A Roth IRA is a great vehicle for saving for retirement. Because you pay taxes on money going into your account, you can withdraw funds tax-free in retirement. And unlike other retirement funds, required minimum distributions don’t apply to Roth IRAs, so your money can grow tax-free for as long as you like. To be sure you’re getting the most from a Roth IRA account, this article will go over some common — and sometimes costly — mistakes people make with their Roth IRAs.
Don’t Skip a Roth IRA Just Because You Already Have a 401(k)
You might be tempted to skip a Roth IRA if you already have a 401(k), but this savings combination can help accrue a considerable nest egg. To take full advantage of both retirement plans, be sure you’re contributing enough to your 401(k) to get the full employer match, if your employer participates in a match program. Once you’ve maxed out your contribution to the employer match, open a Roth IRA and begin funding it.
Don’t Contribute If Your Income Doesn’t Allow You to Qualify
For 2022, married couples filing jointly can contribute to a Roth IRA if your modified adjusted gross income (MAGI) is $204,000 or less ($129,000 for single filers). Contributions begin phasing out above those amounts, and you’re not permitted to contribute to a Roth IRA once your income reaches $214,000 if married and filing jointly ($144,000 for single filers).
If you make contributions when your income places you above the contribution limit, it’s considered an excess contribution. The IRS will charge a 6% tax on the excess amount for each year it remains in your account.
Don’t Contribute Too Much
Just as with income limits, if you deposit more than you’re permitted to contribute to your Roth IRA, you’ll be subject to the same 6% excise tax on the extra funds every year until the overage is corrected. If this slip-up endures for a few years, it has the potential to be costly. To fix this problem, you have until your tax filing deadline to withdraw the excess funds without facing the penalty. Just be sure to also withdraw the interest and any other income generated from those surplus funds.
Don’t Discount a Backdoor Roth IRA
For those earners whose incomes fall above the Roth IRA limits, you have the option of a backdoor Roth IRA. Using this strategy, after-tax contributions are made to a traditional IRA, then the invested money is converted to a Roth IRA. However, because funds deposited into a traditional IRA are pre-tax, expect to pay income tax on the conversion. This move even has the potential to bump you into a higher tax bracket, so it’s never a bad idea to consult a tax professional when you’re considering a backdoor Roth IRA.
Don’t Miss Out on a Spousal IRA
A spousal IRA is an exception to the condition that an individual must have earned income to contribute to an IRA. It permits a working spouse to contribute to an IRA in the name of a spouse who has no income or very little income. Provided the working spouse’s income equals or surpasses the total IRA contributions made on behalf of both spouses, this is a strategic approach to investing.
Depending on your income, your maximum contribution to a spousal IRA is $6,000 each, which increases to $7,000 per person at age 50. So if you’re 51 and your spouse is 49, you’re able to contribute $13,000. Once your spouse reaches age 50 you can begin contributing the maximum $14,000.
Don’t Do Rollovers Without Knowing the Rules
When you do a rollover — withdraw money from one retirement account and deposit it into another — you need to abide by certain rules in order to avoid tax consequences. For instance, if you withdraw funds from a retirement account like a 401(k), you have 60 days to deposit the full amount into your Roth IRA. Neglecting to do so will render the withdrawal a taxable distribution, and may also be subject to a 10% additional early-distribution tax. Also be aware that typically only one rollover per year is permitted.
You can also choose to do a direct rollover where all or a portion of your retirement funds are directly transferred from one qualified retirement plan to another. This move is not taxable, so you can move your money without facing tax penalties, and your money continues to grow tax-deferred until you make withdrawals. However, keep in mind that your contributions to a 401(k) or traditional IRA were pre-tax, so when you roll them into a Roth IRA, they’ll count as income in the year you made the rollover.
Don’t Forget About Beneficiaries
If you neglect to name a living beneficiary for your Roth IRA, the money typically will need to go through probate before your heirs gain access to it. Going to probate means that all your assets, including your Roth IRA, are lumped together, and all debt is paid before the funds are distributed to heirs. This, of course, means that your heirs may not end up with as much as you’d planned. Be sure your named beneficiaries are up to date.
Don’t Just Sit on Your Funds
You have to make contributions to your Roth IRA if you want to take advantage of the tax-free growth and compound interest. You also need to decide how you want to invest those funds. If investment strategy isn’t your strong suit, consider working with a financial professional.
