Tax season is probably the most important time for independent consultants to think like business owners. This especially means being smart about how we handle our money. Our motivation is simple: pay as little tax as possible, ideally without triggering an audit. We all should be asking ourselves (and our accountants) this question:
As a business owner, what can I do to lower my tax bill?
The answer is to maximize your tax deductions for this year and take steps to reap tax saving benefits every year. This article touches on the first and explores the second in depth.
For the Near Term: Take Standard Business Owner Deductions
You don’t have to have a legal business structure like an LLC or S-corp to take advantage of standard business-owner tax deductions. Sole proprietors qualify for deductions too, even if you only consult part time.
Standard business-owner tax deductions include deducting your home office and a portion of your utilities; parking, tolls, and mileage to and from business meetings; books and subscriptions; office supplies, shipping, and postage; retirement contributions, and probably even health insurance premiums on your personal tax return. Obviously, every person’s situation is different so talk with your tax professional. In the meantime, before meeting with your accountant I recommend reading “Top Tax Deductions for Your Small Business” by Stephen Fishman, J.D., author of the book Deduct It! Lower Your Small Business Taxes. Other useful resources are from the IRS, “Deducting Business Expenses” and “Publication 535 (2016), Business Expenses.”
For the Longer Term: Maximize Tax Deductions
When you are self-employed, investing some time now can save you tens of thousands in tax over the years. The two key ways are setting up your own business-owner retirement plan and using a health savings account. It takes a bit of effort and some fiscal discipline to maintain, but doing so provides a double reward of lowering your taxable income (and related taxes due) while increasing your personal savings. Let’s look at these in more detail.
1. Set Up Your Own Business-Owner Retirement Plan
The most advantageous thing you can do to enhance your long-term financial success is set up a business-owner retirement plan such as a Simplified Employee Pension (SEP-IRA) or Individual 401(k). Having one of these plans is like having the goose that keeps laying golden eggs. Each has pros and cons (see attached comparison sheet) but both work essentially the same.
The primary benefit of having a business-owner retirement plan is that every dollar you put into your retirement savings is deducted from your taxable income, creating a smaller adjusted net income. This immediately lowers the tax you owe for the year, and then your savings grow tax free until you withdraw the money in retirement, presumably at a lower tax rate. Thus, this is a double benefit.
The second significant benefit of having your own retirement plan is you can save much, much more than as a regular employee—in some cases up to $59,000 a year! (A traditional company-sponsored 410(k) maxes out at $18,000 unless you are over 50, then it’s $24,000.) If you’re like most people, you’re behind on saving for retirement, so this is a real plus.
Let me share my story about how this “retirement savings magic” works.
A few years ago, my partner was doing my personal returns using TurboTax® and asked me how much I was going to contribute to my retirement account. I said I was planning on $20,000. (Contributions are due the same day your tax return is, usually April 15th.) He said, “Well, that’s good. You’ll lower your tax due by about $5,600, but if you can put $25,000 into your SEP-IRA, you’ll save about $7,000 in tax.” Really? I can lower my tax simply by paying myself more? From that day forward I put about $25,000 a year into my SEP-IRA. Now, 10 years later, those funds have grown substantially, and I no longer worry about my retirement savings. Save money, earn more. To me a self-employed retirement plan is a no-brainer.
Setting up a SEP-IRA or Individual 401(k) is easy and many brokerage firms like Charles Schwab or Fidelity Investments will do it for little-to-no cost. The hard part is figuring out which plan is best for you and setting aside the funds every year. (Tip: Every time a client pays you, siphon off 40% into a separate bank account. Use these funds to pay quarterly taxes and to feed your retirement plan.)
For more examples of SEP-IRA tax savings and the value of compound interest, please see my earlier blog post: Self-Employed? This Tax Tip Can Save You Thousands!
2. Contribute to a Health Savings Account (HSA)
The second-best thing you can do to pay less tax every year is to set up a health savings account and make maximum contributions. A health savings account is not the same as a flexible spending account. With the latter you must “use it or lose it” by year’s end. With an HSA, the funds accumulate year to year like a regular savings account. To set up an HSA, you also need a corresponding high-deductible, HSA-compatible health insurance plan.
Here are some advantages of an HSA:
- Like the retirement plans above, the funds contributed to an HSA are not subject to federal income tax at the time of deposit. In other words, they lower your taxable income.
- Money in the savings account can be used to pay your insurance deductible, tax free.
- Withdrawals to pay qualified medical expenses that are not part of your deductible, like dental and vision expenses, are also tax free.
- Money left in the savings account at the end of the year earns interest and is yours to keep. (Some plans allow you to invest your savings in stocks and mutual funds.)
- Money and compound interest grow tax-deferred. If interest is used to pay qualified medical expenses, it’s also tax-free.
- High-deductible insurance plans usually have lower premiums, so you save money there too.
Here are some of the caveats and drawbacks:
- You can only set this up if you are paying your own insurance. If you have insurance some other way, such as via your spouse, you can’t participate in an HSA. (Note: If you’re married, check to see if your spouse’s company offers a high-deductible HSA insurance option and take advantage of it there.)
- Early and non-medical withdrawals are taxable income and also subject to a steep 20% tax penalty. (When you reach 65 or if you become disabled, you can withdraw HSA funds for non-medical reasons without penalty, but the amounts withdrawn will be taxable as ordinary income.)
- Most HSA’s charge a management fee, similar to bank fees. For example, mine charges $2.50 per month.
- You can’t take a loan from an HSA like you can from a 401(k).
Although the annual contribution limits are fairly low, it’s still worth doing to lower your taxes and increase your savings. The contribution limits for 2017 are $3,400 for an individual and $6,750 for a family; if over 55 you can contribute $1,000 more. (Important note: If you are divorced and your child or children have health insurance through your ex-spouse, you can still contribute at the family limit. I wish I knew this 10 years ago; I could have lowered my taxable income and saved another $30,000!)
Here’s a scenario to consider: you decide to use the HSA as an investment account to squirrel away money for medical expenses in retirement. In other words, you don’t take any withdrawals for expenses before then. You contribute the maximum family amount every year for 15 years and get a 4% rate of return. After the 15 years, you will have $153,543 to use, tax-free, for your medical expenses, including Medicare Part B and Part D premiums and a portion of long-term-care premiums, depending on your age. That’s significant, especially when it’s currently estimated that a 65-year-old retired couple will need $260,000 to cover their likely health costs. The money in an HSA can be used to pay those costs tax free. Accumulating money in an HSA has a distinct advantage over an IRA since IRA withdrawals will be taxed.
In summary, health savings accounts are a “triple play”—deposits are tax-free, withdrawals for medical-related expenses are tax-free, and interest grows tax-deferred. Their major drawback? They have lots of rules and restrictions. It’s fairly easy to set one up; many banks and brokerage firms offer health savings accounts, and you can open an account anywhere as long as you have an HSA-eligible, high-deductible health insurance policy. Finding and getting the health insurance policy is the hard part.
For general information and FAQs about HSAs, I recommend the HSA Center website.
For a good summary of the tax advantages of an HSA vs other savings plans, I recommend this Morningstar article.
To find an HSA plan that best fits your needs (for example, paying current medical expenses or saving for retirement), try this website where it’s easy to compare any of 357 providers.
Remember, there are two sides of the equation to being a successful independent consultant: billing more and keeping more of what you bill!