You can deduct one-half of the amount of self-employment tax that you paid as an adjustment to income on Form 1040. This means that you can take the deduction even if you don’t itemize deductions. The deduction is claimed on page 1 of Form 1040, as an adjustment to your gross income.
If you’re self-employed, you can deduct 100% of the cost of health insurance for you, your spouse, and your dependents as an adjustment to income on Form 1040. However, your deduction can’t exceed the net income from your business less the adjustments for one-half of the self-employment tax attributable to this business activity and for your retirement plan contributions. You also can’t take a deduction for any month that you’re eligible to participate in a health plan offered by either your or your spouse’s employer.
Note: Medicare and COBRA premiums do not qualify for the self-employed health insurance deduction.
You can deduct the amounts that you contribute to a retirement plan, such as a Simplified Employee Pension (SEP), a Savings Incentive Match Plan For Employees (SIMPLE), or a qualified plan as an adjustment to income on Form 1040.
Simplified employee pensions (SEPs) provide 1 option for funding future retirement benefits for yourself. You can set up an IRA designated as a SEP at a financial institution of your choice. The SEP-IRAs will be owned and controlled by the employee but you will make the contributions directly to the financial institution where the account is maintained. You can then deduct allowable contributions on page 1 of your individual income tax return as an adjustment to your gross income. With a SEP, your contribution each year is optional and matching contributions are not required or allowed.
Setting Up the Plan
You must have a written agreement that conforms to IRS requirements. The IRS provides a model SEP agreement form, Form 5305-SEP, that you can use if you want. This agreement must include a written allocation formula for contributions. IRS approval isn’t required if you use the IRS model SEP agreement form, but you must maintain 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 provide notice to each of your eligible employees that they may participate in the plan. Form 5305-SEP can be used for this purpose. When using the IRS model SEP agreement, the plan is not considered to have been adopted until each employee receives this notice.
Finally, a SEP-IRA account must be set up by or for each eligible employee. The accounts can be set up with banks, insurance companies, or other financial institutions that offer IRA accounts.
Contributions
The contribution for 2010 is limited to the lesser of $49,000 or 25% of each employee’s compensation. These same rules apply for your own contribution. Compensation greater than $245,000 for 2010 can’t be used for contribution purposes. Compensation for the purpose of your own SEP contribution is your net self-employment income less the deduction for one-half of the self-employment tax that you paid and less the deduction for contributions to your own SEP-IRA. Because your self-employment income must be adjusted by the amount of the contribution you’re making for yourself, this portion of the computation is accomplished by using a reduced contribution rate. The rate table for self-employed individuals can be found in Publication 560. If your plan uses a 25% contribution rate, the rate for you as a self-employed person will be 20%.
Example: You’re a sole proprietor, and your 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. For this reason, 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 determined 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 one-half of the self-employment tax that 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 * 3.8462%).
Deductions
Any contributions up to the deduction limit that you make to a SEP-IRA for your employees are fully deductible on Schedule C. As a self-employed taxpayer, you deduct the amounts that you contribute to your own SEP-IRA, up to the maximum allowed, on Form 1040.
A SIMPLE plan is a more complicated type of retirement plan available to employers or self-employed taxpayers who don't currently maintain any other type of qualified retirement plan. You can set up a SIMPLE plan if you have no more than 100 employees who received $5,000 or more in compensation for the preceding year.
A SIMPLE can be set up as an IRA or a 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. For more information about SIMPLE 401(k)’s, see IRS Publication 560: Retirement Plans for Small Business. For more information, see IRS Publication 560, Retirement Plans for the Self Employed.
Unlike a SEP or qualified plan, employers who sponsor a SIMPLE-IRA plan are required to make either a matching or nonelective (required) contribution each year. Also, SIMPLE plans don’t limit deductible contributions to a percentage of compensation, as the SEP or qualified plans do.
Setting Up the Plan
You must have a written agreement that conforms to IRS requirements. The IRS has model forms available for your use or you can use a prototype plan available from a bank or insurance company authorized to sponsor SIMPLE IRA plans. To use the IRS model plan, use Form 5305-SIMPLE if you will require all accounts to be maintained at the same institution. Form 5304-SIMPLE may be used if you will allow each employee to chose the financial institution which will maintain their account. As 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.
A SIMPLE plan must be set up by October 1st of the year in which the plan becomes effective. If a new business is formed after October 1st, a plan must be set up as soon as administratively possible to become effective for that year.
Contributions
The maximum contribution to a SIMPLE is $11,500 for 2010. You must match at least 1% and up to 3% of the employee’s compensation. The matching percentage paid by you applies to your contributions as well.
Example: Your net income from your contracting business is $35,000, and you choose to contribute 10% of your earnings to your SIMPLE ($3,500). In addition, your plan calls for employer-matching of 3%. This means that your matching contribution will be $1,050:
$35,000 (Net income) X .03 (3%) = $1,050
Matching contributions must be made by your tax return’s due date (including extensions).
Qualified plans are the most complicated types of retirement plans available to you. There are two types of qualified plans:
Defined-contribution plans include:
Profit-sharing plans. A profit-sharing plan does not require that contributions be made each year. The amount contributed to the plan each year does not have to be fixed. The plan must provide a definite formula for allocating the contribution among the participants and for distributing the accumulated funds to employees after they reach a certain age, after a fixed number of years, or upon certain other occurrences. Profit-sharing plans are often established to allow the employer to offer a 401(k) arrangement to employees (e.g., a 401(k) plan).
Money purchase pension plans. A money purchase pension plan allows for contributions based on a percentage of compensation without regard to profits.
A defined benefit plan is any plan that is not a defined contribution plan. The contributions must be set up to provide definitely determinable benefits to the participants in the plan and generally require actuarial assumptions and computations. Accordingly, it is often necessary to have professional help if you choose to have a defined benefit plan.
Setting Up a Qualified Plan
A written plan must be adopted and employees must be notified. A master or prototype plan document which has already been approved by the IRS can be used to set up your plan. These can generally be provided by the following organizations; banks, insurance companies, and mutual funds. Alternatively, a plan may be designed to suit individual needs. The plan must provide a formula for allocating the contribution between participants and for making distributions upon retirement or certain other events.
Contributions and Deductions
The amount that can be contributed and deducted varies, depending upon the type of plan. In general, contributions to a defined-benefit plan cannot exceed the lesser of:
$195,000 or
100% of a participant’s average compensation for his or her highest three consecutive calendar years.
Contributions to a defined-contribution plan may not exceed the lesser of:
$49,000 or
100% of actual compensation.
A plan administrator or employer who maintains a qualified plan or a SIMPLE 401(k) must file Form 5500, Form 5500-S, or Form 5500-EZ with the IRS each year. SEPs and SIMPLEs set up as IRAs are not required to file these forms.
See Publication 560, Retirement Plans for Small Business, for more information about the requirements for each of the forms.