Solo 401k and undeclared income

[munchabunch]

I was hoping you guys would be able to help.

We are a married couple with only one job, my husband is a stay at home spouse. This means I've maxed one 401k and two IRAs (thank you spousal contributions!) but we don't have a second 401k to fill. I was hoping to do more tax advantaged savings, but I'm not sure it's possible.

We have a small amount of undeclared hobby income, <$2000 this year. It meets all the IRS qualifications for hobby income (not consistent profit, not run as a business, not optimized for gains or advertised, etc.). I've read a lot of excellent articles, and even an incredibly helpful post by another forum member on setting up a solo 401k. This seems to apply if you already have income, like freelancing or a home business. Am I correct that it doesn't make sense to declare hobby income just to put it in a 401k? Right now the earnings were tax free, if I used a 401k I'd have to declare it, then 401k it, then pay taxes on both the money and the gains when pulling it out?

I couldn't seem to find a resource about this and was hoping for a confirmation. Thanks, as always!

[Proud Foot]

For that small of an amount my suggestion would just be to open up a taxable account to invest in.  I don't know all the requirements but I believe that $2k would also be subject to FICA taxes in order to contribute to a solo 401k.

[With This Herring]

I was hoping you guys would be able to help.

We are a married couple with only one job, my husband is a stay at home spouse. This means I've maxed one 401k and two IRAs (thank you spousal contributions!) but we don't have a second 401k to fill. I was hoping to do more tax advantaged savings, but I'm not sure it's possible.

We have a small amount of undeclared hobby income, <$2000 this year. It meets all the IRS qualifications for hobby income (not consistent profit, not run as a business, not optimized for gains or advertised, etc.). I've read a lot of excellent articles, and even an incredibly helpful post by another forum member on setting up a solo 401k. This seems to apply if you already have income, like freelancing or a home business. Am I correct that it doesn't make sense to declare hobby income just to put it in a 401k? Right now the earnings were tax free, if I used a 401k I'd have to declare it, then 401k it, then pay taxes on both the money and the gains when pulling it out?

I couldn't seem to find a resource about this and was hoping for a confirmation. Thanks, as always!

I think there is a bit of a misunderstanding here.  You need to declare hobby income no matter what happens.  It is hobby losses that you don't take.  So, if you have a pet dog with which you enter dog shows as a hobby, and for a few years your dog doesn't win any money, all its grooming expenses and travel expenses don't go on your tax return because they are costs of your hobby.  But then if one year your dog suddenly wins a prize of $700, you need to declare the $700 on your tax return as income, and you get to deduct (as itemized deductions) some of the hobby expenses related to getting that $700, up to $700 of expenses.

IRS Basic Tips About Hobbies

Millions of people enjoy hobbies that are also a source of income. Some examples include stamp and coin collecting, craft making, and horsemanship.

You must report on your tax return the income you earn from a hobby.

Hobby Income = income from Activity Not for Profit
See also page 5 of this PDF of Publication 535.
See also page 28 of this PDF of Publication 525.

[munchabunch]

Ahhhh, thank you With This Herring, that makes so much more sense. For some reason when I first read all those documents and talked to folks I was getting a different impression.

Can you help me in the context of the original question?
1. If the hobby income is deducted 100% using itemized deductions, I assume that means no tax?
2. If the hobby income isn't deducted 100% does it make sense to open a 401k to call it pretax income and deduct it that way?

Thanks!

[With This Herring]

1) IF you have enough deductions to bother itemizing, then you may or may not end up with income on the hobby.  Read through the example on page 6 of Publication 535.  Any allocable otherwise-itemized deductions (home mortgage interest, property taxes) are used first, and then the rest count as miscellaneous deductions and are reduced by the 2%-of-AGI threshold.  So, if you would be itemizing and taking those home items anyway, the net effect on your return is an increase in tax.  If you did not have enough miscellaneous deductions to already cover that 2% threshold, that would mean an increase in tax.  Most likely, I would guess that you will see some increase in tax for this.

2) If you end up with hobby income, I don't think that you can open a 401(k) for it.  Not "it doesn't make sense," but "is not permitted."  I'm not completely certain, but I don't think that you can elect to classify hobby income as (self) employment income, which is required for retirement contributions.  Just like you can't take dividends from your taxable account and call them income for IRA contribution purposes, I don't think you can call hobby proceeds income for 401(k) purposes.

IF you turn this hobby into a business and treat it like a proper business, then you can start reporting income and expenses on a Schedule C, pay self-employment taxes on it, take full amounts of the expenses without worries about itemizing and 2% miscellaneous thresholds, and put that income into a 401(k).

I'm writing this late at night, so pardon any typos.  Other CPAs should feel free to jump in if I have botched anything.  I haven't worked with much hobby stuff on tax returns.

[munchabunch]

With this herring, thanks again for your thoughtful responses. Every time I read enough to "get" something it seems as though another thread unravels into another topic. I appreciate your time and I need to spend some more time reading and thinking about this stuff (like was does my house have to do with a hobby, or showing a dog, etc.). Thank you again.

[With This Herring]

Well, the US Tax Code isn't known for being easy to follow. :)  The IRS really does their best with the instructions, but the rules themselves are a mess.

A problem I have with a lot of the little (non-IRS-provided) tax advice articles online is that they very rarely warn that "This is just a shallow overview of one particular tax concept.  You should refer to Publications XXX and XXX, plus IRB XXX to determine if this information applies to you and how to deal with it."  The most they tend to say is "Discuss this with your tax advisor, as your situation may differ."

Regarding your house:
I don't know what your hobby is, but let us pretend it is making jewelry.  If you had a little room in your home where you did just jewelry stuff, you would properly allocate a portion of your mortgage interest and property taxes to the jewelry hobby based on the relative square footages, assuming you had income that year.  So, if you had $2000 of mortgage interest and $1000 of property taxes, and the jewelry room was 100 square feet of your 2000 square foot house (5% of the area), then you would allocate $100 of mortgage interest (5% of $2000) and $50 of property taxes (5% of $1000) to your jewelry hobby before you started looking at other jewelry-making expenses to offset income.

[munchabunch]

You are amazing and so helpful; thank you again!  The math in the publications is exactly the same as what you outline, but I couldn't figure out the "why".  Because I own a house, part of its cost is related to a hobby?  The publications are not so clear about that.  Your message was much better.

As soon as you described that scenario, it made much more sense.  I've continued to read a few articles each evening but they all tend to slew towards the numbers and not the reasoning.  They also seem very repetitive.  The context makes SO MUCH MORE SENSE and helps the numbers "fit".  I wish the official documentation also clarified these things.

Thank you again.  I'm still learning something new every day.  Next up, the actual legit tax forms.  All I wanted was to make pretty things and sell a few to pay for my supplies, and then it got complicated :).