Successful folks are always in demand, which is why they often pick up board seats, consulting assignments and speaking fees. On top of that, there is the condo in, say, Aspen or Miami that is rented out half the year, producing yet more income. And so, without thinking about it, a problem of success arrives—a much higher tax bill.
Take "self-employment" gigs like consulting. On top of federal and state income taxes and a 0.9% Medicare tax, income may also be subject to the 15.3% self-employment tax, which includes FICA's Social Security and Medicare taxes. When it comes to self-employment income, you're responsible for all the FICA taxes that are normally split by employer and salaried employee.
So what's the most tax-efficient way to receive secondary income? Consider a seat on a company's board, a stimulating part-time job, particularly during semiretirement. Board members are usually paid with cash and shares in the company, typically restricted stock that vests after a few years.
You can reduce the tax impact by deferring the cash portion of your board fee through the company's deferred-compensation plan. Most companies have "nonqualified" plans that allow directors to funnel fees to 401(k)-like plans without contribution limits. The funds aren't tax-deductible, but they grow tax-deferred until retirement.
"If a member of the board who lives in New York moves to another state with no or low income taxes in retirement, they're going to pay a lot less tax," says Mitch Drossman, national director of the Wealth Planning Strategies Group at U.S. Trust. To avoid paying income tax in the original state, you must put the money in a 401(k) and take the income over at least a 10-year period in your new state.
Directors receiving restricted stock that vests over a number of years can accelerate rather than defer the taxes. Usually taxes are owed after stock is vested, based on the value of the stock at that point, but a director can opt to be taxed on its value when first received. This is a bet the stock is going to appreciate in excess of what you're paying in taxes now, usually in cases where "the company is going public or it's a good candidate to be acquired," says Drossman.
If you are generating a substantial self-employed income stream, consider creating your own "defined-contribution plan," similar to a 401(k). They're known as a Keogh or a SEP IRA, and they allow you to sock away 25% of your earnings, either pre-tax or tax deductible, up to $52,000.
A defined-benefit plan, meanwhile, works more like a pension plan, but is more complicated and currently limits maximum retirement payouts to $210,000 a year. But contributions are tax deductible in the year they're made, and that can go a long way toward blunting your current tax blow.
If your extracurricular business generates a profit, structure your windfall for a tax advantage. A limited liability company, or LLC, protects your assets outside the vehicle from lawsuits filed against the LLC, but S corporations can be sweeter for tax purposes. The S corporation owner is usually paid a salary and takes profit distributions. The owner pays taxes on the salary as is normal—including the self-employment FICA charge totaling 15.3%—but the profit distributions aren't subject to the self-employment tax.
But make sure to strike the right balance between salary and profit distributions. "The IRS' position is that the owner must receive reasonable compensation in the form of income. A tax return that shows zero cash income is an automatic red flag for an audit," says Stephen Kirkland, a tax specialist at Atlantic Executive Consulting Group in Columbia, S.C. Furthermore, to legitimately claim S corporation profits, the company must either have equipment, merchandise, or one or more employees.
What that means is, if your extra income is generated by personal services that can't arguably generate profits, such as board membership fees, you can't benefit from an S corporation. And here's another caveat: The IRS keeps a close, skeptical eye on S corporations after a U.S. Government Accountability Office report estimated that these entities, some four million in 2006, underpaid taxes by $23.6 billion in the 2003 and 2004 tax years.
So if you go down the S corporation path, make sure you keep detailed records of your journey.
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