EDITOR'S NOTE: This article was originally published in the April 2009 issue of Kiplinger's Retirement Report. To subscribe, click here.
If you've moved into the ranks of the self-employed, you can shift some of your new expenses over to Uncle Sam. But watch out for the red flags that can catch the IRS's attention.
Generally, you can deduct business supplies, such as a computer, printer, fax machine, copier, software and a cell phone, as well as training sessions and advertising. "If it's essential for the business, it's probably going to be deductible," says Tom Ochsenschlager, vice-president of taxation for the American Institute of Certified Public Accountants.
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When it comes to business meals and travel, be careful. Fifty percent of the cost of meals and entertainment for clients is deductible. For travel, your deductions depend on the major purpose of your trip. If the trip is primarily for business, you can deduct the airfare, food, lodging, dry cleaning, fees for Internet connections and other work-related expenses.
"If you travel to Florida primarily for business, and you tack on a day with the family at Disneyland, you could deduct your flight and other expenses -- except that day at Disneyland," says Bob Scharin, senior tax analyst with Thomson Reuters, a provider of tax information. "If you're on a family vacation at Disneyland and you spend one day doing business with a client in Orlando, you could deduct the costs incurred only for that one day."
You can write off 100% of medical-insurance premiums for yourself and your spouse, as long as you aren't eligible for health insurance from an employer or your spouse's employer. For example, if a wife is employed by a company that provides health coverage to employees and spouses, the self-employed husband can't deduct medical expenses.
Self-employed people with a home office can deduct a portion of utilities, homeowners insurance, maintenance costs and housecleaning. If you have to replace your roof, you could deduct a portion of the cost. You can write off entire expenses that affect only your office, such as installing new carpet.
To qualify, the office must be a room, or section of a room, that's used regularly and exclusively for work purposes, such as meeting with customers, keeping records and ordering supplies. You will need to figure out what proportion of your house is occupied by your home office. For example, if the room takes up 250 square feet of a 2,500-square-foot house, you can deduct 10% of your home's expenses.
Make sure you're serious about your business before taking write-offs. Deductions won't fly if you're more of a hobbyist than a businessperson working to make money. Also, says Scharin, "your deductions for your home office cannot exceed your income from the business you're running out of your home."
Self-employed people can also reduce a tax bill by making tax-deductible contributions to a retirement plan such as a SEP IRA and an individual 401(k). For both, you can contribute 25% of your compensation up to $49,000. Plus you can contribute an extra $5,500 to a solo 401(k) if you're 50 or older.
You can deduct transportation costs for travel between your home office and business sites. Record the date, destination address and the number of miles for each trip. The standard rate for business travel is 55 cents a mile.
To track your expenses, file away receipts. "You have to be able to provide documentation on whatever you deduct for up to three years," says Abraham Schneier, senior manager of the tax division at the accountants' institute. Use Form 8829, "Expenses for Business Use of Your Home," to compute home-office deductions, and report deductions on Schedule C. Visit the "Self-Employed Individuals Tax Center" at www.irs.gov.
You'll pay a 15.3% self-employment tax, for Social Security and Medicare, on the first $106,800 in net earnings, and pay 2.9% for Medicare on net earnings above $106,800. But you can deduct half of your self-employment tax. Also, file estimated tax payments quarterly.
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