money-256296_1280HRAs are often — but not always — a good strategy for sole proprietors. Here are some numbers that lay it out.

Assumptions

  • John is a sole proprietor with $135,000 of net income from his proprietorship
  • His wife Joan does not work outside the home and has no income
  • Insurance premiums total $5,000, and they have another $1,000 of other medical expenses
  • Their itemized deductions total $25,000
  • Assume that John wants to be a sole proprietor and that incorporation is not on the table
  • For the sake of this example, let’s also assume that John has no interest in funding a SEP or other type of retirement plan

Without an HRA

Self-employment tax calculations:

    • $135,000 x .9235 = $124,673
    • $124,673 x .029 = $3,616 Medicare self-employment tax owed
    • $3,616 + $14,508 Social Security self-employment tax owed = $18,124 total self-employment tax owed
    • $18,124 x .5 = $9,062 front-side deduction for self-employment taxes

 

  • *$14,508 is the maximum amount of Social Security tax that can be assessed (using 2014 figures). $117,000 maximum Social Security wage base x .124 = $14,508

AGI calculation

  • $135,000 net income from sole proprietorship – $9,062 for SE tax – $5,000 of insurance premiums = $120,938 AGI

Tax calculation

  • $120,938 AGI – $25,000 itemized deductions – $7,900 personal exemptions ($3,950 x 2) = $88,038 taxable income
  • Income tax on $88,038 = $13,722
  • Plus self-employment tax of $18,124 = $31,846 total tax liability

With an HRA

Assume John pays Joan $5,000 for her work. Assume that John pays his accountant $500 for filing the payroll reports, and a third-party administrator $250 to oversee the HRA.

Calculations relating to Joan’s salary:

  • $5,000 x .0765 = $382.50 employer FICA taxes
  • $5,000 x .0765 = $382.50 FICA taxes withheld from Joan’s wages

Self-employment income:

$135,000 – $5,000 salary to Joan – $5,000 of insurance premiums paid through HRA – $1,000 of other medical expenses paid through HRA – $382.50 employer FICA taxes – $500 payroll fees – $250 TPA fee = $122,868 net income.

Self-employment tax calculations:

  • $122,868 x .9235 = $113,469
  • $113,469 x .153 = $17,361 self-employment tax owed
  • $17,361 x .5 = $8,681 front-side deduction for self-employment taxes

AGI Calculation

  • Joan’s salary of $5,000 + John’s self-employment income of $122,868 – $8,681 deduction for self-employment taxes = 119,187

Tax calculation

  • $119,187 AGI – $25,000 itemized deductions – $7,900 personal exemptions ($3,950 x 2) = $86,287 taxable income
  • Income tax on $86,287 = $13,284
  • Plus self-employment tax of $17,361 = $30,645 total tax liability

It appears that John and Joan will save nearly $1,200 by using an HRA. But I think we need to take cash flow into consideration too. I’ll deal with that in Part 3.

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