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If you are new to working from home, you might not be aware that your income tax situation has changed. If you are self-employed and getting 1099s instead of W2s, you will be responsible for paying Self-Employment Tax in addition to your regular income tax.
What is Self- Employment Tax?
Self-employment tax is the Social Security and Medicare that an employer normally deducts from an employees paycheck. The self-employment tax rate for 2013 is 15.3% (12.4% for Social Security and 2.9% for Medicare) and you will pay that on top of your other income tax.
The amount you pay in self-employment tax is pretty much set in stone, so you can’t lower it. However, you can lower your other income tax by claiming deductions and credits.
One of the items you can deduct and get credit for is contributing to a retirement account, like an IRA.
What is an IRA?
An IRA, or Individual Retirement Arrangement, is similar to a 401K in that it lets you save money, for retirement and offers tax breaks for doing so.
There are two major types of IRAs available to the self-employed: Traditional and Roth.
With a traditional IRA, the money you contribute to the fund is immediately tax deductible. This means that you can deduct that amount when you file and end up paying less in income tax. However, you will have to pay taxes when you withdraw the money at age 59 ½ (or older).
With a Roth IRA, your contribution is not tax deductible. This means you can’t deduct the amount you deposit to the IRA account from your taxes. However, the IRS could still give you a tax credit for contributing to a retirement account, which could lower the amount you owe in taxes. Additionally, because you have already paid tax on the money in the account, you can withdraw it 100% tax free.
How IRAs Work?
Essentially, you would open an IRA account at a financial institution that also handles investment accounts, such as Fidelity, Charles Schwab, Merrill Lynch, or even your local bank.
The amount you need to open an IRA account varies by bank. For example, Fidelity Investments might require a minimum deposit of $2,000, while the Schwab IRA allows you to roll over an old 401(k).
Once you have opened the account, you can manually deposit funds into the account, or do so electronically via direct deposit or electronic transfer from another bank. You can also transfer money directly to your IRA from another account at the same bank.
If you leave the funds in the account, they will accrue interest over time. You also have the option to invest your money, the same way you would in a 401K to increase your return.
You must leave the funds in the IRA account until retirement age to earn the tax benefits. However, both the Roth and Traditional IRA will allow you to withdraw the money early, if necessary. The whole point of these accounts is to help you save up for retirement; if you withdraw early you will be required to pay fees and any applicable taxes.
It’s important to plan for your future, especially when you are self-employed. By putting money into a retirement account, you not only reduce your tax liability, you can also build a nest egg for the future that you can also tap into if a financial emergency arises.
To find out more about IRAs, and other retirement accounts, contact an accountant or a qualified investment professional.