IRAs and Tax Breaks for the Small Biz Owner

If you’re self-employed – or hoping to be soon – you can’t rely on an employer to take care of your retirement. IRAs are an easy-to-open, widely available option that can help protect your future.

The abbreviation “IRA” stands for “individual retirement account.” And while there are actually 11 different types of IRAs, the following two are the most common:

  • A traditional IRA receives pre-tax contributions which are taxed upon withdrawal in retirement. Funds drawn from these accounts before the holder reaches age 59 ½ may be subject to early withdrawal penalties, though exceptions exist if you’ll be using the funds to purchase your first home, pay for qualified education expenses, cover your needs in the event of a disability or death, or pay for unreimbursed medical expenses or health insurance premiums (if you’re unemployed).

  • A Roth IRA receives contributions that have been taxed. As a result, you can withdraw the money you’ve contributed at any time without incurring tax penalties, though you may be assessed taxes and penalties if you withdraw your account’s earnings, based on how long you’ve had the account open.

Account holders may contribute no more than $5,500 (or $6,500 if they’re over age 50) or the total of their taxable compensation (if less than these limits) to any combination of traditional and Roth IRAs.

In addition to these two common IRA forms, self-employed people can take advantage of the following options as well:

  • A simplified employee pension – or, SEP-IRA. The SEP-IRA is a great choice for entrepreneurs and small businesses. This type of account allows owners to contribute up to 25% of their net self-employment earnings (less their SEP-IRA contributions). SEP-IRAs are taxed like traditional IRAs and participants incur similar penalties for withdrawals before age 59 ½, but the contribution limits are much higher on this type of account. Account holders may contribute up to $52,000 for the 2014 tax year.

  • A savings incentive match plan for employees plan – aka, a SIMPLE-IRA. Like the SEP-IRA, the SIMPLE-IRA is designed for small businesses and self-employed workers, though it comes with additional filing requirements and can’t be used if you’ve also maxed out an employer-sponsored retirement account. You’ll also be required to match or make set contributions to the accounts of any of your own employees listed on the plan. If you qualify, though, you can put up to 100% of your self-employment earnings up to $12,000 in 2014 (plus an additional $2,500 if you’re 50 or older) in the account.

How Can an IRA Help Me at Tax Time?

IRAs offer a number of different tax benefits:

  • Pre-tax IRA contributions lower your adjusted gross income (AGI). Self-employed workers are, unfortunately, taxed twice to make up for Social Security and Medicare taxes that are otherwise withheld by traditional employers. Making contributions to a traditional IRA, SEP-IRA or SIMPLE-IRA reduce your AGI before taxes are assessed, potentially shifting you into a lower tax bracket and reducing the amount of tax you’ll pay overall.

  • Investing in a Roth IRA lowers your tax burden in retirement. Any money that you’ve added to a Roth IRA earlier in life can be withdrawn tax free, as these contributions were made from taxed income. If you anticipate that your income will be higher in retirement this can save you a significant amount of tax. Roth IRAs, however, are only available to single filers with an AGI below $129,000 or couples filing jointly with an AGI below $191,000.

Given the complexities associated with freelance investing, it’s a good idea to consult with a CPA or tax advisor – but don’t wait. Although 2014 has passed, many IRA account structures allow you to make “catch up” contributions before the April 15th tax deadline that can be assigned to the 2014 tax year and help reduce your freelance income and corresponding taxes.

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