Among the many benefits of trading is no payroll taxes. While not subject to FICA or self-employment taxes, are you still able to deduct health insurance, contribute to a 401(k) or take advantage of other fringe benefits? Warning: this gets complex! But these are things every serious trader should be aware of.
Whether you sell clothes online or provide contract IT services, you’re subject to self-employment tax or reasonable officer compensation rules (a.k.a. earned income rules). However, as explained in IRS Topic 429, gains and income from trading are not. This is a huge win. Congress has spared traders that 15.3% tax burden, but it impacts your ability to take advantage of a number of tax preferences.
Earned Income Benefits
Health insurance, child care assistance, Solo 401(k) plans, education assistance and Health Reimbursement Arrangements are all part of a category of deductions called Earned Income Benefits subject to rules summarized in Publication 15-B Tax Guide to Fringe Benefits.
The general requirement for many of these benefits is that there is earned income. What is earned income? Earned income is economic benefit (money) derived from work. This includes product sales, professional services, and most forms of compensated work which require a regular and significant time commitment. Hobbies, volunteering, selling your home, investing, retirement benefits, etc. are not earned income. Neither is trading.
Why is this important? Let’s look at your retirement plan options.
Why Invest in Employer Sponsored Plans?
In an employer sponsored plan, the IRS allows a 50-year-old employee to deduct $24,000 to a 401(k) plan, plus an additional $36,000 can come from the employer or in the form of a non-deductible contribution. A business owner with no employees can do this too via a Solo 401(k). Either way, that’s $60,000 that can be contributed to the plan every year.
The IRS also permits 401(k) funds to be converted to Roth 401(k) funds, leaving retirement assets to grow 100% tax free. After five years of maxing-out their plan, this means an employee or small business owner could accumulate $300,000 of tax-free Roth money. If allowed to grow, assuming the plan value eventually doubles and all tax rates to be 25%, when the taxpayer withdraws the funds he would have saved $75,000.
Not to mention, self-directed Solo 401(k) plans do not face the same issues when investing in leveraged assets, such as financed real estate and portfolio margin, as do self-directed IRAs or IRA LLCs. This creates more incentive for rolling over retirement assets from other plans to take advantage of a wider spectrum of investment options.
This is great for the employee or small business owner, but high contribution limit retirement plans, such as the 401(k), are allowed because there is earned income. This means without careful planning traders are limited to just using IRAs, which allow nearly a tenth of the annual contributions as a 401(k).
All is not lost. Traders who incorporate can hire themselves, creating an earned income and allowing Earned Income Benefits. However, don’t proceed without a knowledgeable tax guide! While the tax benefits often justify the cost, the regulation is extremely strict. Federal and state payroll compliance, reasonable compensation precedence, ERISA nondiscrimination testing, EITC due diligence, prohibited transaction rules, and third-party reporting are just a few of the areas on which to be compliant.
Of course, taking a bonus or salary isn’t for everyone. There’s more tax efficient ways to pay yourself. But for those for whom it does make sense, there are tremendous tax savings if planned properly.