Tax and Financial Planning for Freelance Editors

June 21, 2005
Speaker: Lillian R. Lea, EA
Forum organized by Christine Freeman
Notes by Rick Coykendall with Lillian Lea

"Lillian Lea comes with an encyclopedia of knowledge on tax law— in her head," said Bonnie Britt in the introduction to our June forum where members and guests made use of seats at the library's small café tables for a relaxed experience with a mind-numbing topic: taxes.

Since 1974, Lea, a member of the California Society of Enrolled Agents, has focused her tax practice on self-employed taxpayers and small businesses. Enrolled agents are licensed by the federal government to represent taxpayers before the Internal Revenue Service. A taxpayer advocate, Lea also engages in legislative activities. Her talk with us was not intended as tax advice. She recommends conferring with one's own tax advisor to address individual concerns.

Health Savings Account

Though not approved in California, health savings accounts are insurance products used to set aside a limited amount of pre-tax money for medical expenses. Only those with high deductibles on their health insurance are permitted to have them.

Flexible Spending Account

A flexible spending account allows you to put part of your pre- tax wage (or salary) into an account for health-care expenses. Unfortunately, it is not available to the self-employed.

Retirement Plans

For most of us, Social Security will not meet our entire need for retirement income. Lea encourages her clients to contribute to as many kinds of retirement plans as possible, and to consistently make the maximum allowable contribution each year. Generally, this is money that will not be touched until retirement age because early withdrawal triggers penalties on top of taxes.

The simplest plans are Regular IRAs and Roth IRAs. Employees can contribute to 401K, 403B, or 457B (depending on whether in private industry, a non-profit, or government employment). Self-employed people can have SEP-IRA, SIMPLE-IRA, profit-sharing plan, and the new self-employed 401k plan. These are all easy to use "cookie-cutter" plans with little or no added cost. Each has different methods of calculating individual contributions. Maximum contributions vary by plan.

The more complex plans require a pension administrator.

Roth IRA

A Roth IRA contribution is not deductible at the time you make it, but timely withdrawals are tax free. Because you pay tax on money put in, the younger you are, the more valuable tax-free withdrawals will be in the future. The Roth IRA is subject to income limitations.

Regular IRA

Contributions to a Regular IRA can be deductible or non-deductible, depending on whether or not you have another retirement plan. A regular IRA is the first plan many people can afford.

First-Time Home Buyers

Some people want to cash in their retirement plans for a down payment on a house but Lea said that may not be wise. By the time they pay the penalty for early withdrawal (10% Federal and 2.5% California) plus regular income taxes, raiding a retirement plan can cost over 40% of the distribution in penalties and taxes. In some cases, Lea said, it might be less expensive to borrow on a credit card.

However, if you qualify as a "first-time home buyer," you may be able to withdraw up to $10,000 from your IRA toward the purchase of a home. A first-time home buyer is defined as someone who has not owned a home for two years.

Saver's Credit

There is a "Saver's Credit" for low-income people who make a contribution to certain retirement plans, including IRAs. This can make the contribution affordable, by not only saving the tax for the deduction, but also getting the additional tax credit. An IRA can be opened with as little as $50, depending on the financial institution.

Progression of Retirement Plans

Once a year, you can move money out of an IRA to another institution, but the rules are strict. It must be done in sixty days to avoid penalty.

SIMPLE vs. SEP

Lea does not like the term "SIMPLE IRA" because an inexperienced bank teller might sell you a regular IRA.

The government loves acronyms. SIMPLE stands for Savings Incentive Match Plan for Employees. Employees may defer up to $10,000 into a SIMPLE IRA for 2005 (limits change often), and employers may be required to match the contribution, but only up to 1% or 3% of wages.

Self-employed people have the same limit for a deferral, but they can also put in the "employer" 3% contribution as well. They use "Net Earnings from Self-Employment" for the calculation, which is usually on Line 4 of Schedule SE.

You can't defer more than you earn.

SEP (also called a SEP-IRA) stands for Simplified Employee Pension Plan. Employers (not employees) contribute to SEP-IRAs. The self-employed can put up to 20% of "net self-employment earnings" in a SEP. You cannot have both a SIMPLE and a SEP; if you open a SIMPLE, you would have to close the SEP.

A SIMPLE must be opened by October 1 of the year in which you begin contributing. A SEP, on the other hand, may be opened until the extended due date of the tax year for which you want to make a contribution.

Deductions

Entertainment is the most common category of tax deductions people forget to take. If you discuss business over a meal, you can take it as a deduction. But trying to deduct every meal won't work. Any deduction must detail who, what, when, where, and why it is business. Writing this information on your receipt is fine, though you only have to keep the receipt if it's over $75. Under that amount, you don't need to retain the receipt but you still have to track the information on a calendar. Old calendars are handy in the event of an audit.

Mileage is another valuable deduction too frequently forgotten. Tracking mileage on MapQuest is easy. Click on Directions, type in the "from" and "to" points; add your notes, and file it.

Transportation costs via BART, or your parking fees, to attend BAEF meetings may be deductible as business expenses.

Home Office Deduction

There's a persistent myth that taking a home office deduction can trigger an IRS audit. In practice, Lea said, it mostly doesn't. The "exclusive" rule still stands, however. You have to be able to prove that your home office is used exclusively for your business operations. It can be a corner of your kitchen, yes, but you can't chop vegetables there.

Lea cited one case where a woman lived in a 400 square-foot studio apartment and claimed an exclusive home office space. The IRS said there was no way she could reasonably claim any exclusive use in such a small space.

Many homeowners used to avoid taking a home office deduction because of the complexity. But in 2002, the IRS changed the rules on that and said even if you had the home office during the entire time you owned the house, as long as it was not in a separate structure, all you have to do when you sell the house is pay tax on the depreciation taken after May 6, 1997.

Business Licenses

Every town has its own rules for having a business license if you are self-employed, and it seems the denser the population, the more rules there are. Find out the rules in your city. Having a business license has not been essential when it comes to proving to the IRS that you're an independent contractor, Lea said.

A Sales Tax on Services?

As we shift from a retail to a service economy, efforts will continue to try to tax services. Lea suggests we be alert for this kind of legislation because editing may some day fall into a proposed taxable category.

The problem for service businesses is that clients may decide to take their business to a state (or country) without sales tax on services, or may expect us to absorb the tax ourselves without passing it on to them. Lea notes that all tax laws have become increasingly complex over time. If you're doing your own taxes, consider using a computer program, but know that programs are only as good as the input.

For record keeping, many of Lea's clients use Quicken, a computerized checkbook that can be helpful in categorizing income and expenses. QuickBooks does more than Quicken but may not be necessary for a small service business. While not a true accounting program, QuickBooks has a definite learning curve, and not everyone needs its level of complexity. You can use it for invoices, but those in attendance who did not do a lot of invoicing noted that setting up a template in MS Word was fine for their purposes.

Lea praised the "hot topic" page on the IRS website for background on many of the topics examined at this forum. She also praised us, saying this audience of editors stayed with the ins and outs of the complicated discussion much longer than most.