Whether a small business owner is working with an accountant or on their own, it’s critical to establish a bookkeeping process in order to mitigate the possibilities of unexpected cash flow problems. Tracking finances and transactions provides stability for your business and allows you to focus on company goals and growth. Here are some tips for efficient bookkeeping.
Separate Business and Personal Expenses
This should be done as soon as you establish your business. Separating personal and business accounts is beneficial in that it helps to:
Avoid blurred lines on expenses that could prompt an IRS audit.
Limit your personal liability should your business ever be sued.
Clarify business expenses for bookkeeping practices
By opening business accounts, you will begin to develop business credit, which is separate from your personal credit history. A good business credit score translates to lower rates on insurance policies and increases your borrowing potential.
Track All Business Expenses
It might seem like a no-brainer, but tracking and categorizing expenses and revenue streams are essential for tax purposes and profit monitoring. Doing so allows you to easily spot different areas of strength and growth based on chronicled data. Whether you use an accounting software program, a basic spreadsheet like Excel, or even a pen-and-paper ledger, what matters is that you find a process that works for you and stick with it.
Keep a Consistent Schedule for Bookkeeping
Unless your small business offers financial services, it’s unlikely that you started your company due to a love of numbers and bookkeeping, so it’s understandable if this might be a task that’s tempting to push to the backburner. However, consistently scheduling blocks of time for balancing the books will help simplify your life, especially during tax season. If your business has grown to the point where you loathe the time it takes to keep up on bookkeeping, you might be ready to hire on a bookkeeper.
Be Prepared for Major Expenses
Even if you have meticulously maintained balance sheets and cash flow reports, you don’t have a crystal ball to predict surprising expenses. That’s why it’s crucial to plan for such expenses, especially unplanned ones, with a separate emergency fund dedicated specifically to your business. Aim to save enough cash to cover expenses for three to six months. Having cash stashed away also helps to avoid going into debt for your business. Operating with little to no debt means less risk and a faster profit, which means you’ll have more capital to put back into your business for growth opportunities.
Prepare for Personal and Business Taxes
Do your best to dodge surprises and errors with your small-business taxes by preparing throughout the year. Here are some things to keep in mind:
Income tax: The manner in which you’re required to pay income taxes depends on how your business is structured legally. For example, if you have a sole proprietorship, your business taxes are paid as part of your personal income tax known as “pass through” taxes. However, if you have a structure like a Limited Liability Company (LLC), you’ll owe self-employment taxes and no corporate taxes. Be sure that you understand how your business is structured legally so you know how you’re required to pay income taxes.
Payroll tax: In order to file payroll tax returns, you need a Federal Employer Identification Number (FEIN). If you operate across more than one state, you will also need a State Identification Number for each state in which your business operates. Payroll taxes are deposited either semiweekly or monthly and reported quarterly.
Sales tax: If you’re in the business of selling products, you need to collect sales tax from each customer. These taxes differ by state, county, and city. If you sell online or across multiple locations, it might be beneficial to consult a tax professional to be sure you’re collecting sales taxes correctly.
Consider Hiring and Accountant
While most accounting software programs have some form of technical support, the risk of user error is high. Real-world accounting professionals can offer an experienced set of eyes to ensure your records are accurate and your finances are organized. The hours you devote to keeping up on your business’s books and taxes could be better spent brainstorming new ideas, managing your team, and searching out new growth opportunities.
In general, the likelihood of an IRS tax audit for a small business is slim, but there are various factors that can greatly increase the chances of being targeted. The IRS checks for a range of red flags to pinpoint businesses that are more likely to have discrepancies in their taxes. Read on for seven triggers that could raise your odds of an IRS audit in the future.
Multiple Net Losses
If you report net losses in more than two out of five years of operation, your chances of an audit increase. After all, the purpose of a business is to generate income. Consistent loss of income is a red flag for the IRS. Sole proprietorships are even more at risk than other small businesses due to the commingling of personal and business funds that tend to occur in these setups. The IRS may want to investigate whether your sole proprietorship is actually a business or a hobby, as business expenses are deductible while hobby expenses are not. Be sure to keep detailed records for any deductions you are legitimately entitled to.
Filing Payroll Taxes Late
If you’re aiming to fly under the IRS’ radar, regularly missing filing deadlines is not the way to do it. Aside from penalty fees, late filing can lead to scrutiny that timely filing wouldn’t invite. It’s in your best interest to get ahead of the game in order to avoid dealing with IRS headaches in the future.
