Outside the Box: Your side hustle can give you a better retirement: Here are the ways to save

Outside the Box: Your side hustle can give you a better retirement: Here are the ways to save

If you have both wage income (W-2 income) from a job and income from part-time self-employment (so-called Schedule C income), you may be missing out on a unique opportunity to simultaneously save on taxes and stockpile additional savings for retirement.

Whether it’s the high-school teacher who does carpentry over the summer, the office employee who sells crafts at weekend flea markets, or the college professor who has consulting income from industry, there are too many freelance independent contractors who fail to take advantage of the opportunities available to them.

Moonlighting employees may see their extra work as largess for current consumption. However, they can save tax dollars by sheltering some of their Schedule C income in a retirement plan. Because the income from the second business is not typically accounted for in the family budget it makes a desirable and painless source of savings.

Think of the spare income as a path to financial independence.

Finally, consider the consequence of not saving a portion of your supplemental income. If you’re accustomed to living on multiple streams of earnings during the working years, you will need to account for the second remuneration to establish the proper replacement ratio when calculating retirement needs.

Which plan is best?

Many earners with Schedule C earnings are only looking to save a modest amount of their supplemental income. For these people tax planners often recommend a SEP. A SEP has the advantage of being easier and less costly to establish and administer than most other alternatives. All a person needs to do is contact any type of financial institution (bank, insurance company, mutual-fund company, brokerage house, etc.) and the vendor will walk you through the process. Since a SEP is a retirement plan that uses an IRA as the receptacle for contributions it allows for a variety of investment choices. In addition to the IRA investment paperwork, it only requires the easy to understand Form 5305 (SEP) for documentation.

Here is how it might work: Joe works full time in the maintenance department of ABC Company and paints houses on the side. He makes $10,000 extra each year. Joe may decide to set aside $1,500 annually in a SEP (note: because of the so-called Keogh rules the maximum contribution is limited to 20% of income from self-employment). Joe contacts any financial firm, CPA, or financial planner, fills out a minimum of paperwork, picks an appropriate investment option, and voila…he has saved taxes and increased his retirement nest egg. In some cases Joe could just as easily set up a deductible IRA. However, in the case at hand Joe was unable to make deductible IRA contributions because Joe and his wife’s combined adjusted gross income is more than the amount allowed by the IRS.

SEP or Profit-Sharing Plan

Even though the SEP is a great choice for people who are not interested in saving a large amount of their income from the second job, it may not always be the best choice. In particular, people considering a SEP should also carefully analyze whether a profit-sharing plan is a better option. For a little extra administrative effort (or extra cost attributable to the plan’s administration) there are a few advantages for a profit-sharing plan over a SEP.

For one thing a profit-sharing plan allows for plan loans (loans are not permitted from a SEP). Taking a plan loan from money stored for retirement may be a ready and easy source of liquidity that allows you to not worry about credit restrictions that apply commercially and allows you to pay the interest to yourself. In addition, the profit-sharing plan may be a better choice if the solo practitioner is thinking of expanding and adding some part-time employees. When this is the case, the ability to exclude part-time employees who work less than 1,000 hours may be more cost effective in a profit-sharing plan than a SEP (a SEP must fund a contribution for anyone earning over $600), and if future employees are a consideration, the profit-sharing plan can use a cross-tested formula.

This formula allows the owner of the growing small business to skew the majority of plan contributions to her.

Looking to save more?

For a person who seeks substantial savings from her Schedule C income, the so-called solo-k plan might make sense. The solo-k is a 401(k) plan that enables you to end run the 20% “Keogh” rule because salary deduction contributions are also allowed to be made and they are not counted against the 20% limitation. For example, Sally is a 35-year-old IT professional who has $20,000 in consulting income. She can contribute the entire amount ($20,000) to her solo-k ($4,000 under the 20% limit, plus $16,000 in elective salary deferrals). In addition, a 40-year-old doctor who works for the hospital but has a $100,000 private practice on the side can save $38,500 (the $20,000 Keogh contribution plus the maximum $18,500 in 401(k) salary deferrals). Note: a doctor who is 50 or older can make an additional $6,000 catch-up contribution for a total of $44,500.

Two other factors favor choosing a solo-k:

•The solo-k may utilize a Roth feature. When this is the case there are no immediate tax savings, but qualifying distributions may be received tax-free.

•Like the profit-sharing plan, the solo-k could add a loan feature.

How much tax savings?

In addition to stockpiling savings for retirement the tax savings garnered by contributing to a solo-k can be significant. Take Sam who is a schoolteacher earning $50,000. Sam also works carpentry jobs in the summer making $20,000. Sam might be in a combined federal (12%), state (2%), and local (1%) tax bracket of 15 percent. So, Sam will save $3,000 in taxes by contributing the entire $20,000 to a solo-k.

Finally consider that Sam will also save big on Social Security taxes. In addition to being subject to federal, state, and local taxes, Schedule C income is subject to SECA taxes (Social Security payroll taxes that apply to self-employment income).

If Sam ignored the solo-k opportunity and declared the entire $20,000 as income under Schedule C, he would be paying a combined SECA tax rate of 15.3%, or $3,060 in addition to his federal, state, and local taxes. He would get an above the line deduction of $1,530 (one-half of the SECA tax) to take the sting out of the SECA tax, but his total tax savings would still be substantial if he avails himself of the solo-k opportunity.

Avoid the financial fumble: Taking some of your Schedule C income and investing for retirement is essential to meeting your retirement goals. Choosing the vehicle for saving is not overly complicated and the tax savings can add up.

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