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My Six Biggest Tax Deductions for 2006: 401k/Retirement Contributions

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This is the second of my big six income tax deductions for 2006 and this one is a little bit of a freebie because you don’t really need to do anything in order to claim it because your employer will automatically deduct 401K contributions from your income, which will ultimately be reported in your W-2. So, with a 401K, you simply do nothing and you get this deduction. How about people who contribute to a Traditional IRA? And for those who have businesses, or are independent contractors, and are contributing to a SEP-IRA as an employer (I’ll be doing this for the second year in a row)? That’s when things get a little trickier.

Traditional IRAs

If you have taxable income (and you won’t turn 70.5 this year), you’re eligible for a Traditional IRA. For 2006, you’re allowed to contribute $4,000 towards the Traditional IRA (this maximum limit is also shared with a Roth IRA, so you can only contribute a total of $4k any type of IRA) if you are under 50 and up to $5,000 if you’re over 50, it’s called a catch-up provision. You must open an IRA with an approved institution.

How much of the contribution you can deduct depends on your modified adjusted gross income. If you are a single filer, you get a 100% deduction if your MAGI is under $50,000; a partial if your income is between $50,000 and $60,000; and no deduction if your MAGI is over $60,000. If your MAGI is over $60,000, then it is far better you to contribute towards a Roth IRA since you get no deduction in the first place.

SEP-IRAs

If you have self-employment income, the Simplified Employee Pension Plan (SEP-IRA) is a great way to defer some of your income and any business, sole proprietorships included, that earns any income can start something like this. You can contribute up to 25% of compensation to a maximum of $44,000 (2006 limits) and deduct this from your Schedule C income.

For more on SEP-IRAs, I wrote a whole series of articles when I was investigating it for my side business (this site), hopefully you will find them helpful:

  • Primer on Self-Employment Taxes, or Why SEP-IRAs? – A brief introduction to self-employment taxes and my logic in opening a SEP-IRA in the first place.
  • Introduction to SEP-IRAs – More on SEP-IRAs and how the employer deduction works.
  • Vanguard Deposit Recoding Sample Letter – I accidentally made a contribution as an employee (bad, because the SEP-IRA contribution limits are shared with Roth and Traditional, and I maxed out my Roth contribution already) so I had to send Vanguard a letter to reclassifying the contribution as an employer contribution for 2006.
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4 Responses to “My Six Biggest Tax Deductions for 2006: 401k/Retirement Contributions”

  1. bad username says:

    You can’t deduct it from your Sched C income. It’s counted as income and subject to self-employment tax, but then it is deducted “above-the-line” on your 1040.

  2. jim says:

    Ahhh very true, I mis-wrote, thanks!

  3. Foobarista says:

    Don’t forget Self-employed 401Ks. SEP-IRAs are useful if you have both work income and access to a work 401K as well as Schedule C income, or have employees outside your immediate family in a business, but Self-employed 401Ks are better in most cases if you’re self-employed.

  4. Bryan Decelles says:

    You might want to consider a company sponsered 401K plan if you are self employeed and a one person company.

    It may have some interesting advantages. I am just starting to learn about this option and would appreciate comments. So it seems that though employee matching and profit sharing you can contribute up to $45,000 (well above the 15,500 limit if you worked for someone else). Further is seems that the 401K is considered as a reduction in your MAGI while the SEP is not considered a reduction in you MAGI just AGI. There are a number of advantages to reducing you MAGI for a number items including in my case 1K/kid child credits, and 25K/year passive loss from real estate (MAGI 120K-150K).


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