After the first full year of running a moonlight business, I found that we’d earned a nice profit. The money wasn’t yet as much as I earned from my day job, but it represented more spare funds than our family had seen in a long time.
Unfortunately, anyone who knows US tax law* will tell you that the extra income you earn as a sole proprietor is taxed at your highest marginal rate, and is subject to additional self-employment taxes.
This means that while the IRS might take, say, 20% of the of the earnings from a typical day job, you’re likely to pay closer to 40% of your additional business earnings in federal tax. Once your business starts to earn a real profit, you could be shocked by your federal tax bill.
Your Secret Weapon
Fortunately, if you can do without spending some of those extra earnings right away, the US tax code currently offers a powerful way to postpone – and almost certainly diminish – the taxes on much of your moonlight earnings. Your secret weapon is the Solo 401(k) .
Similar to the 401(k) savings plans offered by larger employers, a Solo 401(k) allows sole proprietors and their spouses put money from pre-tax earnings into a savings plan. That money and any dividends aren’t taxed until you withdraw the funds at a later date.
This helps you avoid paying federal tax on those earnings right away, and since you’ll likely be in a lower tax bracket when you retire, could help you avoid paying much of the total tax in the long run.
The amount of income that you can shield from immediate federal taxes with a Solo 401(k) changes each year, and depends on your age and net business profit. In general, your maximum contribution can range from $20,000 to over $50,000, plus more for a spouse.
I’d urge you to set up a Solo 401(k) as soon as your business shows a profit. It’s great to know you’re avoiding taxes and contributing to your security. You can search online for Solo 401(k) Providers to help create your account.
More Money Tips
The following suggestions are covered in depth in other articles.
- You can avoid bad investments by heeding Steve’s First Rule of Money.
- Read our story about how to keep your money safe.
- If you sell physical goods, be careful to avoid the inventory trap.
- To stay out of QuickBooks Hell, use your accounting software only for the things it does well.
Next, we’ll cover those important guidelines to help keep your money safe.
* I am not a CPA. This information changes with different circumstances, so please find a good accountant or tax professional to help you.