I was getting really excited about setting one of these up this year. I guess you can contribute up to $44k per year to your retirement with $148K+ in income. This looked like a pretty sweet deal, until I looked at it some more. First, I guess you have to set up an entity. Which is not a big deal; it's a one-time fee of less than $1000. But then you're already in the 39% tax bracket at $100K in taxable income. Plus you have to pay self-employment tax, which I think is like 15%! (Even though there's a cap on the 12.4% social security portion.) Does anyone have one of these set up? I just don't see the point. I hope I have the facts wrong.
The first $15K +/- into a self-employed 401(k) actually can save you more at the Federal + State income tax rates than it will cost you in additional FICA/Social Security taxes. That's cash money in your pocket. Beyond the 401(k) portion, then there's the roughly $28K +/- Profit Sharing portion, and that can sometimes be roughly a wash in income tax savings verses additional Social Security taxes. So, for the Profit Sharing portion you need to decide, is a lifetime of tax deferred growth worth a basically break-even tax "savings" today? For some people the answer is YES. For others the answer is NO THANKS.
I will be setting one up this year. I set up the LLC earlier this year. I have a full-time job which hits the SS/FICA cap so I will only pay self-employment tax on medicare. SSB
It's not a no-brainer due to some of the things you mentioned, but for most, the savings from the tax-deduction of the contribution more than outweighs the additional taxes due for SE. Plus, you're contributing towards your retirement, and grow those funds tax-deferred. Check out your individual situation with a CPA, but it made sense for me... FYI, I'm set up as an LLC, which is a pass-through entity, so all earnings are taxed at the same individual rate, not a higher corporate rate. So, there's no difference in taxation.
Let's say you make the minimum $148,000 after trading expenses and you have $20,000 in deductions. Without a retirement plan, your fed taxes will be about $30,000. Conversely, if you contribute the maximum $42,000, your taxes will be about $18,500. So you save about $11,500. But you have to pay about $13,000 in self employment taxes. (Which I assume you can deduct from your federal taxes, so it's more like you're paying about $9,500.) So with the retirement plan you're paying $9,500 (right now) to avoid paying $11,500 (right now). You're saving $2,000 (right now). Of course, you have to pay taxes on the $42,000 later with the retirement plan, whereas without one you obviously have no future tax obligation. So the question is, at this income level, does it make sense to be given $2,000 right now for the obligation to pay taxes on $42,000 later? Of course it depends on when you retire, as well as what your tax rate will be when you retire, but I kind of doubt it. Maybe it makes sense if you're making $250,000 or more, since you hit a ceiling on social security tax at around $100,000. And only if you don't pay corporate tax rates, which I previously assumed you would have to.
The reason this doesn't make sense to me is you're paying almost $12,000 in social security taxes once your income hits approx $94,000. (Ok, maybe it costs you $9,000 when you deduct this from your federal taxes.) Plus, you're paying 2.9% (maybe more like 2% after the tax deduction) for medicare, which doesn't have a ceiling at $94,000 like social security does. (Now that I think about it, it makes even less sense at higher income levels, because you're continually paying 2% of your income for an amout that's progressively a smaller portion of that income.) And you're doing this not to reduce your taxes, just to defer them. Now, deferring income is a great concept, but it won't necessarily save you money if it costs you as much as self employment taxes do. So again, is it worth $9,000 out of your pocket, plus 2% of your income, out of your pocket, to defer $42,000?
You left out State Income taxes in your example, and you left out the power of http://www.unionfederalbank.com/learning-center/financial-library/tax/tax-deferred-compounding.aspx tax-deferred compounding. When these two are factored in then taxpayers can make a decision Yes/No. For traders/investors, who can escape Social Security taxation, the answer is not as clear-cut as other occupations where earnings are subject to SS tax anyway. On the other hand, for darn-good investors the power of tax-deferred compounding say 50% growth a year within a plan can be phenominal.
OK, so with state tax maybe $1,500-$2,000 more favoring the retirement plan. Good point. Of course, if I take the $42,000 I would have put in a mini 401-K and put it in the S&P 500 or a mutual fund, and don't take it out until I retire, it will have the same compounding effect as putting it in the retirement account.
I wouldn't just assume you owe self employment tax on cap gains. I have not researched it, but I have seen commentary to the effect that self employment earnings do not include cap gains. The reasoning would be that cap gains are a return on capital not personal services. An accountant who specializes in trader taxation should be able to answer this question.
Toonces - the whole point of doing this (which I have been since 99) is to compound the shit out of that money. If you are an awesome trader and you can nail a 50% return for 8 years (like I have) you will have 26 times your original investment (not even counting ongoing contributions 1.5^8=25.6). However if you are taxed at 40% your 50% return is reduced to 30% and you only end up with 8 times your original contribution (1.3^8=8.2). Which would you pick, 8 or 26? Even with modest returns you get even more extreme examples than this over time because as the number of years you are tax deferred grows larger the money is growing at an increasingly exponential rate compared to the same money being taxed. Just do it!