Author Topic: Help me maximize contributions and tax advantages  (Read 1290 times)

diffusate

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Help me maximize contributions and tax advantages
« on: February 20, 2018, 09:01:53 AM »
I need a little help! I'm about to get proceeds from a house sale, approximately $400k. I currently work as an independent contractor. Last year I earned about $55k and this year will be about $60k. I want to put as much as possible into tax advantaged accounts.

I've already maxed my 2017 Roth IRA. From my research I'm eligible for an SEP. I set one up through Vanguard, but can someone help clarify the maximum contributions? Can I still contribute for 2017 as well as 2018?

Anything else I should consider? HSA? I have a high deductible plan through the ACA.

Thanks!

SeattleCPA

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Re: Help me maximize contributions and tax advantages
« Reply #1 on: February 20, 2018, 07:19:36 PM »
Are you sure you need to put the money into tax-deferred space?

E.g., if you put the money into (say) a total stock market index and earn roughly $8K in potentially qualified dividends that are taxed and (say) another $8K of untaxed capital gains, is it possible the $8K of dividends won't even be taxed?

P.S. If your taxable income is less than $39K with the qualified divs and you're single... or if your taxable income is less than $74K with the qualified dividends and you're married... your qualified dividends tax rate is 0%.

Bicycle_B

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Re: Help me maximize contributions and tax advantages
« Reply #2 on: February 20, 2018, 09:09:59 PM »
I'm not a tax expert, so please use my remarks as a research starting point rather than taking them as gospel.  Here are a couple of tricks (ok, basic tax techniques for small business owners) as I understand them.  I haven't used these personally, just read about them while trying to plan ahead.  Please accept any corrections from wise commenters (such as SeattleCPA!).

1. Pass-through income deduction.  This is part of the new tax plan that was passed last year.  2018 is the first year it's in effect.  It applies to anyone who owns a sole proprietorship, or any other form of business that has "pass through" income - business income that gets treated as personal income.  The new tax law allows you to deduct 20% of that income and pay no income tax on it.
2. Declare 40% of remaining income as dividends.  I have been told that the IRS allows sole proprietors and LLC owners to classify up to 40% of income as dividends.  Dividends get better tax treatment than ordinary income.
3.  Solo 401(k) plan.  This is the self-employed person's version of a corporate 401(k) plan.  It is used if you don't have any employees, the business is just you.  If this is your case, maybe you would benefit more than from an SEP.  If so, you can contribute $18,500 per year, plus 20% of your taxable self-employment income (I think you first deduct from the self-employment income another 7.65% for self-employment taxes).

Example:  sole proprietor, $50,000 of income (meaning, revenues less expenses for 2018 are $50,000 before any deductions or taxes). 
1.  Use pass-through income deduction.  50,000 x 20% = 10,000 deduction.  Income goes down to 40,000.
2. Declare 60% as ordinary income, 40% as dividends.  40,000 x 60% = $24,000 ordinary income.  $40,000 x 40% = $16,000 dividends.  You pay 15.3% employer/employee payroll tax (FICA, OASDI) on the ordinary income, but zero payroll tax on dividends.
3a.  Determine basis for 401(k) calculation.  24,000 x 7.65% = 1836.  $24,000-1836 = $22,184 ordinary income less employer portion of payroll tax; basis for 401k calc is 22,184.
3b.  22,184 x 20% = 4,437. 
3c.  Max 401k contribution = 18,500 + 4,437 = 22,937. 
3d.  Ordinary business income = 24,000 - 22,937 = 1,063.

I think the result would be something like:

1,063 Ordinary business income
12,700 standard deduction
You don't owe any income tax on ordinary income at all!!!

12,700 - 1,063 = $11,637 amount of dividends sheltered from tax by standard deduction
16,000 -11,637 = $4,363 business dividends subject to tax

Supposing this person also had $400,000 in proceeds from sale of a primary residence, in which the house cost $120,000 but had depreciated $20,000 and had sales expenses of $25,000:
400,000 - (120,000-20,000) - 25,000 = 275,000 capital gains
275,000 -250,000 = $25,000 amount of capital gains subject to tax
(tax code allows deduction of $250,000 capital gains from sale of house that the owner lived in for the majority of the year in 3 of the last 5 years, aka a primary residence)

$04,363 taxable business dividends
$25,000 taxable capital gains
----------
$29,363 taxable amount subject to the income tax rate for dividends and capital

If I understand correctly, dividends and capital gains up to $37,700 (the point at which low tax rates rise up to high rates in this year's tax code) get a tax rate of 0%.  Meaning that our taxpayer would owe income tax of zero!

He/she still owes payroll tax though:
24,000 x 15.3% = $3,672.

Totally curious to see whether this is anywhere close to correct.  Experts?  SeattleCPA?


« Last Edit: February 20, 2018, 09:26:14 PM by Bicycle_B »

PDXTabs

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Re: Help me maximize contributions and tax advantages
« Reply #3 on: February 20, 2018, 11:10:44 PM »
I need a little help! I'm about to get proceeds from a house sale, approximately $400k. I currently work as an independent contractor. Last year I earned about $55k and this year will be about $60k. I want to put as much as possible into tax advantaged accounts.

