything out. Well, guess what, none of this applies to you if you're a clergyman or a displaced person or a refugee or a victim of human trafficking. It's just for self-employed people trying to pay their taxes and save for retirement.
There are so many things wrong with the tax treatment of self-employment, but the most infuriating one is that tax obligations and tax-advantaged retirement account contributions are based on calendar-year income, while for actually existing sole proprietors like me calendar-year income is completely unknowable.
So with that in mind, I want to lay out some simple formulas you can use to calculate your estimated tax payments and allowed retirement contributions at the end of each calendar month, both in order to avoid tax penalties for underpayment and to avoid scrambling to max out retirement savings contributions at the end of the year, which is too close to timing the market for my taste.
All the calculations below are for poor self-employed people and sole proprietors (if you make over $117,000 you can afford an accountant, which I am not, nor do I have any training in tax law). But since I cannot find any other resource that lays out all these calculations in simple language, I had to write my own.
Additionally, since obligations and limits work on a tax-year basis the following calculations will only work if you make at least a small profit each month. Otherwise, the months where you make a loss will offset your profitable months and throw the whole thing into chaos.
Below I am not using any gibberish IRS terms of art. Just plain English (IRS math in parentheses).
Self-employment taxes
Self-employment taxes are 14.13% of your profit from self-employment. Calculate each month’s self-employment tax by taking all your income from self-employment and deducting each month’s business expenses (which you plan to itemize on Schedule C), then multiply that number by 0.1413 (15.3% of 92.35%).
There are a number of reasons that this formula will lead to overpaying self-employment taxes, the most obvious one being deductions that you’ll calculate when filing your taxes annually, but that aren’t incurred monthly, for example home-office expenses. If you have already lived in the home your home-office is located in for an entire tax year, you may already know your monthly home office deduction and be able to add it to your monthly expenses when calculating your self-employment taxes. Otherwise you’ll overpay by 14.13% of your home office deduction.
Pay your estimated taxes by April 15 (for profit from self-employment between January 1 and March 31), June 15 (for profit from self-employment in April and May), September 15 (for profit from self-employment in June, July and August), and January 15 (for profit from self-employment in September, October, November, and December).
SEP IRA contributions
SEP IRA’s are very easy to set up and make contributions to.
You can deduct contributions of up to 18.59% of your profit from self-employment to a SEP IRA each month (20% of (100% minus half of 15.3% of 92.35%)).
If you aren’t deducting your home office and other annual business expenses monthly, you’ll contribute slightly more than you’re technically allowed to deduct each month (since lower profit from self-employment lowers the calculation above). You can make it up at the end of the year by skipping a contribution until you find out the exact amount you're eligible to deduct.
Enter the amount you contribute (up to the deductible maximum calculated above) on Form 1040, line 28.
One-participant 401(k) contributions
Instead of or in addition to a SEP IRA, you can set up a one-participant 401(k) plan, which shares the same deductible contribution limit as above (18.59% of profit from self-employment).
The key advantage of the one-participant 401(k) over the SEP IRA is that you’re able to make contributions “as the employee" as well as “as the employer.” Your “as the employer” contributions are deducted on Form 1040, line 28, as above, with the 18.59% of self-employment profit limit.
But you can also contribute up to 74.35% of your profit from self-employment “as the employee" (the remaining 80% of (100% minus (half of 15.3% of 92.35%))). If you choose to make that contribution as a traditional (pre-tax) contribution, it’s added to your Form 1040, line 28 “as the employer” contribution. If you make it as a Roth (after-tax) contribution, it’s not deducted (you pay taxes on the amount of your contribution in the year you make it, but not on any withdrawals in retirement).
One-participant 401(k)’s may have higher fees, so there’s no point in setting one up unless you want to make that “as the employee” contribution as well.
Retirement Savings Contribution Credit
The RSCC is one of my absolute favorites. Unfortunately, it has several moving parts which interact in a very frustrating way.
The RSCC is calculated based on your traditional and Roth IRA contributions, and the “as the employee” contributions described in the section above. It’s calculated on up to $2,000 combined of all three kind of contributions (you can mix and match).
