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SIMPLE or SEP for freelance income? (first time post)


Guest cn22
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Hi all,

So glad I found this forum!

Current situation: I expect to have around $3,000 - $4,000 in freelance income for 2007, and wanted to shield all of that amount from taxes.

Other info: I will be employed and contributing to a company 401(k) for the latter half of 2007. I have already maxed out a Roth IRA.

By the way, I've already received $1,000 for freelance income. The thought of having 30-40% taxed sucks.

I want to know - SIMPLE or SEP? I can contribute more money to SIMPLE, but other than that I am confused on the best option for me. Also, can I convert SIMPLE or SEP to a traditional IRA after 2 years?

Thank you for your help in advance!

CN

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Other info: I will be employed and contributing to a company 401(k) for the latter half of 2007.

That's important. If you max out on the 401(k), then you can't do anything in a SIMPLE because as an individual, you get one combined deferral limit of $15,500.

That leaves the SEP. Your maximum contribution is 25% of net earned income after taking the contribution into account, which is approximately 20% of net before the contribution...you have to make an adjustment for half of your self-employment taxes, and it's going to be exactly 20% after that adjustment.

Ed Snyder

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You haven't stated your age and whether this outside income will be recurring, but you might want to consider a Roth IRA. Since you will only be able to contribute 20% of your net profit (after reduction for 1/2 self-employment tax) you are probably only going to have a tax deduction of $600 to $800. You would not receive any tax deduction for a Roth contribution, but, assuming you meet certain requirements, the earnings will be distributed tax free.

Assuming you have $4,000 you can contribute to a Roth and are taxed at a 40% rate, it would only take you about 6 years to reach a break even point, with a 6% rate of return IMHO, I think this may be a better strategy than deducting $800 off your income now and paying tax on it at a later date.

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Other info: I will be employed and contributing to a company 401(k) for the latter half of 2007.

As noted above, you can put a lot into a 401(k). I'd start by finding out what the rules are for the 401(k) you'll be in, specfically, what is their maximum contribution percentage rate. Then ask yourself what % you'd likely put in on a normal basis. Figure out how much money you expect to earn at the 401(k) job in 2007 and figure how much you could put into the 401(k) if you did the maximum contribution rate. If the difference between your normal % and the max % is enough for you to put away most or all your freelance income, then just wait and max out your 401(k). The same goes for future years if you have recurring income; if you wouldn't reach the 401(k) max at your normal %, then consider maxing out to defer that income.

Kurt Vonnegut: 'To be is to do'-Socrates 'To do is to be'-Jean-Paul Sartre 'Do be do be do'-Frank Sinatra

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Hi guys,

Thanks so much for your quick responses.

Bird & Masteff - I am allowed to contribute the full amount to the 401(k), i.e. $15,500. I probably won't be able to, though.

Lame Duck - I already have contributed $4,000 to the Roth IRA for 2007... unfortunately that tax advantage is closed to me for the rest of the year!

More questions...

1. Let's say I get $4,000 in freelance income for 2007. Can I contribute $11,500 to the company 401(k), and then $4,000 to a SIMPLE IRA? My total deferral would still be $15,500.

2. If I set up a SIMPLE IRA through Vanguard, how do I fund it? Can I simply send them $4,000, and when I file taxes for 2007 fill in some form that I have a SIMPLE IRA and have deferred all of my freelance income (thus avoiding taxes)?

Thanks again.

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1. Let's say I get $4,000 in freelance income for 2007. Can I contribute $11,500 to the company 401(k), and then $4,000 to a SIMPLE IRA? My total deferral would still be $15,500.

Yes. See IRS Publication 560 which explicity confirms that you combine the amount put into the SIMPLE with any amounts deferred in any other employer plan during the year. I'd suggest asking the company (w/ the 401(k)) if they are able to input your other plan deferrals into their system so it will automatically cap your deductions and prevent you going over the limit (some payroll systems can do this, don't be put out if they can't).

2. If I set up a SIMPLE IRA through Vanguard, how do I fund it? Can I simply send them $4,000, and when I file taxes for 2007 fill in some form that I have a SIMPLE IRA and have deferred all of my freelance income (thus avoiding taxes)?

