Self-Employment Tax Considerations When Starting a Consulting Business

After a long career and decades of experience, you’ve finally reached retirement. Now what?

You may have considered what you will do with your newfound time and flexibility while still maintaining your connections and skills. We often work with retirement-aged individuals who are contemplating or have been approached about offering consulting services. It’s an obvious and popular choice for retirees, as a means to counsel companies and keep abreast of their industries.

The benefits seem apparent. Consultants can supplement retirement income in an unpredictable market. Additionally, by continuing to work after retirement, you can defer Social Security distributions and leave your retirement accounts virtually untouched, maximizing earnings. But, what are the impacts and potentially hidden costs of a consulting career in retirement?

Let's walk through financial factors and various scenarios, so you can enhance, not hinder, your retirement years.

How to Protect Your Personal Assets When Starting a Business

The very last thing you want is to retire, consult, and then have the personal assets you accumulated over many years of hard work threatened because of a lawsuit.  So the very first thing we want to discuss is liability protection.

You want to consider the following points:

1. 1. Is the service I am providing in a litigious field?  For example, a construction engineer on an off-shore platform is subject to a greater risk of litigation than an editor of professional journals.
      
      
   2.  Does it make sense to set up a separate legal entity or will appropriate insurance policies be sufficient protection?  For example, if you are on the board of an organization, you probably only need Directors & Officers Insurance.  But, if you are that construction engineer on the off-shore platform, you may want to set up a separate legal entity AND have a good insurance policy.
      
      
   3. What is the cost of protecting your assets, and are the benefits of consulting worth the costs of setting up these protections?  Depending on your circumstances, often the best approach is to set up a separate legal entity through which to operate.  However, sometimes a good insurance policy is all you need.

If you decide that setting up a legal entity is worth it, an excellent choice of entity for consulting is a Limited Liability Company (LLC).  An LLC provides limited liability protection for its owners, thus separating your personal assets from potential liabilities arising from your consulting business.  

Items to consider when establishing your LLC:

• You will need to register the LLC by filing appropriate documents with your state.  This can be a thoroughly complicated process, so it is best left to attorneys. Willis Johnson & Associates can help you correctly establish your LLC by coordinating with our network of attorneys. 
• Determine the state annual reporting requirement for LLCs.  Most states, including Texas, require the filing of an annual information report, and some states require the payment of a yearly fee. 
• Determine the federal annual reporting requirement for LLCs.  You will likely establish a single-member LLC for your consulting business, which means you are the 100% owner (member).  For U.S. tax purposes, a single-member LLC is a disregarded entity, which means you will report this income as a sole proprietor on a Schedule C, Profit or Loss from Business, of your Form 1040.  If, however, you have a partner, you will have a separate tax return to file for the consulting business.

Good Record Keeping and Business Deductions

You will want to keep detailed records of your income and expenses to report to the IRS and complete any required state filing requirements.

Business Considerations Regarding Business Expenses:

•  The IRS audits a lot of small businesses, so it is vital that you set up a separate bank account for your consulting and don’t run personal expenses through your business account.  You don’t want to run business expenses through your personal account either. And the same is true for credit cards, you will want a dedicated business credit card on which you don’t charge personal expenses and vice versa. 
• The IRS requires that all expenses deducted on a tax return have proper documentation.  This means you must have appropriate documentation to support your expenses, so keep receipts, appropriate bank records, and credit card statements pertaining to those expenses.
• You must maintain a travel log to deduct any business mileage. This travel log must be maintained concurrently with your activity, so be sure to keep an up-to-date calendar of your business driving, including running errands to buy supplies, attending a networking event, and traveling to meet with clients.

With these record-keeping requirements in mind, let’s talk about some deductions that are available to consultants:

• Computers, phones, office supplies, business travel, marketing, continuing education, insurance, and other such costs.  A full list of deductible expenses can be found on the Expenses portion of Schedule C.
• You can also deduct expenses for legitimately officing out of your home.  There are some special rules here that you need to pay attention to claim an office in the home, and keep in mind that you may only deduct certain costs designated specifically for your consulting business.
• If you meet specific requirements, you can receive up to 100% in deductions for your medical insurance premiums.
• You can also establish a retirement plan to make deductible contributions.

Additionally, there is a 20% Qualified Business Income deduction, otherwise known as the Section 199A or QBI deduction.  This deduction is basically 20% of your net income from your business. From your net income, you must reduce the self-employment tax deduction and any retirement plan contribution. 

If you have a very high income, there are limitations in place, and for service providers at this high level of income, the QBI deduction is no longer available. 

How to Save for Retirement When Self-Employed

As a self-employed consultant, you have lots of opportunities to establish a retirement plan in which to contribute your earnings and get a tax deduction for this contribution. These contributions will grow tax-free, just like the retirement account you had while employed.  

