7 things to do when starting a business to avoid nasty surprises

The only thing that hurts more than paying an income tax is not having to pay an income tax. Thomas Dewar

When you decide to start a business, taxes may be the last thing you think about. However, not realizing that you owe the self-employment tax as well as income taxes can lead to a nasty surprise when you file your taxes. This post is aimed at avoiding that costly surprise.

But, before we discuss the self-employment tax, there are other important steps to take when you become self-employed. Here are the 7 things to do after you start your own business to avoid nasty surprises:

Avoid nasty surprises – set up bookkeeping, form your entity, get licensed, buy insurance, and pay taxes

Bookkeeping – set up bookkeeping using software like QuickBooks (either online or on your laptop). You don’t want to be scrambling to find receipts at tax time or not be able to tell somebody if you are making money or not.

You can save time by downloading from your bank and credit card companies. If you set up things well, all income and every expense will be properly categorized for your profit and loss statement, or P&L. The P&L and balance sheet help you monitor your business to see how well you are doing and are essential for preparing your tax returns. The balance sheet will also come in handy if you need to apply for financing.

For all these steps, you may want to hire an accountant or speak to an attorney.

Entity – for many small businesses, being a sole proprietor is appropriate. You avoid paying corporate excise taxes and filing annual reports. However, if you have partners, you may want to form a partnership, corporation or LLC (details on choosing are beyond the scope of this post).

If your business involves risks that could lead to law suits, form a corporation or LLC to shelter your personal assets from liabilities of the business that insurance may not cover. Make sure that any actions you take for the business are in your capacity as an officer or manager – i.e., never sign personally.

Remember, you may want to consult with an attorney.

Get licenses, file annual reports and pay local taxes – certain businesses require a license to operate. Most entities are required to file annual reports. And, your city may impose taxes on the personal property in your business. Be sure to find out so you don’t owe penalties for failing to file and pay.

Buy health and other insurance – in addition to liability insurance, you will want to obtain health insurance if you are no longer working for another employer. You may get favorable treatment for this expense on your income taxes. You can also purchase insurance to cover damage to equipment, loss of data, identity theft and so on.

File payroll taxes – if you hire people to work for you and pay them over $600 per quarter in any year, you need to report the compensation. If they are independent contractors, you file a form 1099 with the IRS. If they are employees, you file a W-2 with the Social Security Administration. You also provide these forms to your people for the income tax filings.

You may need to withhold and remit FICA and Medicare taxes. Also, your employees may request that you withhold and remit federal and state income taxes (unless you live in a state that does not impose income taxes). Failure to withhold and pay to the IRS and state can lead to serious penalties.

Pay your income tax – one big shock for many who start a business is how much they owe in taxes. When you received a paycheck, you probably did not focus much on the fact that your employer withholds federal and state income taxes and FICA and Medicare taxes. And, you never had a chance to spend what was withheld.

However, when you run your own business, you have full access to the pre-tax income, so you must diligently allocate funds ahead of time so that you don’t come up short at text time. To avoid owing interest on the taxes due, you make estimated tax payments each quarter to the IRS and state.

Pay the self-employment tax – when you were an employee, your employer withheld FICA and Medicare taxes from your paychecks. The employer also contributed FICA and Medicare taxes on your behalf

When you become self-employed, you are responsible for both the employee and employer amounts. This tax is based on your net self-employment income

A lot to remember, right?

Maybe, but knowing and planning is far better than trying to scrape together money in April to cover taxes you did not expect.

Good luck with your new business!

In future posts, we will examine partnering with others, assessing your profitability, rules on deducting expenses, and entry into the real estate market.

 

Year-end planning, 2016 version

The election of Donald J. Trump could have a significant impact on your finances. Individual and corporate tax laws may change, the Affordable Care Act may be eliminated, trade war may ensue, infrastructure building may boost jobs and sectors of the economy, and national defense and diplomacy could lead almost anywhere – your guess is as good as anyone else’s.