You'll have to complete Form 5304-SIMPLE (which you don't file w/ the IRS, just put in your records). Per Publication 560, you'll report the SIMPLE contributions on Schedule C of your personal 1040.

As of the mechanics, in general, yes, you just send Vanguard a check or possibly even have them draft your account. Here's their page on SIMPLEs for more:

https://flagship.vanguard.com/VGApp/hnw/acc...viewContent.jsp

Kurt Vonnegut: 'To be is to do'-Socrates 'To do is to be'-Jean-Paul Sartre 'Do be do be do'-Frank Sinatra

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masteff - thank you for your informative answer! this is all starting to make MUCH more sense to me now...

A Vanguard rep told me that I need to withhold for SS tax, so I should contribute only a percentage of my freelance income into SIMPLE IRA.

For example, if FICA is 7.6%, does that mean I should only contribute 92.4%? Am I understanding this wrong?

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I am allowed to contribute the full amount to the 401(k), i.e. $15,500. I probably won't be able to, though.

If you don't mind, I'd like to go back to this fork in the road. You won't be able to because...?

I just don't see the sense in going through the hassle of setting up a SIMPLE if you can accomplish the same thing by upping your 401(k) contributions.

Ed Snyder

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Hey Bird,

I'd rather have a SIMPLE and a 401(k) because the lower 401(k) contributions will result in a bigger paycheck and I can defer taxes on all freelance income. If I just max out the 401(k), I'll have to have smaller paychecks AND get taxed on freelance income. I get more money in my hands if I have a SIMPLE and a 401(k) rather than just a 401(k). Hope that made sense.

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No, sorry but that doesn't make sense. You get one $15,500 limit so using the SIMPLE for some of it instead of the 401(k) doesn't result in any net advantage.

If you're talking about cash flow then I suppose it might make a difference in the short run but at the end of the day (year) it won't make a bit of difference. In fact, using a SIMPLE instead of a SEP will result in lower net deductions:

401(k) - $10,500

SIMPLE - $4,000 (no you can't do 100% because of self-employment taxes but this is close enough)

Total - $15,500

401(k) - $15,500

SEP - $800 (20% of $4,000 = 25% of net $3,200; no you can't quite do that much; see above)

Total - $16,300

Do what you want but a SIMPLE is not going to increase your tax savings, and it's a PITA.

Ed Snyder

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Guest varkius
Hi all,

So glad I found this forum!

Current situation: I expect to have around $3,000 - $4,000 in freelance income for 2007, and wanted to shield all of that amount from taxes.

Other info: I will be employed and contributing to a company 401(k) for the latter half of 2007. I have already maxed out a Roth IRA.

By the way, I've already received $1,000 for freelance income. The thought of having 30-40% taxed sucks.

I want to know - SIMPLE or SEP? I can contribute more money to SIMPLE, but other than that I am confused on the best option for me. Also, can I convert SIMPLE or SEP to a traditional IRA after 2 years?

Thank you for your help in advance!

CN

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Guest varkius

I'm a reporter looking for some true stories about sole proprietors and/or small business owners who are using SIMPLEs. A fund company that provides them is touting SIMPLEs for the micro-sized businesses. Known anyone willing to share a story?

It would be published on Dow Jones Newswires and may get picked up by The Wall Street Journal.

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  • 3 months later...

Unless you have business expenses to claim, you may be better off not paying self-employment income (this year). The situation may change next year. Personally, I am not convinced you have any SE income for plan purposes.

If an individual writes only one book as a sideline and never revises it, he would not be considered to be "regularly engaged' in an occupation or profession and his royalties therefrom would not be considered net earnings from self-employment. However, where an individual prepares new editions of the book from time to time, and writes other books and materials, such activities reflect the conduct of a trade or business, and, if it is not one of the excluded professions of section 1402© of the Self-Employment Contributions Act, the income from it is includible in computing net earnings from self-employment, subject to the limitations of section 1402(b) of the Act. [i.R.C. § 1402(e)-(k); Rev. Rul. 68-498, 1968-2 C.B. 377]

Hope this helps.

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