Two of the simplest retirement plans for self-employed individuals are:

• Simplified Employee Pension Plan (SEP)
• Solo 401(k)

However, if you make a significant amount of income in your consulting gig — say above $300,000 — there are opportunities to put away $200,000 or more into tax-deductible retirement accounts.  

Simplified Employee Pension Plan 

 A SEP-IRA allows you to set up a traditional (non-Roth) IRA for yourself and also for any employees you may have.  You have until the date your tax return is filed (including extensions) to set up a SEP-IRA, make a contribution, and receive a deduction on your tax return.  For example, with an extension, the deadline to file your tax return is October 15, 2024. You have until October 15, 2024, to open and fund the SEP-IRA to receive the deduction on your 2023 return.

What to Know About the SEP-IRA

• A SEP-IRA is established by opening a SEP-IRA account prototype plan with an insurance company, mutual fund, bank, or other financial institution.
• Contributions are elective each year, which means you do not have to make contributions in a year when income is down.
• You can deduct the contributions to your SEP-IRA, which reduces your taxable income.
• Contributions to a SEP-IRA cannot be designated Roth contributions.  However, once you have made a contribution to a traditional SEP-IRA, you can perform a Roth conversion.
• The maximum employer contribution to a SEP-IRA in 2024 is the lesser of 25% of net income (limited to $345,000) or $69,000 ($76,500 for those age 50 or over).  For 2024, the maximum employer contribution is $69,000 ($76,500 for those age 50 or over), with an income limitation of $345,000.

Let’s illustrate with a couple of examples.

Example 1: You are age 58 and have net income from your consulting practice of $100,000 for 2024.  Your maximum SEP-IRA contribution will be $25,000 (25% of $100,000) 

Example 2:  You are age 58 and have net income from your consulting practice of $325,000 for 2024. Even though 25% of net income is $81,250, your maximum SEP-IRA contribution will be $76,500, the maximum contribution for individuals over 50 in 2024. 

Solo 401(k) Plan

A Solo 401(k) plan is another excellent option for saving for retirement while self-employed.  Unlike a SEP-IRA, a Solo 401(k) must be established in the year in which you take the deduction on your tax return. Following the recent passage of SECURE 2.0, you must establish the 401(k) plan prior to the tax filing deadline for the year you want the plan established. For example, if you want to establish a Solo 401(K) plan in 2024, you must have it established by April 15, 2025, to receive a deduction on your 2024 tax return. The good news is that once the plan is established, you have until you file your tax return (including extensions) to actually make the contribution to the 401(k).

How a Solo 401(k) Works

• These plans can have only one participant, which is you.  Employees cannot be added to the plan.
• A Solo 401(k) can be funded with either pre-tax, after-tax, or designated Roth contributions. 
• These plans come at a compliance cost because you may be required to file an annual Form 5500 (EZ or SF) with the Department of Labor. 
• The yearly maximum is determined by two different types of contributions: 
  • Employee contribution (also known as Elective Deferral): For 2024, the maximum employee contribution is $23,000 ($30,500 for those age 50 or over).
  • Employer contribution (also known as Profit Sharing): Assuming you are consulting as a sole proprietor, you can contribute an additional 20% of net income from your consulting practice. (Generally, plans for self-employed individuals call for discretionary contributions of 25%. This results in a recalculated maximum contribution rate of 20% for the self-employed owner because net income is reduced by the self-employment tax deduction and the employee contribution to the Solo 401(k)).

Please note that the combination of these two types of contributions cannot exceed $69,000 for 2024 ($76,500 for those age 50 and over). 

Let’s illustrate this with a couple of examples.

Example 1.  You are age 58 and have net income from your consulting practice of $100,000 for 2024.  Your total contribution to your 401(k) for 2024 is determined as follows:

Elective deferral (the maximum)	$30,500
Profit sharing (20% net income)	$20,000
Total contribution for 2024 to Solo 401(k)	$50,500

Example 2.  You are age 58 and have net income from your consulting practice of $250,000 for 2024.  Your total contribution to your 401(k) for 2024 is: 

Elective deferral (the maximum)	$30,500
Profit sharing (20% net income)	$50,000
Combined amount	$80,500, this amount exceeds the annual limitation.
Total contribution for 2024 to Solo 401(k)	$76,500, the annual limit for 2024

Which is Better — The SEP-IRA or the Solo 401(k)?

Some things to consider before choosing which plan is best for you:

• Do you have employees?  A Solo 401(k) can only have one participant, which is you.  If you have employees you wish to cover with a retirement plan, you will need to choose the SEP-IRA.
• How much income do you expect to earn?  Your income will determine the maximum contribution you can make. In general, if you earn less than approximately $345,000, a Solo 401(k) is the best way to maximize your contributions because it provides for both an employee deferral and profit-sharing contribution. 
  