So then, how do you incorporate this into year-end planning? Very carefully!

Corporate Taxes

Our analysis starts with a review of his proposal to limit corporate income taxes to 15% as a way to illustrate how tricky planning is:

Analysis of the way this limit applies to pass-through entities suggests that the 10-year cost could be anywhere from $4.4 trillion, assuming owners of pass-throughs pay 33% tax, to $5.9 trillion, assuming owners only pay a 15% tax.

Those are hefty cost numbers, which is why it is tricky to assume that any major tax changes will be enacted in 2017.

Income Taxes

There could be three rates on ordinary income: 12%, 25% and 33%, with the latter starting at $225,001 for married filers and $112,501 for single filers. The 0.9% and 3.8% Affordable Care Act surtaxes on upper-incomers would be eliminated. So would the AMT (“alternative minimum tax”). The 20% maximum capital gains tax would remain. Standard deductions would go up, personal exemptions would be eliminated and breaks for dependent care would be increased.

Check here for 2017 tax rates.

Estate taxes

The President Elect has revised his estate tax proposal, calling now for pre-death tax on appreciation in assets of large estates, subject to a $10-million-per-couple exemption. This may be accomplished by limiting the step-up in basis for heirs who inherit capital assets from large estates.

Another change would be elimination of the IRS’s proposal to restrict the use of valuation discounts for gift and estate tax purposes on intrafamily transfers of closely held firms.

Investing and retirement

Infrastructure building could boost certain investments, while conflicts on trade agreements could hurt many.

His proposed tax changes for retirement plans include extending the age for which contributions to IRAs are allowed and delaying required minimum distributions (RMDs).

Okay, enough, how does one act now?

Some moves still make sense

Tax plan – deferring income into 2017 and adding deductions to 2016 should work well, unless doing so puts you in the AMT, in which case the reverse will work best.

Most of our suggestions from our 2015 year-end planning post still work, including RMDs, 3.8% Medicare surtax, itemized deductions, stock options, investment income and sole proprietor and small business income. Also check out our estate planning post for more ideas.

If your deductions include donating to charities, gifting appreciated assets leverages your donation. That is, you can avoid the income tax on capital gains while still benefiting from the charitable deduction. Watch for the rules on exceeding 30% of your adjusted gross income and donating to private charities.

Research Your Charities

Check out websites like such as ImpactMatters and GiveWell to make sure what you donate has the best impact. Other tools include Agora for Good, a tool to track donation impact over many sectors.

Investing – your strategy should not be altered in any dramatic way now.

If you do sell mutual funds, be sure to wait to buy replacement funds until after the dividend distribution date, so you do not end up with a taxable distribution on gains in which you did not participate

Summary

Many of the income and estate tax rules may change during 2017. However, for now, your safest plan is to assume little changes and stick to the “traditional” techniques outlined above.

If you have any questions, please contact me!

“Simplify your finances? No; “Gain control, understand your finances?” Yes

After reading a recent article in Kiplinger’s Finance Magazine  on simplifying your finances, I wondered if your personal finances can really be made simple.  While many of us may hope so, I am not sure that “simple” is best.

However, gaining control of your finances and gaining a better understanding do make sense.

clutter-286975_1920 Okay, that does need to be simplified!

Here are some ways that help you gain control that may also “simplify” your life:

Cash management and Debt management

Set up automatic payments with vendors so they use your bank or credit card, or set up payments using your bank website.

  • If the payments are regular, and of similar amounts, you save time and can plan on the withdrawals.
  • However, if you change banks, sorting and resetting auto-pay at the new bank can be a major headache. Similarly, if you change credit cards, you need to update information with all vendors.

You can also automate tracking of your spending by using websites like Mint or Personalcapital.  Or, you can use Quicken or QuickBooks software from Intuit to track your bank and credit card accounts.  You can download from your bank and credit card websites into the program and then review to analyze your cash flow and spending.

