Whether you’re operating as a full-time, self-employed sole proprietor or you’ve started a side hustle that brings in some extra money, being self-employed means that you have options to minimize your taxable income.
If you’re a sole proprietor, you already know the freedom that comes with self-employment — but what about the taxes? You have income tax to consider, sure, but did you know there’s also a self-employment tax?
With that in mind, we’ll take a look at how sole proprietorships are taxed as well as how you can maximize your tax credits and other tax-saving opportunities.
This practice also enables strategic financial planning, allowing more funds to be allocated towards savings, investments, and other financial goals, paving the way for long-term financial stability and growth.
This article was submitted by Jorge Sanchez, M.D.
Sole Proprietorship Taxes
When you’re self-employed, your earnings are subject to both income tax and self-employment tax.
Your net self-employment income is taxed at your normal income tax rate, just as your earnings would have been if you were an employee. But as a sole proprietor, you get to deduct business expenses against your revenue, which you can’t do as an employee.
Your self-employment income is also subject to self-employment taxes, which are 15.3% of your net income. Self-employment taxes are the equivalent of the Social Security and Medicare taxes that are withheld from an employee’s W-2 earnings.
Note that the Social Security portion of self-employment taxes only applies to the first $160,200 of wages for 2023. This figure is updated annually for inflation. If you’ve already paid Social Security taxes on some (or all) of this amount through a W-2 job, then the amount of your self-employment income subject to the tax will be reduced.
Maximize Your Tax Credits
One of the first steps towards minimizing your taxes is to maximize your tax credits. There are several tax credits available each year that will directly offset your taxable income.
There are two categories of tax credits – refundable and non-refundable – and it’s important to know the difference when planning out your tax strategy. Non-refundable tax credits can only be used to offset your tax for the year and any credit in excess of your taxes will either carry forward or be lost (depending on the credit). Refundable credits in excess of your taxes will be refunded to you.
Child Tax Credit
If you have dependent children under the age of 17, you are eligible for the child tax credit. The credit is phased out for high earners, starting at $400,000 for married filing jointly and $200,000 for all other filing statuses.
For 2023, the credit is $2,000 for each child, and $1,600 of the credit is refundable. The credit is reduced by $50 for every $1,000 Modified Adjusted Gross Income (MAGI) exceeding the threshold, which is effectively a 5% tax on income in the phaseout range.
The IRS also has specific criteria for who qualifies as a dependent child for the tax credit.
For other dependents that don’t meet the qualifications for the child tax credit, you can claim the Credit for Other Dependents at $500 per dependent.
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There are two education credits related to higher education expenses that can reduce your taxes – the American Opportunity Tax Credit (AOTC) and the Lifetime Learning Credit (LLC).
The AOTC provides a tax credit of up to $2,500. You receive a 100% credit for the first $2000 spent on higher education expenses and 25% of the next $2,000. This credit is only available to full-time students during their first four years of higher education.
The AOTC starts to phase out once your income reaches $80,000 (or $160,000 for married filing jointly). The credit fully phases out over the next $10,000 of earnings (or $20,000 for married filing jointly), so most physicians won’t qualify for this credit.
The LLC is subject to the same phase-out ranges as the AOTC. It provides a 20% credit of up to $10,000 in higher education expenses. Unlike the AOTC, the LLC can be claimed for an unlimited number of years and for graduate school expenses.
The Saver’s Credit can provide a significant boost if you’re making eligible contributions to your IRA or employer-sponsored retirement plan. To be eligible for the Saver’s Credit, you must be at least 18 years old, not claimed as a dependent on someone else’s return, and not a student.
The credit is up to 50% of your retirement contribution limited to $2,000 of contributions ($4,000 if married filing jointly). The credit is fully phased out if you make more than $36,500 (or $73,000 if married filing jointly). See the IRS publication for full details on the income and credit phase-out levels. Most physicians won’t qualify for this credit, but if you’ve retired, the credit may be available to you.
Minimizing Taxable Income
One of the best (and maybe most obvious) ways to minimize your taxes is to reduce your taxable income.
With the progressive tax system we have in the U.S., not all dollars are taxed evenly. Your taxable income may be taxed at anywhere from 10% to 37%, and that’s just federal taxes. Depending on your state, you may pay anywhere from 0% to 13.3% in state taxes as well.