Cash Balance Defined Benefit Plans

If your consulting gig is producing significant income over a period of years, say in the range of $600K or higher for five or more years, you may want to consider a cash balance defined benefit plan.  Such a plan will enable you to put away $300,000 or even more into a tax-deductible retirement account each year. 

These plans are not free to set up, and you must contribute yearly.  So, this is a long-term commitment. Additionally, an actuary is needed to calculate the amount of yearly contribution.

To illustrate the extent you can contribute, let’s assume a 58-year-old male earns $600,000 net income from consulting in 2024.  This individual can receive an annual cash balance pay credit (which is put into the plan) of about $245,000. Additionally, he could supplement that with a 401(k)/profit sharing plan elective deferral and a profit sharing contribution.  This could result in deferring well over $320,000 in income to a retirement plan, receiving a significant tax break from income and self-employment taxes.

The large tax breaks from deferring so much income may be worth the costs of setup and yearly compliance. The benefits of contributing such large amounts to a retirement plan are worth investigating.  

Navigating Self-Employment Taxes

If you’ve never been self-employed before, self-employment (SE) tax can come as a big shock.  Self-employment taxes are the Social Security and Medicare taxes paid on the net earned income of self-employed persons. 

Social Security and Medicare taxes are assessed on both employees and employers, each paying 7.65% of the earned income of the employee. When you were employed, your employer withheld 7.65% of your salary from your paycheck, and your employer also paid another 7.65%. Your employer paid this total of 15.3% of taxes to the Department of the Treasury for your Social Security and Medicare taxes.  

However, when you become self-employed, you are considered both employer and employee and must pay both sides of the Social Security/Medicare tax, a total of 15.3%.  Consequently, by becoming self-employed, your tax rate has already increased 7.65%.

Establishing an Hourly or Project Rate

When establishing your hourly rate for consulting, you’ll want to pay careful consideration to this. Whatever you were making per hour as an employee will not be the same rate you want to charge when consulting.  When you’re consulting, you’re responsible for paying the additional 15.3% self-employment tax AND you’re responsible for paying for your benefits. Be sure that your hourly rate covers these additional costs that were once incurred by your employer. 

Self-Employment Tax Considerations

• Your overall tax liability on your individual tax return will now include both your income tax and also your self-employment tax liability. This is because your self-employment tax is calculated on your Form 1040 using Schedule SE. The amount that is calculated on Schedule E will be added to your total tax liability on your Form 1040. 
• To avoid a penalty for underpayment of taxes imposed by the IRS, you should estimate and pay your tax liability each quarter. The payment due dates are the same every year – April 15, June 15, September 15, and January 15. You can make these payments in many ways, the simplest is through the IRS website.

Estimating and paying your quarterly liability is a huge component of your consulting business.  

How Consulting Impacts Your Social Security Benefits

If you are already receiving Social Security benefits and then you begin to consult, you stand a good chance of losing some of the benefits you are entitled to.  Let’s take a look at the rules involving earning income and receiving SS benefits, keeping in mind the SSA has said that your full retirement age is 66-67, depending on your birth year:

• If you are younger than full retirement age (ex. 66-67) when you begin collecting SS benefits, your benefits will be reduced by $1 for each $2 you earn above an annual earnings limit ($22,320 for 2024).
• If you begin collecting benefits in the year of your full retirement age, your benefits will be reduced by $1 in benefits for each $3 you earn over an annual earnings limit ($59,520 for 2024).   

Additional Taxes on Social Security Income as a Result of Consulting

Now there is a caution here:  If you earn income from consulting while also receiving SS benefits, it may subject up to 85% of your SS income to taxation at ordinary rates.  So you may make your plans to receive no reduction in benefits, but you may have to pay taxes on your SS benefits. It also may result in higher premiums for your Medicare. 

Our key takeaways from these scenarios regarding Social Security benefits are:

• Don’t collect SS benefits until you reach full retirement age (at the earliest) to maximize your lifetime benefits.  The longer you postpone receiving benefits, the larger your lifetime benefits.
• Consulting after you retire will help you prolong the collection of your SS, which maximizes your lifetime benefits.
• You can earn unlimited income after full retirement without losing any of your Social Security benefits.
• Deciding to take benefits before your full retirement age AND consulting will result in rather sizeable reductions to your lifetime benefits.

Are you Ready to Work as a Consultant?

At Willis Johnson & Associates, we focus on providing comprehensive financial planning for every stage of life to maximize your opportunities for success. Understanding these issues is very important because making a decision without all the facts could be very costly for you if you decide to add consulting to your list of retirement activities. Learn more about the services we offer and our commitment to helping your family make the most of your resources.