Self-Employment Deductions in content page of articles
You can deduct part of the self-employment tax you paid as an adjustment to income. So, you can claim the deduction even if you don't itemize deductions. Claim the deduction on Form 1040, page 1 as an adjustment to your gross income.
Self-Employed Health-Insurance Deduction
The Small Business Jobs Act of 2010 created a new deduction for health insurance premiums paid by self-employed individuals. If you're self-employed, you can deduct 100% of health insurance costs as an adjustment to your income for:
Children under age 27 at the end of the tax year
Claim the health-insurance deduction as an above-the-line deduction on Form 1040, line 29.
You can't claim a deduction for any month that you qualify to participate in a health plan offered by either:
Your spouse's employer
Self-Employment Retirement Deductions
You can deduct your contributions to a retirement plan as an adjustment to income. Plans include:
Qualified plan -- defined-contribution plan or defined-benefit plan
SEPs provide 1 option for funding future retirement benefits for you and your employees. You can set up an IRA designated as a SEP-IRA at a financial institution of your choice.
You’ll own and control the SEP-IRA. However, you’ll make the contributions directly to the financial institution. You can then deduct allowable contributions as an adjustment to your gross income. With a SEP, your contribution each year is optional. Matching contributions aren’t required or allowed.
Setting Up a SEP
You must have a written agreement that conforms to IRS requirements. You can use the IRS model-SEP agreement, Form 5305-SEP. This agreement must include a written allocation formula for contributions.
IRS approval isn't required if you use Form 5305-SEP. However, keep the original agreement in your records. You can establish the plan at any time up to the due date of your return, including extensions.
You must also notify each of your eligible employees that they can participate in the plan. You can use Form 5305-SEP to notify employees. The plan isn’t considered adopted until each employee receives this notice.
A SEP-IRA account must be set up by or for each eligible employee. The accounts can be set up with:
Other financial institutions that offer IRA accounts
You can make contributions to a SEP at any time up to the due date of your return, including extensions. The amount of allowable contributions is based on the formula described in the plan. It can’t discriminate in favor of:
Highly compensated employees
The self-employed owner
The contribution for 2012 is limited to the lesser of $50,000 or 25% of each employee's compensation. This also applies to your own contribution. Compensation greater than $245,000 for 2012 can't be used for contribution purposes. This compensation is your net self-employment income minus both of these:
The deductible part of the self-employment tax you paid
Deduction for contributions to your own SEP-IRA
You must adjust your self-employment income by the contribution you're making for yourself. So, this part of the computation uses a reduced contribution rate. The rate table for self-employed individuals is in Publication 560. If your plan uses a 25% contribution rate, the rate for you as a self-employed person will be 20%.
Ex: You’re a sole proprietor whose net self-employment income is $38,000. The contribution rate set in your SEP plan is 4%. The deduction for contributions to your own SEP-IRA and your net self-employment income depend upon each other. So, you determine the deduction for contributions to your own SEP-IRA indirectly by reducing the contribution rate called for in your plan.
The reduced contribution rate for your SEP-IRA is figured by dividing the contribution rate for your plan (4%) by 1 plus your plan rate (1 + 4% = 1.04). In this case, your contribution rate is 3.8462% (4 / 1.04 = 3.8462%).
After subtracting the deduction for half of the self-employment tax you paid ($2,684.62), your compensation for SEP purposes is $35,315 ($38,000 - $2,684.62). The maximum contribution you can make to your SEP-IRA is $1,358 ($35,315 x 3.8462%).
You can deduct contributions you make to a SEP-IRA for your employees up to the deduction limit. You’ll make the deduction on Schedule C. As a self-employed taxpayer, you deduct the amounts you contribute to your own SEP-IRA, up to the maximum allowed.
A SIMPLE plan is a more complicated type of retirement plan available to employers or self-employed taxpayers who don't currently have a qualified retirement plan. You can set up a SIMPLE plan if you have 100 or fewer employees who received $5,000 or more in compensation for the prior year.