Setting up direct deposit for payroll into your checking is great.  You can also split part so it goes to savings or even have some go to your investment accounts.  You will then need to follow up to invest the cash that accumulates, but having money set aside saves it from being spent, and adds to your investments

Investing

Kiplinger’s recommended consolidating retirement accounts to avoid low balance fees.  It also makes updating beneficiary designations easier.

While avoiding fees makes sense, am not sure that putting all investments into a single retirement account does.  You cannot do this if you have Roth and pre-tax accounts like a 401(k) plan, and you probably should not do it if you have contributory IRA and 401(k) accounts that are subject to different tax rules.

Kiplinger’s also recommended using one broker for your taxable accounts.  This makes more sense, in that you have a higher balance which should mean lower fees and more attention from the broker.  However, I prefer using exchange traded funds, or ETFs, and avoiding most broker fees, which means essentially no attention from a broker.

One article said that your investment plan should be to “sign up and forget it.”  While avoiding investment pitfalls like second-guessing yourself out of panic when a fund goes down is good, I do think you need to review and rebalance your investments once a year.

Another article recommended using an “all in one” fund for investing.  Now, this really troubles me.  If your sole goal is retirement, then an age-targeted fund could make sense.  But, if you are saving for goals with different time horizons, this is a bad idea.

If you use an age-targeted fund, do your homework on the funds.  For example, if the fund plans to suddenly shift to bonds when you retire, that will not serve you well because you are likely to have several decades for which you will need the growth from stocks.

Protecting your information

Having a master password for access to all your other passwords reminds me of the joke about the student who repeatedly distilled his notes down, first to an outline, then to note cards, and finally to one word.  How did he do on the day of the exam?  He forgot the word.

Nonetheless, having passwords is clearly important so having a way to manage them is as well.  Check out this recent review of apps for managing your passwords PC Magazine Best Password Managers for 2015.  You can manage the passwords yourself by creating a document that you save as a PDF and then encrypt.  But don’t forget the password you used for the PDF!

Store files in one place

We did a post on using cloud storage when you do not need originals.  Here is another site to check out:  Shoeboxed

Credit cards

In addition to downloading transactions as noted above, you can track your credit score and credit history by using sites like Credit Karma

Estate planning

For insurance purposes, and for your estate plan, having a record of possessions, you can list all your property using sites like Know your stuff home inventory.

Conclusion?

There are ways to gain better understanding of your finances that also make your finances simpler.  But setting simplification as your primary goal risks distorting your finances – too simple may be a bad result.

P.S. Our sister website, www.wokemoney.com, encourages you to gain a better understanding of your finances so you can handle your own planning.  Let me know what you think.

What is the AMT?

 Not, it is not a dyslexic version of ATM!

 Back when people could shelter almost 100% of their high income, Congress decided to make that more difficult by creating the alternative minimum tax (“AMT”), a minimum tax that all must pay with a rate of 28%. This along with sweeping changes made in 1986 made it difficult for the top taxpayers, people with income over $1 million, to get much below an average tax of 20%.

On the other hand, an AMT rate as high as 28% is still great if your marginal rate is 39%.

Why do you care? Despite the title, you do not get to pick

You must pay the higher amount determined by the regular and AMT tax calculations. If you have to pay the AMT, you are paying almost a flat rate of 26% to 28%, not a graduate rate, and you are losing the value of many itemized deductions, including state income taxes paid, most mortgage interest and miscellaneous deductions. To make sure you pay taxes, certain “preference” amounts are added to your AMT income, including incentive stock options and alternate depreciation schedules.

Data on 2012 income tax indicates that nearly every married taxpayer with income between $100,000 and $500,000 owed some AMT. Thus, the AMT is no longer just for the ultra rich!

So what do you do? Plan carefully

Make sure that efforts to reduce regular taxes do not push you into paying the AMT. Here is one example: If you have a year with high ordinary income, be sure to pay all of the state income taxes due during that calendar year, since you are less likely to be in the AMT doing so but are like to be in the AMT next year if you wait until April to pay those state taxes. The lower ordinary income of next means that you will certainly be in the AMT.