The RSCC is calculated as a percentage of those contributions. The lower your Adjusted Gross Income (Form 1040, line 38), the higher a percentage of your combined contributions (up to $2,000) you’re eligible to claim as a credit, up to a maximum of 50% of $2,000.
But the RSCC is additionally capped at the total federal income tax owed (unrelated to self-employment tax described in the first section), for example on Form 1040, line 47.
That means if you’re already in the AGI band that gives you the highest percentage credit (AGI less than $18,000 for single filers), traditional IRA and pre-tax one-participant 401(k) contributions will lower the cap on the amount of RSCC you can claim by lowering the federal income tax owed (Form 1040, line 47).
On the other hand, if your AGI puts you in a lower percentage band, making traditional IRA and pre-tax “as the employee” one-participant 401(k) contributions can lower your AGI, making you eligible for a higher percentage credit.
There’s unfortunately no way to calculate this on a month-by-month basis, since it can only be calculated at year-end once you know your final profit from self-employment.
Finally, let me point out the most infuriating thing about the RSCC: a single filer making exactly $18,000 in AGI will, after the standard deduction and personal exemption only owe $788 on Form 1040, line 47, meaning even though they’re in the highest credit calculation band, if they contribute the full $2,000 they’ll still only be able to claim a credit for $788!
That’s how the rich get richer, my friends.
Earned Income Credit
Self-employed people are eligible to claim the Earned Income Credit (as long as their profit from self-employment and AGI fall within certain ranges).
To calculate your earned income credit, you have to check the EIC table for both 92.94% of your profit from self-employment (100% minus half of 15.3% of 92.35%) and your AGI from Form 1040, line 38. You’re entitled to the lesser of the two amounts, so there’s no way to goose your EIC with AGI deductions (although there is in combination with business deductions).
Conclusion
Well. I’m glad I got all this off my chest.
Are there other common tax situations self-employed people face which could stand for some simplified calculations?
Well, I make a hell of a lot less money now than I did before I became self-employed, so CPA's and CFP's are not in my near future.
Which reminds me of the absolute most infuriating thing about the tax code, which is that everybody is so freaking terrified of actually giving anyone any advice. They have to recite the entire goddamn tax code chapter and verse to make sure they're not leaving anything out. Well, guess what, none of this applies to you if you're a clergyman or a displaced person or a refugee or a victim of human trafficking. It's just for self-employed people trying to pay their taxes and save for retirement.
There are so many things wrong with the tax treatment of self-employment, but the most infuriating one is that tax obligations and tax-advantaged retirement account contributions are based on calendar-year income, while for actually existing sole proprietors like me calendar-year income is completely unknowable.
So with that in mind, I want to lay out some simple formulas you can use to calculate your estimated tax payments and allowed retirement contributions at the end of each calendar month, both in order to avoid tax penalties for underpayment and to avoid scrambling to max out retirement savings contributions at the end of the year, which is too close to timing the market for my taste.
All the calculations below are for poor self-employed people and sole proprietors (if you make over $117,000 you can afford an accountant, which I am not, nor do I have any training in tax law). But since I cannot find any other resource that lays out all these calculations in simple language, I had to write my own.
Additionally, since obligations and limits work on a tax-year basis the following calculations will only work if you make at least a small profit each month. Otherwise, the months where you make a loss will offset your profitable months and throw the whole thing into chaos.
Below I am not using any gibberish IRS terms of art. Just plain English (IRS math in parentheses).
Self-employment taxes
Self-employment taxes are 14.13% of your profit from self-employment. Calculate each month’s self-employment tax by taking all your income from self-employment and deducting each month’s business expenses (which you plan to itemize on Schedule C), then multiply that number by 0.1413 (15.3% of 92.35%).
There are a number of reasons that this formula will lead to overpaying self-employment taxes, the most obvious one being deductions that you’ll calculate when filing your taxes annually, but that aren’t incurred monthly, for example home-office expenses. If you have already lived in the home your home-office is located in for an entire tax year, you may already know your monthly home office deduction and be able to add it to your monthly expenses when calculating your self-employment taxes. Otherwise you’ll overpay by 14.13% of your home office deduction.
