You’ve probably noticed–ok, you’ve VERY LIKELY noticed–that I’ve put this blog on hold. I’ve been working on a new blog project with a friend. Please check it out! It’s called Random Seattle.
In the post Taxes and Financial Independence, I wrote about retirement funds, investment income, and other areas that allow you to either claim deductions on your taxes, or reduce your tax burden. What I didn’t cover were business entities that you can create in order to protect your income.
I realize this is boring as crap. At least for me it is. But if you get taxes right, you can save a ton of money, and get to FI that much faster.
I actually don’t mind paying taxes. I bet you’ve heard the Oliver Wendell Holmes quote that “Taxes are what we pay for civilized society”. I’m with him—I want to throw some money in the hat for garbage pick-up, police, libraries, schools…but then again, I want to pay as little as I need to.
Thus, here’s the scoop on the two main business entities that are relevant to you if you work for yourself, or if you own investment property.
LLC is the typical business type for rental properties, because LLCs are meant to cover “non-active” income. I.e., instead of working all day, you kind of sit back and collect rent, minus the odd afternoon spent fixing a tenant’s sink.
On personal taxes, rental income has the same tax rate as salary income. But, if you create an LLC for your investment property, you don’t have to pay Social Security (12.4%) or Medicare (2.9%) on rental income. That’s huge. An added benefit is the protection you get in lawsuits—if you have a litigious tenant, they can sue the assets owned by your LLC, but not your personal assets.
With an LLC, you can deduct pre-tax expenses, such as related travel, uniforms, computers, phone bills, advertising, promotion, gifts, car expenses, and health care premiums.
Besides the social security / Medicare break, you get the regular deductions that you’d get without an LLC. That means you can add furniture and appliances to the cost basis of the property and depreciate the proper amount each tax year. Same thing for improvements—like an addition, new AC, replace plumbing, renovating the kitchen—you can depreciate these. Materials, tool rental, and labor can also be depreciated. For repairs, such as repairing a roof, plumbing, electric, replacing a broken window, you can deduct the full cost of the repair in the tax year that the repair was completed.
S Corps are a business type that covers “active work”—anything you do that brings in income, as opposed to passive income you might get from a rental property.
As an S corp, you have to pay yourself a reasonable salary, for which you pay regular taxes, and distribute the rest of the income to yourself as profit. The profit distribution to yourself (or any other shareholders) is free from Social Security (12.4%) or Medicare (2.9%) taxation. DEFINITELY read more about what the IRS defines as paying yourself a “reasonable income”. It’s tricky because they don’t give us a dollar amount, or a percentage of profit. But they DO apparently do regular audits of S Corps because of the potential for abusing the tax benefit of income vs. profit distribution.
Like with an LLC, an S Corp allows you to deduct pre-tax expenses, such as related travel, uniforms, computers, phone bills, advertising, promotion, gifts, car expenses, and health care premiums.
Health Care Premiums and Costs
Whether your tax entity is an LLC, an S corp, or you file as a freelancer, you can deduct health care premiums. If you itemize your deductions (on Form 1040, Schedule A), you can deduct expenses you paid that year for medical and dental care for yourself, your spouse, and your dependents if your total medical expenses exceed 10% of your adjusted gross income. http://www.irs.gov/taxtopics/tc502.html. Yeah, more eye-bending reading.
I’ll be back with new posts later this week. In the meantime, read other people’s great posts!
A tweet in time saves nineteen thousand dollars: David of Raptitude writes about going on sabbatical. That’s the sweet side effect of saving money: you buy your freedom.
Google Voice: The $0 Phone Plan: you have choices to the standard (expensive) cell phone plans—Brandon gets you up to speed on Google Voice.
Affordable Healthcare Marketplace: this is the time to educate yourself about your new health insurance options beginning Jan 1, 2014. I’m one of the people who will be paying more—but only about $40 more. And, going forward, I know that I can continue to work for myself (or not work at all, if that’s what I want!), and still have access to health insurance. Yippee!
How I Live in a 400 Sq Ft House: you know from my blog that I love small homes. Everything about them is awesome: less upkeep and cleaning, fewer repairs, less need for furniture, lower taxes / mortgage / rent, less expense for utilities…I could go on and on. This blogger tells you her story.
We Are All Richer Than We Think: Writer David Geller quotes Henry Ford to make his point—”If money is your hope for independence you will never have it. The only real security that a man will have in this world is a reserve of knowledge, experience, and ability.”
Thoughts on Financial and Personal Independence: J.D. Roth is back from Ecuador, with a great story to share.
