Self-Employment Tax Deductions
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 as an adjustment to your gross income.
Self-employed health insurance deduction
The Small Business Jobs Act of 2010 created a new deduction. This applies to 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 these people:
- Your spouse
- Your dependents
- Your 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 employer
- 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 are one 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 your contributions.
If you use Form 5305-SEP, IRS approval isn’t required. 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. You haven’t adopted the plan 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 through any of these:
- Insurance companies
- 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 2019 is limited to the lesser of:
- 25% of each employee’s compensation
This also applies to your own contribution. Compensation more than $265,000 for 2019 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. You can find the rate table for self-employed individuals in Publication 560. If your plan uses a 25% contribution rate, the rate for you as a self-employed person will be 20%.
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 type of retirement plan. It’s available to employers or self-employed taxpayers who don’t have a qualified retirement plan. You can set up a SIMPLE plan if you have 100 or fewer employees. They must have 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 regular 401(k) plans have.
To learn more, see Publication 560: Retirement Plans for Small Business at www.irs.gov.
Employers who sponsor a SIMPLE IRA plan must match or make a required contribution each year. This isn’t true for a SEP or qualified plan.
Also, SIMPLE plans don’t limit deductible contributions to a percentage of compensation. SEP or qualified plans do limit them.
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
Figure out which IRS form you’ll need to use:
- If you’ll require one institution to maintain all accounts, use Form 5305-SIMPLE.
- If you’ll allow each employee to choose the financial institution to maintain his or her account, use Form 5304-SIMPLE.
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 Oct. 1 of the year the plan becomes effective. If you form a new business after Oct. 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 $12,500 for 2019. 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.
There are two types of qualified plans:
- Defined-contribution plans
- Defined-benefit plans
Defined-contribution plans include:
- Profit-sharing plans — This plan doesn’t require you to make contributions each year or with fixed amounts. However, the plan must provide a definite formula for these:
- 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 you to make contributions based on a fixed formula. You’re required to make contributions to a money-purchase pension each year. So, 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 definite 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:
- Insurance companies
- Mutual-fund companies
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 three 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 one of these forms each year:
- Form 5500
- Form 5500-SF
- Form 5500-EZ
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 Publication 560: Retirement Plans for Small Business at www.irs.gov.
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You can claim the standard deduction or itemized deductions to lower your taxable income. The standard deduction lowers your income by one fixed amount. On the other hand, itemized deductions are made up of a list of eligible expenses. You can claim whichever lowers your tax bill the most.