Self-Employment, Taxes and SEP-IRAs

I generate a good bit of self-employment income, and naturally I want to shield as much of this as possible from taxes. The problem with self-employment income is that it’s subject not only to state and local income taxes, but also to self-employment tax. You know that pesky 7.65% that you pay toward social security and medicare at your regular job? Well, if you’re self-employed, you get to double it (at a regular job, your employer pays the other half). So on top of everything else, you get to pay an additional 15.3% of net income. Lovely.

One crazy idea that I had was to try and shelter this money in a SEP-IRA. As it turns out, self-employed individuals can make employer contributions to a SEP-IRA on their own behalf in an amount equal to (roughly) 20% of their self-employment income (you can also make an employee contribution; more on this below). The reason that I said ‘roughly’ is that the IRS has a convoluted worksheet that slightly reduces the base income upon which the 20% is calculated (you reduce it by 1/2 of the self-employment tax, to be exact). But I digress…

My thinking was that maybe, just maybe, the employer contributions would escape not only income tax, but also self-employment tax. I actually wrote a bit about this last spring, but it turns out that I was wrong. Rather, it seems that the employer contribution is deducted from your 1040, but not from Schedule C. Thus, it escapes income tax, but it does not escape self-employment tax.

This is not to say that setting up a SEP-IRA is a bad idea. After all, it gets you around income taxes. But it does something else, too…

As I noted above, you can contribute to your SEP-IRA as either the employer, the employee, or both. In the case of the latter, it counts against your annual IRA contribution limit, so it reduces the amount that you can contribute to a traditional or Roth IRA. But in the case of the former, there’s no effect on your annual IRA contribution limit. Thus, it seems that you can use employer contributions to your SEP-IRA as a way of legally exceeding the IRS contribution limits ($4000 this year, $5000 next year).

So there you have it… SEP-IRAs aren’t quite as useful as I had hoped, but they still have their own unique advantages.

Oh, and I’m not done yet when it comes to avoiding self-employment taxes… Keep an eye out for at least one more idea on this front — and this one works (though I’m not sure it’s worth the trouble).