The Mad Fientist is about to become FI! Emotions of Financial Independence.
I love my Seattle neighborhood. We’re about to start a tool library—a sustainable way to save resources and money.
Pay attention to tax deductions and tax-advantaged investments, and you’re well on your way to financial independence. Depending on whether you’re an employee or self-employed, some of your choices will differ. I loved the 401k with matching $$ when I was an employee. But the SEP IRA is great for self-employed people, as is the ability to deduct any health insurance premiums I pay. Like we used to say in the early 2000’s: CHA CHING!
When I was still an employee, I was saving almost 50% of my post-tax income. I maxed out my 401K, did an HSA (to which my employee contributed $1,000), maxed out my Roth IRA, and also got a great tax deduction from my mortgage interest. Because of that, even though my income was in the low 6 figures, my tax rate was only about 12% in 2012.
There are a ton of deductions and tax-advantaged ways to save on your next bad-ass federal return. Here are the main ones you should think about:
Mortgage interest: I do NOT have the mortgage on my primary residence paid off, by design. There are a couple great reasons for this, one being the tax deduction for mortgage interest I pay. In most cases, you can deduct all of your home mortgage interest. You can also deduct the amount you paid for mortgage insurance premiums. Sweet! Read, read, read.
Traditional IRA: This is the original IRA. Its great benefit is that in the tax year for which you contribute to this, you don’t pay any federal tax on the amount you put aside. The drag is, when you begin to withdraw money from the IRA, you do pay tax on any withdrawals. It’s a wildcard as to what the tax rate will be at that point.
You can make contributions to a traditional IRA if you received taxable compensation during the year, and you were not age 70½ by the end of the year. If you’re aiming for financial independence, you need to know that you can’t include earnings and profits from property, such as rental income, or interest income and dividend income.
The contribution limits are, not surprisingly, complex and Kafkaesque, but generally, the limit in 2013 is $5,500. If you’re over 50, you can contribute $6,500, but hopefully you’ll be financially independent by then! Read up on the rules.
Roth IRA: With the Roth IRA, you pay taxes on any money you contribute, but when you take distributions during retirement, you get that money tax free. Nice! The contribution limits for this are the same as for a traditional IRA. Read up on the rules.
SEP IRA: A SEP IRA is a type of traditional IRA for self-employed people or small business owners. Any business owner with one or more employees, or anyone with freelance income, can open a SEP IRA. Your contributions are tax-deductible, and go into a traditional IRA. Like a traditional IRA, the money in a SEP IRA is not taxable until withdrawal.
One of the key advantages of a SEP IRA over a traditional or Roth IRA is the high contribution limit. For 2013, contributions to a SEP-IRA are the lesser of 25% of your income, or $51,000. Yup, you can read more about it.
401K: You can invest in a 401K only if you have an employer who sponsors the program. Although it really sucks, you cannot invest in a 401K if you’re self-employed. Tax-wise, this works like a traditional IRA. You can invest up to $17,500 in 2013. Many employers also do some amount of matching, which is great free money. Take it! I always contribute the max to a 401K when I’m working for a company. Read up!
HSA: To be an eligible for an HSA, you must be covered under a high deductible health plan (HDHP). For 2013, if you have self-only HDHP coverage, you can contribute up to $3,250. If you have family HDHP coverage you can contribute up to $6,450. The money you place in your HSA is not taxed. There are other health care related, tax advantaged programs, including MSAs, FSAs, and HRAs. And yes, the IRS tells you all about them.
Health insurance premiums and expenses: If you itemize your deductions on Form 1040, Schedule A, you can deduct the amount of your medical and dental expenses that exceed 10% of your adjusted gross income. And, if you’re self-employed, and have a net profit for the year, you can deduct (as an adjustment to income) the premiums you paid on a health insurance policy covering medical care including a qualified long-term care insurance policy covering medical care. You can’t take this deduction for any month in which you were eligible to participate in any subsidized health plan maintained by your employer, your former employer, your spouse’s employer, or your former spouse’s employer. I love any deductions for self-employed people! Read details here.
That’s the list! Needless to say, if you have dependents, or a home office, or have done energy-saving home updates, or many other things, you can get even more deductions. Call it a kick-back from our free-spending government.
I continually find fantastic blog posts, articles, and videos that make me think about money, financial independence, and sustainable living. Instead of keeping these to myself, I’ll share them each Friday so you have some fun weekend reading.
Why 2.5 billion heartbeats might change the way you think about money: We need to start hating debt again
Say Hello to Rockstarfinance.com: J Money at Budgets Are Sexy has what I think is a great news web site—a continuous listing of articles, videos, whatever related to finance and money. Great design, great idea.