A SIMPLE can be set up as a SIMPLE IRA or a SIMPLE 401(k). If the plan is set up as an IRA, a separate SIMPLE IRA account is set up at a financial institution for each eligible employee. A SIMPLE set up as a 401(k) is considered a qualified plan. However, it's not subject to the nondiscrimination and top-heavy rules that can complicate regular 401(k) plans.
To learn more, see IRS Publication 560: Retirement Plans for Small Business.
Employers who sponsor a SIMPLE IRA plan are required to make a matching or a required contribution each year. This isn’t true of a SEP or qualified plan.
Also, SIMPLE plans don't limit deductible contributions to a percentage of compensation. SEP or qualified plans limit deductible contributions.
Setting Up a SIMPLE IRA Plan
You must have a written agreement that conforms to IRS requirements. You can use:
IRS-template forms -- Form 5305-SIMPLE or Form 5304-SIMPLE
Prototype plan available from a bank or an insurance company authorized to sponsor SIMPLE IRA plans
If you use an IRS form:
Use Form 5305-SIMPLE if you’ll require 1 institution to maintain all accounts.
Use Form 5304-SIMPLE if you’ll allow each employee to choose the financial institution to maintain his or her account.
Like with the SEP plan, you don't need to file the form with the IRS. The form must be completed, signed, and maintained in your records.
You must set up a SIMPLE plan by October 1 of the year the plan becomes effective. If you form a new business after October 1, you must set up a plan as soon as possible to become effective for that year.
The maximum employee contribution to a SIMPLE is $12,000 for 2012. You must make matching contributions by your return's due date, including extensions.
You must match 1% to 3% of the employee's compensation. The matching contribution percentage paid by you also applies to your own contribution.
Ex: Rick’s net income from his contracting business is $35,000. He contributes 10% of his earnings to his SIMPLE:
$35,000 x .10 = $3,500 (SIMPLE contribution)
Since the plan calls for employer-matching of 3%, his matching contribution will be $1,050:
The 2 types of qualified plans are defined-contribution plans and defined-benefit plans.
Defined-contribution plans include:
Profit-sharing plans -- This plan doesn't require contributions be made each year or have fixed amounts. However, the plan must provide a definite formula for:
Allocating the contribution among the participants
Distributing the accumulated funds to employees:
After they reach a certain age
After a fixed number of years
Upon certain other occurrences
Employers often establish profit-sharing plans to offer a 401(k) plan to employees.
Money purchase pension plans -- This plan requires contributions be made based on a fixed formula the plan determines. Since you’re required to make contributions to a money-purchase pension each year, they aren't used very frequently.
A defined-benefit plan is any plan that isn’t a defined-contribution plan. An employer usually gets professional help for a defined-benefit plan since:
Contributions must be set up to provide definitely determinable benefits to the plan participants.
The plan usually requires actuarial assumptions and computations.
Setting Up a Qualified Plan
After you adopt a written plan, you must notify your employees. You can use an IRS-approved template or prototype plan document to set up your plan. You can usually get such a document at:
You can also design a plan to meet your individual needs. The plan must provide a formula for both of these:
Allocating contributions among participants
Making distributions upon retirement or certain other events
Qualified Plan Contributions and Deductions
The amount you can contribute and deduct varies, depending upon the type of plan.
Contributions to a defined-benefit plan usually can’t be more than the lesser of these:
100% of a participant's average compensation for his or her highest 3 consecutive calendar years
Contributions to a defined-contribution plan can’t be more than the lesser of these:
100% of the participant’s compensation
A plan administrator or employer who maintains a qualified plan or a SIMPLE 401(k) must file 1 of these forms each year:
SEPs and SIMPLEs set up as IRAs are usually not required to file this form.
To learn more about the requirements for each form, see IRS Publication 560, Retirement Plans for Small Business.