Pay your estimated taxes by April 15 (for profit from self-employment between January 1 and March 31), June 15 (for profit from self-employment in April and May), September 15 (for profit from self-employment in June, July and August), and January 15 (for profit from self-employment in September, October, November, and December).
SEP IRA contributions
SEP IRA’s are very easy to set up and make contributions to.
You can deduct contributions of up to 18.59% of your profit from self-employment to a SEP IRA each month (20% of (100% minus half of 15.3% of 92.35%)).
If you aren’t deducting your home office and other annual business expenses monthly, you’ll contribute slightly more than you’re technically allowed to deduct each month (since lower profit from self-employment lowers the calculation above). You can make it up at the end of the year by skipping a contribution until you find out the exact amount you're eligible to deduct.
Enter the amount you contribute (up to the deductible maximum calculated above) on Form 1040, line 28.
One-participant 401(k) contributions
Instead of or in addition to a SEP IRA, you can set up a one-participant 401(k) plan, which shares the same deductible contribution limit as above (18.59% of profit from self-employment).
The key advantage of the one-participant 401(k) over the SEP IRA is that you’re able to make contributions “as the employee" as well as “as the employer.” Your “as the employer” contributions are deducted on Form 1040, line 28, as above, with the 18.59% of self-employment profit limit.
But you can also contribute up to 74.35% of your profit from self-employment “as the employee" (the remaining 80% of (100% minus (half of 15.3% of 92.35%))). If you choose to make that contribution as a traditional (pre-tax) contribution, it’s added to your Form 1040, line 28 “as the employer” contribution. If you make it as a Roth (after-tax) contribution, it’s not deducted (you pay taxes on the amount of your contribution in the year you make it, but not on any withdrawals in retirement).
One-participant 401(k)’s may have higher fees, so there’s no point in setting one up unless you want to make that “as the employee” contribution as well.
Retirement Savings Contribution Credit
The RSCC is one of my absolute favorites. Unfortunately, it has several moving parts which interact in a very frustrating way.
The RSCC is calculated based on your traditional and Roth IRA contributions, and the “as the employee” contributions described in the section above. It’s calculated on up to $2,000 combined of all three kind of contributions (you can mix and match).
The RSCC is calculated as a percentage of those contributions. The lower your Adjusted Gross Income (Form 1040, line 38), the higher a percentage of your combined contributions (up to $2,000) you’re eligible to claim as a credit, up to a maximum of 50% of $2,000.
But the RSCC is additionally capped at the total federal income tax owed (unrelated to self-employment tax described in the first section), for example on Form 1040, line 47.
That means if you’re already in the AGI band that gives you the highest percentage credit (AGI less than $18,000 for single filers), traditional IRA and pre-tax one-participant 401(k) contributions will lower the cap on the amount of RSCC you can claim by lowering the federal income tax owed (Form 1040, line 47).
On the other hand, if your AGI puts you in a lower percentage band, making traditional IRA and pre-tax “as the employee” one-participant 401(k) contributions can lower your AGI, making you eligible for a higher percentage credit.
There’s unfortunately no way to calculate this on a month-by-month basis, since it can only be calculated at year-end once you know your final profit from self-employment.
Finally, let me point out the most infuriating thing about the RSCC: a single filer making exactly $18,000 in AGI will, after the standard deduction and personal exemption only owe $788 on Form 1040, line 47, meaning even though they’re in the highest credit calculation band, if they contribute the full $2,000 they’ll still only be able to claim a credit for $788!
That’s how the rich get richer, my friends.
Earned Income Credit
Self-employed people are eligible to claim the Earned Income Credit (as long as their profit from self-employment and AGI fall within certain ranges).
To calculate your earned income credit, you have to check the EIC table for both 92.94% of your profit from self-employment (100% minus half of 15.3% of 92.35%) and your AGI from Form 1040, line 38. You’re entitled to the lesser of the two amounts, so there’s no way to goose your EIC with AGI deductions (although there is in combination with business deductions).
Conclusion
Well. I’m glad I got all this off my chest.
Are there other common tax situations self-employed people face which could stand for some simplified calculations?
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