I'm pretty sure that you can put 25% of your taxable income into a SEP-IRA (for both 2017 and 2018).

I don't know what you want to do with your money, but you can also buy $10K worth of I Savings Bonds (plus $5K more with your tax return?). This money isn't taxed until you redeem the bond, which pays interest for 30 years.

diffusate

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Re: Help me maximize contributions and tax advantages
« Reply #4 on: February 21, 2018, 09:25:57 AM »
Thanks all! This is super helpful if still confusing. Bicycle_B, I like where you're going, but I'm not sure I can do all that as I'm paid as an individual and issued a 1099, don't have any corporate structure set up. I'm thinking it would be useful to pay to talk to someone. Who though? CPA? Tax preparer? Any referrals in the Seattle area and ideas of what it might cost?

Bicycle_B

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Re: Help me maximize contributions and tax advantages
« Reply #5 on: February 21, 2018, 04:21:34 PM »
Thanks all! This is super helpful if still confusing. Bicycle_B, I like where you're going, but I'm not sure I can do all that as I'm paid as an individual and issued a 1099, don't have any corporate structure set up. I'm thinking it would be useful to pay to talk to someone. Who though? CPA? Tax preparer? Any referrals in the Seattle area and ideas of what it might cost?

CPA who does tax planning, I would think.  I only know Seattle from the forums.  Not sure if SeattleCPA does this sort of thing. 

SeattleCPA

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Re: Help me maximize contributions and tax advantages
« Reply #6 on: February 21, 2018, 07:05:26 PM »
I'm not a tax expert, so please use my remarks as a research starting point rather than taking them as gospel.  Here are a couple of tricks (ok, basic tax techniques for small business owners) as I understand them.  I haven't used these personally, just read about them while trying to plan ahead.  Please accept any corrections from wise commenters (such as SeattleCPA!).

1. Pass-through income deduction.  This is part of the new tax plan that was passed last year.  2018 is the first year it's in effect.  It applies to anyone who owns a sole proprietorship, or any other form of business that has "pass through" income - business income that gets treated as personal income.  The new tax law allows you to deduct 20% of that income and pay no income tax on it.

The Sec. 199A deduction is lesser of 20% of taxable income or qualified business income. So it helps... but it's not a big deal if someone makes $55K and then reduces that with $12K of standard deduction and $28K of pension contributions. In this case, the 20% of $10K to $15K of taxable income means a $2K to $3K deduction which produces maybe $200 to $400 of savings.


2. Declare 40% of remaining income as dividends.  I have been told that the IRS allows sole proprietors and LLC owners to classify up to 40% of income as dividends.  Dividends get better tax treatment than ordinary income.

A pass-thru entity doesn't pay qualified dividends. It pays distributions. Distributions, BTW, aren't taxed. Also, there is no "40% rule"... the rule is that S corporations need to pay reasonable compensation to their shareholder-employees... and that the leftover amount is paid as a distribution.

FYI, a regular corporation does pay qualified dividends. But the new tax law would mean business had already paid a 21% tax. E.g., $10,000 of pre tax corporation profits turns into $7900 of money available for qualified dividends. That $7900 gets taxed at 0%, 15% or 20%... plus possibly the Obamacare surtax.


SeattleCPA

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Re: Help me maximize contributions and tax advantages
« Reply #7 on: February 21, 2018, 07:07:30 PM »
I need a little help! I'm about to get proceeds from a house sale, approximately $400k. I currently work as an independent contractor. Last year I earned about $55k and this year will be about $60k. I want to put as much as possible into tax advantaged accounts.

I'm pretty sure that you can put 25% of your taxable income into a SEP-IRA (for both 2017 and 2018).

I don't know what you want to do with your money, but you can also buy $10K worth of I Savings Bonds (plus $5K more with your tax return?). This money isn't taxed until you redeem the bond, which pays interest for 30 years.

If your self-employment earnings equal $60K, you'll get to contribute about $12K to a SEP. Note that that $12K is roughly 25% of the net amount you have left over after the SEP... ($60K-$12K... or $48K).

Bicycle_B

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Re: Help me maximize contributions and tax advantages
« Reply #8 on: February 21, 2018, 07:12:17 PM »
Thanks, SeattleCPA!

SeattleCPA

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Re: Help me maximize contributions and tax advantages
« Reply #9 on: February 21, 2018, 07:12:46 PM »
Thanks all! This is super helpful if still confusing. Bicycle_B, I like where you're going, but I'm not sure I can do all that as I'm paid as an individual and issued a 1099, don't have any corporate structure set up. I'm thinking it would be useful to pay to talk to someone. Who though? CPA? Tax preparer? Any referrals in the Seattle area and ideas of what it might cost?

Your best tax savings gambits are to (1) operate as an S corporation if you're an independent contractor and (2) max your pension.

Here's an article from my blog that explains:

https://evergreensmallbusiness.com/million-dollar-s-corporation-mistake/

BTW, you need an eligible entity in place ASAP in order to get S corp savings for 2018. If you're in Washington state, that probably means a Washington LLC. Here is a blog post that gives steps for doing that.

https://evergreensmallbusiness.com/forming-a-washington-state-llc/

SeattleCPA

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Re: Help me maximize contributions and tax advantages
« Reply #10 on: February 21, 2018, 07:13:17 PM »