But reaching a new tax bracket doesn’t mean that all your income will be taxed at the highest rate. Here are the 2023 tax brackets:
|Tax rate||Single||Head of Household||Married Filing Jointly or Qualifying Widow||Married Filing Separately|
|10&||$0 to $11,000||$0 to $15,700||$0 to $22,000||$0 to $11,000|
|12%||$11,001 to $44,725||$15,701 to $59,850||$22,001 to $89,450||$11,001 to $44,725|
|22%||$44,726 to $95,375||$59,851 to $95,350||$89,451 to $190,750||$44,726 to $95,375|
|24%||$95,376 to $182,100||$95,351 to $182,100||$190,751 to $364,200||$95,376 to $182,100|
|32%||$182,101 to $231,250||$182,101 to $231,250||$364,201 to $462,500||$182,101 to $231,250|
|35%||$231,251 to $578,125||$231,251 to $578,100||$462,501 to $693,750||$231,251 to $346,875|
|37%||$578,126 or more||$578,101 or more||$693,751 or more||$346,876 or more|
For a single person with $40,000 in taxable income, the first $11,000 is taxed at 10% and the next $29,000 ($40,000 – $11,000) is taxed at 12%. The total tax on this income would be $4,580 ($11,000 * 10% plus $29,000 * 12%), which is an effective tax rate of 11.45%.
Note that there are two points at which the tax rate jumps significantly – from 12% to 22% and again from 24% to 32%.
If your income is low enough that you fall into the 12% tax bracket, you should consider maximizing that bracket. This can be done by increasing your income or doing a ROTH conversion that year. It’s especially important if your RMDs will push you into a higher tax bracket in retirement.
Qualifying for the QBI Deduction
The Qualified Business Income (QBI) Deduction will dramatically reduce your taxes if your income qualifies for the deduction.
- What is QBI? QBI is the net amount of income, gain, deduction, and loss from any qualified business. Essentially, it’s the net profit your business makes during the year.
- What businesses qualify? Most sole proprietorships, partnerships, and S corporations can qualify for this deduction.
- What is QBI Income? QBI income refers to the income earned by these qualified businesses.
- How is the QBI deduction calculated? Generally, the QBI deduction is 20% of your qualified business income. However, this deduction may be limited based on factors including type of business, the amount of W-2 wages paid by the business, and the unadjusted basis of certain property used by the business.
QBI can change based on your profession. Physicians are considered a Specified Service or Trade Business and are subject to a phase-out of the 20% deduction once their income reaches $170,050 (or $340,100 for married filing jointly). As long as your income is under these thresholds, you can deduct 20% of your self-employment or partnership income as a QBI deduction.
How to Reduce Taxable Income for High Earners
For high earners, there are several strategies to minimize taxes, including utilizing retirement contributions, making the most of business expenses, and employing strategic tax planning.
Maximize Retirement Contributions
Retirement contributions offer an avenue to reduce taxable income while saving for your future.
For sole proprietors, a Solo 401(k) allows for significant pre-tax contributions, thereby reducing your taxable income for the year. For 2023, you can contribute up to $22,500 as an employee contribution to your 401(k). The employee contribution cannot be more than your self-employment earnings for the year. If you are over 50, you can contribute an additional $4,500 as a catch-up contribution.
You can then contribute an additional 25% of your net income up to a contribution of $43,500. To maximize your contribution, you would need to have a net income from your business of $174,000. The maximum contribution is adjusted each year for inflation.
Once your Solo 401(k) plan has assets of more than $250,000, you are required to file a 5500 return for the plan each year.
IRAs have much lower contribution limits than a 401(k), but they might be sufficient if you do not expect to have significant sole proprietorship income. You can contribute up to $6,500 each year (or $7,500 if over age 50).
While defined benefit plans (a.k.a. pensions) have largely fallen out of favor, as a sole proprietor, they can give you a substantial tax deduction. These plans have greater upfront costs than other retirement plans, so they should only be considered if you expect to have significant sole proprietor income.
To determine your contribution each year, you’ll need to work with an actuary to determine your contribution range, but depending on your age and prior contributions, you can potentially contribute hundreds of thousands of dollars.
These plans are usually shut down once you retire, and the accumulated savings are rolled into an IRA.
ACA Subsidy Cliffs
The Affordable Care Act (ACA) provides subsidies to assist individuals and families in purchasing health insurance through the marketplace if they do not have access to affordable health coverage elsewhere. These subsidies are calculated based on a percentage of the Federal Poverty Level (FPL), and individuals or families earning up to 400% of the FPL are eligible.
If an individual or family’s income exceeds this limit, even by a small amount, they will face what’s known as the ACA subsidy cliff. This means they would lose eligibility for these subsidies entirely leading to a significant increase in their health insurance costs.
The cliff is particularly impactful for those near retirement age, as premiums are generally higher for older adults. As such, for some self-employed individuals, it may be beneficial to carefully manage income to stay below the 400% FPL threshold and avoid falling off the ACA subsidy cliff.