Low Shareholder-Employee Salaries
It’s a common move for small business owners to structure their business as an S-Corp instead of an LLC in order to avoid the 15.3% self-employment tax. S-Corp owners must offer their shareholder employees “reasonable” compensation, which is reported as wages on a W-2. The IRS specifically keeps an eye out for S-Corps with extremely low salaries paid to shareholder employees. Double check that all shareholder-employee salaries are within the average pay range according to position, company size, industry, and profitability. It is typically the individual tax return of a shareholder-employee that flags the audit, which then generates an investigation of the company.
Excessive Deductions
Though sole proprietors run a greater risk of scrutiny from the IRS, all small-business owners should be mindful of whether every meal and travel expense truly qualify as a business deduction. According to the IRS, this means the expense is “ordinary and necessary”. Be sure to review year-over-year deductions to remain consistent.
Business Use of a Vehicle
When deducting vehicle use as a business expense, choose between the actual vehicle expense (use the appropriate calculation for this) and the IRS standard mileage rate. Choosing both will alert the IRS. If your vehicle is used solely for business purposes, you may be able to claim a deduction for the depreciation on the vehicle. However, you’ll need evidence in the form of mileage logs that record the dates and purpose of every trip you made throughout the previous year.
Cash Transactions
It is difficult to track and verify cash business deals, thus large cash transactions, such as business equipment or investment property, tend to send a red flag to the IRS. It’s best to use a credit or debit card for these transactions, but if you choose to use cash, be sure to record your transaction meticulously to create your own paper trail. You will also need to file IRS Form 8300 to report any cash payments exceeding $10,000.
Calculation Errors
Make no mistake: the IRS checks your math. When small businesses do their own taxes, it might be easier to round numbers or use averages, but this throws off the math. Be sure to work in decimal points when you report earnings and expenses. Even small blunders, such as erroneous totals for expenses, missing 1099s, or transposed numbers can attract unwarranted attention from the IRS.
There are some valuable tax deductions available for self-employed people. The key is knowing what they are and how they can help reduce your tax bill. Here are some key self-employment tax deductions to remember.
Home Office Deductions
This deduction allows you to deduct any portion of your home that is used specifically and regularly for work. There are two methods used for deducting home office expenses:
Regular Method: To use this method, you will itemize the actual expenses incurred by completing form 8829. The list of deductible expenses includes furniture, appliances, utilities, insurance, maintenance, and repairs. If you plan to use this method, it’s important to keep accurate and detailed receipts.
Simplified Method: To use this method, you will simply apply the standard deduction of $5 per square foot of home used for business, up to a maximum of 300 square feet. This is an easier way to account for home office expenses than the method above, but keep in mind that the 300 square-foot limit amounts to a maximum deduction of $1,500.
Vehicle Use for Business
You may be able to deduct the use of your vehicle on your tax return if you regularly use it as part of your business. There are two methods of calculating these expenses:
Actual Expense Method: Employing this method authorizes you to deduct specific costs essential to operating your business vehicle, such as gas, oil changes, tires, registration fees, insurance, and depreciation. If you also use your business vehicle for personal use, you will need to calculate the portion of the operating costs that you generated due to business travel, and only that amount is deductible.
Standard Mileage Rate: To use this approach, you will multiply the number of business miles driven by a flat per-mile rate. This rate can vary from year to year. For tax year 2021, it decreased from 57.5 cents to 56 cents per mile.
Health Insurance
If you are self-employed, you can deduct the cost of health care premiums for you and your family. This includes any children under 27 who are on your health plan, regardless of whether you claim them on your return. However, you won’t qualify for this deduction if you or your spouse are eligible for an employer-sponsored health plan.
Social Security Taxes
Employees who work for a company have payroll taxes deducted from their paychecks, and Social Security and Medicare are typically split equally between employee and employer (i.e., employee pays 7.65% and employer pays 7.65%). However, the self-employed pay the total 15.3% tax, which consists of a 12.4% Social Security tax and a 2.9% Medicare tax. The 15.3% tax is owed if your net earnings for the year are greater than $400. The good news for the self-employed is that they can write off half of the self-employment tax without the need to itemize. For tax year 2021, the maximum amount of self-employment income that’s subject to the 12.4% Social Security tax is $142,800. In 2022, it increases to $147,000.
Retirement Tax Shelters and Credits
If you are self-employed, you are eligible to contribute pretax money to a simplified employee pension (SEP) or a solo 401(k). This is in addition to an IRA account. Both SEPs and solo 401(k)s allow higher annual limits than regular individual retirement accounts.