Brandon Curtis at andhigherstill.com rolls up some new investment ideas in his post Nontraditional Investments. I do P2P lending, but got some other ideas from this.
When did goods get so bad?: David at Raptitude is a pleasure to read, and right on in this post.
Becoming financially independent and living a sustainable lifestyle go hand-in-hand. Part of buying less, and consuming fewer products that are shoved in our faces hundreds of times a day, is being a creative inventor. Inventing solutions and items that work for you, instead of mindlessly consuming services and products. It’s the way we need to live today: using fewer resources and fossil fuels, and more ingenuity.
We each have the ability to creatively think through problems or needs, and possible ways of solving them. And we also have the capability of inventing many solutions. There’s no need for us to be spoonfed products—like the by now notorious Hutzler Banana Slicer—or services like professional veggie gardeners who come to your home to garden for you. We can figure out how to make things, and do things, and spin around the splendid wheel of DIY virtue. This decreases your reliance on expensive and wasteful stuff that you buy as a consumer. This increases your confidence, your smartypants brain, and your independence in a world where you’re expected to be mindless consumers.
If you’re wondering, and even if you’re not—the photo is of stakes I put in place for my apple tree. As it’s grown, it’s started leaning precariously, especially now that apples are weighing it down. A neighbor suggested I stake it, and told me where to buy stakes. I liked the suggestion, but not the idea of consuming yet another product to do so. So I watched some videos on YouTube, and set to work figuring out how to do it.
I have a small pile of 2 x 2s, from a bean pole system. I sawed one in half, and chopped an end of both of the parts into points that I could hammer into the ground. Then, using a couple heavy duty bungee cords, I pulled the tree onto the stakes. The bungee cords are left over from when I owned a car. Now the tree’s happy, and I’m happy.
I get that creating a stake for an apple tree isn’t even close to rocket science. But I love having been able to assemble the parts without having to be a mindless consumer. I was an inventor! I felt like a legit and authenticate citizen, instead of a consumer fanning the flames of “growth”—that being a sordid way of using up resources, which I hope one day soon we can call “old school growth”, and laugh and laugh at how silly we used to be.
There are tons of items or services I’ll never be able to create myself. For example, medical machinery, painkiller drugs (am a big fan of those), trains and tracks (love trains!), complex software (although with a bit of work, you should be able to do simple software for yourself), and the proverbial space rocket.
So I’ll keep appreciating the smart people who collaborate to create those things, while I move on gaining new skills and focusing on things I can invent with my own brain smarts and elbow grease.
This is my shortest post ever, but one I think is really important.
I’m currently gearing up to finish my sabbatical and go back to paid work. You might do paid work. You might also do gardening, cleaning, volunteering, helping friends or neighbors, childcare…it’s all work. Don’t make the mistake of respecting only your paid work, or of neglecting the other types of work, which likely give you more pleasure or sense of purpose than your paid work.
Put paid work in the right perspective—the thing you do that brings money into your life, and that will lead to your financial independence—and leave enough room in your head and heart to do the purposeful, unpaid work that lends meaning or pleasure to your life.
During my sabbatical, many friends / acquaintances have had judgments about my time off. If I say I’m too busy to meet up with them, they are confused, or even indignant, that I’d claim to by busy during my time away from paid work. Some people absolutely won’t accept that the unpaid work I do (landscaping projects, home projects, blogs, helping friends out) is a legitimate way to spend my time, given that I’m not even close to an “acceptable” retirement age.
Long story short: if you achieve early financial independence, and choose to stop doing paid work at that time, be prepared for the skewed judgments of people who are still chained to their paid jobs. Focus on your values, and the activities that are important to you, and drown out the noise of negative nellies.
Where ever you live in the United States, you can find a realtor or real estate service that offers low-commission services when you buy or sell a home.
I sold my condo in March 2007 using a partially online service, Redfin. My part of the deal was to provide photos and description of my property. And, if I was interested in an open house, I had to plan and host the event (I didn’t, as history shows that open houses rarely lead to a sale). That’s it—that’s all I had to do. Redfin agents did all the showing, all the negotiating, all the paper work up to where the escrow company took over.
As the seller, I of course was responsible for paying all the agent fees, for both buyer and seller agents. The standard for this in Seattle is 6%. I still had to give 3% to the buyer’s agent. But, with Redfin as my seller’s agent, I gave them a flat $2,000. That saved me $9250 in seller’s agent fees. A ton!