Note: some states also impose an AMT, making planning quite … er, taxing!

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Oh, that looks complicated!

Good planning pays off, as in the example above, where preserving the deduction can be a very substantial savings on your federal income taxes.

Roth or not to Roth? Deciding requires predicting your future tax rate

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More employers now provide the option of a Roth 401(k) as well as a traditional 401(k), so you may ask:

Which should contribute to a Roth 401(k) or a traditional 401(k)?

The answer is not so simple and it depends on your income tax rate now and at retirement. Before offering background and explanation, we start with this Quick Summary

If you have a high tax rate now, and expect a low tax rate later, pick the traditional 401(k)

The traditional plan is better because get the current tax deduction, reducing taxes now at the higher tax rate. This may be true for people in middle or later years of employment.

Note: this is only financially better if you invest the amount of taxes saved.

If you have a low tax rate now, and expect a high tax rate later, pick the Roth 401(k).

The Roth plan is better because you avoid higher taxes later. This may be true for most people starting work now.

If expect to have the tax rate later as you have now, pick the Roth 401(k)

The Roth plan has other benefits described below.

Background – How the Plans Work:

Tax deferred growth

Earnings on both the traditional 401(k) and the Roth 401(k) are not taxed. Not paying taxes on investments in your retirement account means more grows and compounds tax-free – that is why contributing to a retirement plan is so important.

Contributions “pre-tax” vs. after tax

Contributions to a traditional 401(k) are made “pre-tax,” meaning that the amount contributed is excluded from your taxable income for the year.

Contributions to a Roth 401(k) are made after tax – they are not excluded from taxable income.

Taxing withdrawals vs. no tax

Withdrawals from a traditional 401(k) are taxed in the year of withdrawal.

Withdrawals from the Roth plans are not taxed. That is, the after-tax contributions are not taxed a second time and neither is the growth on those contributions.

Other rules – early withdrawal and require minimum distribution

There are penalties for withdrawal before reaching age 59½, unless certain exceptions are met, such as disability or first-time home buyer.

You must begin withdrawing when you reach age 70½ under the IRS Required Minimum Distribution or “RMD” rules. For more on RMD rules, see IRS Retirement Topics – RMDs

Hedging your bets:

If you are not sure of your tax rates, or if you just want more options because you cannot predict, then you can opt to combine plans. For example, you can contribute to your traditional 401(k) up to the employer match and then put the rest in a Roth IRA, if the contribution limits allow.

Conversions:

When you change jobs, you can convert a 401(k) to a Roth IRA, but doing so is a taxable event. If you expect your tax rate to be higher in the future, this is a good move. However, you will want to pay taxes due from other sources. If you have to take funds from the IRA to pay the taxes, you reduce the amount going into the Roth IRA which dramatically reduces the future benefit.

If you convert after-tax contributions made to a traditional 401(k) or non-deductible IRA, you have less on which taxes are due because the after-tax portion is not taxed in converting to a Roth IRA.

Other considerations:

While a Roth 401(k) is subject to RMD, a Roth IRA is not. If you can re-characterize the Roth 401(k) to a Roth IRA, you avoid the RMD. This may mean that you pass more on to your heirs. Also, you may gain investment flexibility compared to a company plan.

If you use a Roth plan, then your taxable income at retirement will be less than if you were withdrawing from a traditional plan where withdrawals are taxed. This could lessen tax due on social security benefits.

On the other hand, if you expect to use funds in your retirement plan to donate to a charity, you are better off getting the tax savings for yourself now. The charity is not subject to much if any income tax.

Also, if you expect your heirs to receive your retirement plan assets and know that those heirs will be in a lower income tax bracket, you should use a traditional plan now to get the tax benefit for yourself. How can you possibly determine that heirs will get more of your retirement than you and also be in a lower tax bracket? I cannot imagine – well, maybe I can, but none of the ideas sound good. Anyway, it seemed like a good idea to mention (they teach you to think this way in law school).