Be your own boss. While you’re at it, cut your taxes.

What follows is a short guidebook to tax rules for self-employed workers and moonlighters, with a particular emphasis on ways to stash profits away for use in retirement.

Our illustrative taxpayer is Mildred, 55, who has left a job as a corporate counsel and hung out a shingle as a trusts and estate lawyer. She’ll work three days a week and have more time for volunteering. She can cover her grocery bills out of other resources and wants to use her self-employment profits toward retirement saving.

Mildred’s revenue in 2020 is $113,000. She runs up $13,000 in expenses like professional dues, the cost of a home office and subscriptions to legal databases. These are things that she would not be permitted to deduct as an employee. As a self-employed person she can deduct them. Moreover, these aren’t personal deductions that go on Schedule A; they’re business deductions that come off the top and reduce gross income.

The net profit from the business is $100,000. Mildred multiplies this by 0.9235 to arrive at $92,350. On this, she pays 15.3%, or $14,130, as payroll tax (Social Security plus Medicare).

Divide the payroll tax by two to get $7,065 and subtract that from Mildred’s net to arrive at $92,935. From this figure deduct what Mildred pays for health insurance (for herself and immediate family).

Suppose she spends $18,000. Now her taxable income has shrunk to $74,935. The $18,000 is a superdeduction, valid against gross income. It doesn’t affect Mildred’s ability to claim a standard deduction in lieu of Schedule A.

There are more ways to shrink the taxable income. Mildred sets up a “solo 401(k),” allowed to self-employed people who have no employees other than a spouse. As an oldster (defined as 50 and up) Mildred can put away $25,500 in a tax-deductible “deferral contribution” to a 401(k) in 2020.

Mildred’s taxable business income is down to $49,435. But there’s yet another way to put money aside for retirement. Mildred can make an “employer contribution” to the 401(k) equal to 20% of that peculiar $92,935 figure, which was equal to business profit minus half the payroll tax. Multiply 20% by $92,935 to get $18,587.

The combined deferral and employer contributions allow Mildred to salt $44,087 away for retirement. This is another superdeduction. Her taxable income from the law practice is now down to $30,848.

There’s one more nifty write-off. Take 20% of this $30,848 off per the Trump tax cut provision for “pass-through” income. So Mildred gets a $6,170 deduction here, leaving her with a taxable income of $24,678 from her business.

Nice work if you can get it. The self-employed get a health insurance deduction that employees don’t get, can stash an extra 18.59% of net income in a tax-deferred account and get a 20% pass-through deduction aimed at rewarding job creation.

We’ve rushed past many of the subtleties. Let’s address a few of them.

That $92,935 number is very important. It has to cover the health insurance plus the combined retirement contribution. If there isn’t enough profit to cover both, one has to give.

You’re almost always better off with a deduction for insurance, which permanently reduces taxable income, than with a deduction for a retirement plan, which merely defers taxation. If your moonlight income is modest and you’re forced to choose, you will probably opt for the insurance deduction and cut or eliminate the retirement contribution. When you’re done subtracting half of payroll tax, health insurance and retirement from profits, you can’t have a number less than $0.

Next subtlety is that the pass-through deduction has some complicated limitations. We’ll avoid the details and just note that Mildred will be on safe ground this year if she files a joint return that shows less than $326,600 of taxable income before subtracting the pass-through.

Lastly: Mildred could get more mileage out of the pass-through deduction by designating her $25,500 deferral as a Roth contribution. (The “employer contribution,” 18.59% of her net, cannot go in a Roth account.) That would probably be a good move, since Roth accounts often make sense anyway.

In this case, the Roth option would increase Mildred’s otherwise taxable income from the business by $25,500 because with Roth you don’t reduce your taxable pay. So going Roth would kick up Mildred’s pass-through deduction by $5,100.

Some brokers have a Roth option on their solo 401(k)s, some don’t. If yours doesn’t, and you want to squeeze the last dollar out of the pass-through deduction, you have to move the whole plan to a new broker.

Q. Can I do a 401(k) deferral at both my corporate job and my sideline?

A. Yes, so long as the total from all jobs this year is not higher than $19,500 for young workers or $25,500 for old ones.

Q. Why do brokers offer no-fee solo 401(k)s?

A. Because they are as simple to administer as IRAs. Retirement plans for firms with multiple employees, in contrast, are messy.

Q. Can I keep an existing solo 401(k) at broker A while opening a new one at broker B with a Roth option?

A. If these are for the same business, no.

Q. Is there a limit on the 18.59% deduction?

A. That, plus the deferral, can’t exceed $57,000.

Q. Can I get bigger retirement deductions with a defined-benefit plan?

A. Yes, if you want to pay actuary fees. Not worth the bother for a five-figure sideline.

Q. How hard is it to move a 401(k) from one broker to another?

A. Allow for two dozen phone calls and emails, and for a trip to your bank for a “medallion guarantee.”

Q. Worth it?

A. Maybe. The pass-through deduction vanishes in 2026.

Q. Where did that 0.9235 come from?

A. A clumsy attempt by Congress to put the self-employed on an equal footing with employees. It’s equal to 1 – 0.0765, 7.65% being the employer’s share of the payroll tax. The correct multiplier would have been 0.9289, or 1/1.0765.

Q. Where did the 18.59% come from?

A. It equals 20% x (1 – 0.9235 x 0.0765).

Q. Where did that 20% come from? Isn’t the employer contribution maximum 25% of pay?

A. It derives from a comically circular definition in the tax code in which you are supposed to calculate the max as a percentage of pay minus the max.

This is the sixth in the 7 Rules for Wealth series. For the table of contents, go to this home page.

Originally published at Forbes

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