Social Security Taxable Brackets
Social Security benefits may be taxable depending on your total income, which includes not only wages, self-employment, interest, dividends, and other taxable income but also non-taxable interest and half of your Social Security benefits. If the sum of these incomes exceeds certain thresholds, a portion of your Social Security benefits becomes taxable.
For single filers in 2023, if this combined income is between $25,000 and $34,000, up to 50% of your Social Security benefits may be taxable. If the combined income is more than $34,000, up to 85% of your benefits may be taxable. For couples filing jointly, these thresholds are $32,000 to $44,000 for up to 50% taxation and over $44,000 for up to 85% taxation.
Because there is no phase-in to these brackets, it’s important to monitor your total income if you are receiving Social Security benefits.
Income Tax Examples
Let’s take a look at a couple of examples.
John made $80,000 in net self-employment income this year. On this income, he would owe self-employment taxes of approximately $11,475 (15.3% of $75,000). John can deduct half of his self-employment taxes, or about $5,738, from his income when calculating his taxable income.
John also contributes $10,000 to his Solo 401(k) and has $15,000 of deductions. His taxable income is now reduced to $80,000 – $5,738 – $10,000 – $15,000 = $49,262. By strategically utilizing tax deductions, John has significantly reduced his taxable income, lowering his federal income tax obligation.
Maria is married and earned $180,000 in net self-employment income this year. The Social Security portion of her self-employment taxes would apply only to the first $160,200 of her income. Therefore, her self-employment taxes would be approximately $23,391 (12.4% of $160,200 for Social Security plus 2.9% of $180,000 for Medicare).
Maria can deduct half of this self-employment tax, or about $11,695, from her income when calculating her taxable income.Maria is also eligible for QBI, which allows her to deduct an additional $36,000 ($180,000 * 20%) from her taxable income.
If Maria contributes $20,000 to her SEP IRA and has $25,000 of deductions, her taxable income is now reduced to $180,000 – $11,695 – $20,000 – $25,000 – $36,000 = $87,305.
Steven and Kim are married and file a joint return. They have two dependent children under the age of 17. Kim is a self-employed physician who makes $445,000, and Steven does not work.
Kim makes a $22,000 solo 401(k) contribution each year, and the family spends $18,000 on health insurance. They do not itemize their deductions on their return. The deductible portion of Kim’s self-employment taxes is $16,400.
The couple’s AGI is $445,000 – $22,000 – $18,000 – $16,400 = $388,600.
The couple’s taxable income before QBI is $388,600 – $25,900 (standard deduction) = $362,700. The couple falls just below the threshold where QBI starts to phase out, so they will also receive a deduction of $77,720 ($388,600 * 20%). The couple has a taxable income of $388,600 – $77,720 – $25,900 (standard deduction) = $284,980.
This is a nearly ideal situation for a married couple – they receive the full QBI deduction and child tax credit while using the majority of the 24% tax bracket.
To maximize your deductions and minimize your taxes, as a working physician, you’ll want to utilize your full 24% tax bracket. This allows you to receive the full benefit of the QBI deduction and avoid the large jump to the 32% bracket. So keeping your taxable income (note this is not your AGI or MAGI), near the top of the 24% bracket will achieve this goal.
For families with children moving into the 32% bracket also means that you are approaching the child tax credit phaseout, which will increase your marginal tax rate by an effective 5% within the phaseout range.
Planning out your income and optional deductions such as pre-tax retirement contributions (or alternatively, making Roth contributions if you have additional room in the 24% bracket) will minimize your taxes over the long run.
What is the sweet spot of income?
The sweet spot of income will vary depending on your marital status and number of dependents. For sole proprietors, ensuring that your income is eligible for the QBI deduction will be one of the most impactful moves you can make. Maximizing retirement contributions, utilizing the full 12% tax bracket, and ensuring that you claim all eligible credits will help you maximize your take-home pay from your business.
There are tools available to help you determine your ideal income. Kathryn at Making Your Money Matter created a thorough spreadsheet which allows you to evaluate several scenarios to maximize your savings while minimizing your taxes. There is a fee to download this tool, but the insight and potential tax savings make it a worthwhile investment. (Full disclosure: PoF receives a referral fee for purchases through Kathryn’s website).
How much should I put into my 401(k) to reduce my taxes?
Historically, the advice has always been to max out your 401(k). However, if you are in the 24% tax bracket, you may want to consider putting money into a Roth 401(k). Making Roth contributions while you’re in a lower-earning year (and lower tax bracket) can save you money in the long run if you expect to be in a higher tax bracket in retirement.
How often do you review your financial plans? Isn’t it time for a checkup to ensure you’re on track?
Are you ready to take control of your finances and minimize your tax liability? Why not start with a consultation with a financial advisor today?