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Primer on Self-Employment Taxes, or Why SEP-IRAs?

Why am I opening a SEP-IRA? The short answer is because I don’t want to pay taxes today if I can delay them into the future, say, in twenty years or so when I’m gray and ready to sail off to the Bahamas. Right now, all the income from this blog and Bargaineering [3] is considered self-employment income. On self-employment income, unlike regular employment income from my job, I have to pay a self employment tax and an income tax – double whammy.

The self-employment tax is based on the income reported on Schedule C: Profit or Loss From Business [4] (link to the Schedule C instruction pdf from the IRS) and is 15.3% of the net income (profit). So you pay that and, since the business income is reported as income on your tax return, the regular income tax you pay. If you made $1,000 in business profit and are in the 25% tax bracket, you pay $153 in SE tax and $250 in income tax, for a total of $403 in taxes on $1,000 of additional income. Ouch.

You can break out the 15.3% self-employment tax: 12.4% to Social Security and 2.9% towards Medicare. The maximum you have to pay towards Social Securiy is $11,160 (2005) so if you happened to make a million bucks, you pay the same social security as someone who made $90,000 in self-employment income. There’s no maximum for Medicare. That ends the self-employment tax primer…

So, now we get to why I want to open a SEP-IRA. A SEP-IRA contribution is deductible as an expense and so for ever $1 I contribute, I pay forty cents less in taxes this year. When I take distributions when I’m retiring, I pay my income tax which will likely be less than 40%.

There is a downside… the site didn’t make a tremendous amount and there are usually fees associated with the brokerage maintaining the SEP-IRA. On my Vanguard account, there is a $10 custodial fee for balances under $5,000. So, if I only can contribute $500 to the SEP-IRA this year, that $10 fee represents a 2% “tax” each year. (Vanguard SEP-IRA account information page [5]) Luckily there are no other fees.

Finally, in my Vanguard SEP-IRA I can only contribute to mutual funds and the “smallest” fund is their STAR Fund ($1,000 min). Since as an employer my contribution limit is $461, I’m going to contribute an additional $600 as an employee as an employer for 2006 for a starting balance of $1,061 from which a $10 fee will be deducted since the balance is under $5,000. I’ll do a brief writeup on the STAR fund in the future but it’s a decent fund with a 11.15% return since it’s inception in 1985.

Update: Thanks to TurboTax and Gail’s questions, but I did a little more digging and learned that the employee contribution to a SEP-IRA was considered a contribution to a Traditional IRA, so the cap of $4,000 extends to Roth IRAs as well. Since I already fully funded my Roth IRA for 2005, I had to recode my deposit from a 2005 Employee contribution to a 2006 Employer contribution.