They were very easy to work with, so when I was ready to buy a house in late 2010, I used them as well. When I bought my house, (about 400k), I got a refund from Redfin of several thousand dollars at signing with the escrow company. That was based on the 3% fee they received from the house seller.
They saved me THOUSANDS with both transactions, and did all the work I can’t do myself (contracts, offers, escrow stuff). I will never use mainstream agents again.
I just went to the Redfin site to remind myself how it worked, and it looks like they’ve changed the way they do fees. They now get a bit more, but it’s still worth it by thousands of dollars. The fee differs based on whether you buy or sell a place. I live in Seattle, where the traditional fee for selling is 6%. That is split half-and-half b/w the buyer and seller agent. The buyer agent still gets their half (3%), but Redfin only takes 1.5%. Their current fee info is at: redfin.com/buy-a-home/refund.
Caveat: Redfin is only active in a few large cities in the U.S. But do a quick Google search—you’ll find various low-rate agents in your neck of the woods. Make sure you read reviews before you engage them. I bet you’ll find an agent or company that does a great job for you, saves you a ton of money, and gets you that much closer to financial independence.
I’ve been spending weeks trying to write this blog post. A post by Mr. Money Mustache, and comments accompanying that post, have helped me solidify my thinking on this.
On what? The growing tone in the US that “the System is unfair and stacked against me” (and my apologies to readers from other countries—maybe you can share your experience with us). Or, to borrow a word from one of MMM’s commenters, fatalism. Yikes, even typing the word brings my mood down about 100 degrees.
It’s something I’ve been thinking about, and spending weeks writing a blog post about, because I was doing a lot of reading and thinking about what the reason(s) is (are). Where and when did this tone start? I was born in and grew up in the US, but the daughter of immigrants who were astounded at the wealth of this country. They frankly weren’t the best parents, and weren’t well-educated, and we never had a ton of money. So that meant I put myself through college (first in my family), have gotten some great jobs, bought my first, and then second, property on my own, and have seen a lot of the world, on my own dime.
It’s been a tough, but fun, adventure so far. But, every day–seriously, every day–I think of how lucky I am to have my tiny house, clothes, food, $ to eat / drink with friends, access to car sharing, and most importantly, access to opportunity, even though it’s imperfect access.
In some sense, I think the US “system” is fairer than it’s ever been in history. If you’re a woman (I am!), a minority, a poor person, someone who hasn’t had access to a good education—if you have any one of dozens of ways of standing out like a sore thumb in this society—you have more laws and law enforcement than ever in our history to help bring some sense of justice to your working and personal life. As a woman, I’ve definitely been condescended to by various douche brains, had my ass grabbed at work (twice!), and had the regular experiences any woman can tell you about. But, I’m also aware that 50 years ago, no one would have taken my complaints about bad behavior seriously—it would have been par for the course. 100 years ago, I couldn’t even have voted for elected officials who might help change laws for women. 150 years ago, I would have had almost no access to real income opportunities. 200 years ago, I couldn’t even have owned property except in very limited circumstances, and wouldn’t have had access to deodorant or a good moisturizer….the list goes on and on…
Point is, pick any impediment you think you have to getting ahead—any impediment you think that makes you say “the system is stacked against me, and is totally unfair, and I’ll never get ahead” and realize that in many ways you have a fairer playing ground than you would have had any other time in history. And yeah, it’s not perfect, but exactly what perfection are you waiting for?
The “elephant in the room” of this post is the glaring unfairness in the US system. US corporations and private interests really do have an unfair advantage in the tax system, in the amount of money that top executives and leaders take home, in the access they have to state and federal legislators to gain advantageous profit and employment laws and regulations.
In the face of that, I plan to do a couple things to stave of fatalism, and I hope you do, too:
- Keep getting the best work I can, at the best rate / salary I can get. I’ll keep saving and investing a big portion of that, so that I can be financially independent asap (My Financial Independence Goal: Dec 31 of 2016).
- Do whatever I can to change “the system” in ways that are important to me. Right now, the two bees in my bonnet are crappy long-distance train service in the US, and the high debt and high taxes in Illinois (where I want to own a rental property, and live part of the year). Your thing might be Wall Street regulation, decreasing dependence on fossil fuels, saving turtles…whatever it is, empower yourself by writing emails and making calls. If every citizen does this, just about every available issue will get covered, and improved.
Yes, our “system” is very imperfect, and yes, it’s unfair. But, it’s definitely functional enough for you to find opportunities, make a pretty good living, and maybe make some positive changes. When people unload their fatalism on me, and tell me they can’t get ahead, I think “wow, you are really boring me with your whinypants words”, and move on to a more compelling conversation.