Covid-Related Sick and Family Leave Credits
These tax credits are applicable for the first nine months of 2021. As a self-employed person, if you were unable to work (including telework or working remotely) due to certain COVID-19 related circumstances you are eligible to claim sick and family leave credits that are comparable to credits authorized for other businesses. These circumstances include personal sickness or quarantine, awaiting the results of a COVID test, and caring for a dependent who was sick or unable to attend school or daycare because of sickness, closure, or quarantine.
The credit amounts you are ultimately eligible for will depend on a few different factors, including the reason for missed work, timeframe of missed work, and duration of missed work. You will need to fill out the IRS’s Form 7202 to calculate your credits.
Deduction for Qualified Business Income
The qualified business income deduction (QBI) allows eligible self-employed and small-business owners (including sole proprietors) to deduct up to 20% of their qualified business income on their taxes.
In order to qualify, in general, total taxable income in 2021 must be under $164,900 for single filers and $329,800 for joint filers. These limits raise in 2022 to $170,050 for single filers and $340,100 for joint filers. If your taxable income is above these limits, complex IRS rules will verify whether your business income qualifies for a full or partial deduction.
Expensing
Expensing (also known as Section 179 deduction) lets you deduct the full purchase price of certain qualifying business assets in the year you bought them. The tax break applies to physical items—equipment (new and used), machinery, office furniture, off-the-shelf software, etc. Intangible assets such as patents and copyrights do not qualify, but improvements to business buildings as well as any installation of fire alarms and security systems do qualify for the tax break. You also cannot use this deduction for purchased land and real estate.
For tax year 2021, up to $1.05 million worth of equipment is acceptable for the immediate write-off of expenses, but this amount decreases if you put more than $2.62 million of new assets into service over the course of any single year. The equipment must have been purchased (or financed) and placed into service by December 31, 2021.
Setting goals is a necessary start to achieving a financially secure future, but sticking to those goals is another hurdle altogether. Unexpected expenses, the costs of day-to-day life, and failure to track spending all have the potential to derail any roadmap we may initiate. Read on for actionable strategies to help you stay on track to reach your financial goals.
Be Clear About Your Objectives
Most of us have heard that every dollar should have a name, which means that when it comes to saving, you need to be clear on your objectives. What are you saving for? It could be a down payment on a house, a child’s education, retirement, a dream vacation, etc. Many of us save for a combination of objectives, so it’s also important to be crystal clear on the reasons behind your financial goals. Knowing your “why”—for any goal in life—will create intrinsic motivation. The goal becomes a priority despite whatever external forces are at play.
Establish Small, Attainable Goals
Many financial goals are lofty, whether paying off student debt or saving for retirement or anything in between. They take diligence, consistent monitoring, and a solid framework to reach. In other words, financial goals require micromanagement. If your goal is to save $5,000 for an emergency fund, write down the steps you plan to take to achieve this goal, then put them into action and monitor them constantly. Some of these steps could include, for example, reframing your budget to account for the emergency fund, setting up automated weekly deposits into your savings account, and finding a money managing app that works for you.
Compartmentalize
In order to meet a specific goal, think about dedicating a separate account for it. You can even set up automatic direct deposits so you’re not tempted to use the money for something else. Be sure to label this account with a name that reflects your goal, such as “Early Retirement”. This can be applied to any financial goal. In fact, you may have several different accounts allocated to different goals.
Break Down Big Goals into Quarterly Milestones
Once you compartmentalize your goals, think of your bigger goals in terms of quarterly increments. If you want to save $20,000 in two years for a down payment on a house, rather than focusing on the daunting path ahead, make a plan to allocate a certain amount each month, then review the account every quarter. In this case you would need to save roughly $834 per month. When you see that you’re saving $2,502 per quarter, the end goal of $20,000 in two years is undeniably within reach.
Build a Flexible Budget
In order to reach financial goals like the $20,000 down payment example above, you need to keep spending in check. When you know how much money is coming in and leaving your account on a monthly basis, you can better determine how much you can allocate to different goals. When you create your budget, keep in mind that it should be realistic yet flexible so you can make smart adjustments as needed.
Save Your Raise
When saving for financial goals, aim to save at least half of any raise, bonus, or unexpected funds. Better yet, save it all. As tempting as it can be to splurge on a big purchase, you’ll be happier in the long run when you refrain from impulsivity in favor of staying the course to meet your future goals.
