Self-Employed Adjustments

What happens to health insurance and retirement when you are your own employer?

A natural question is:

“What if you are self-employed? Do you still get health-insurance and retirement deductions?”

Yes — often you do.

The easiest way to think about it is to go back to a question we used on the Retirement page:

Where did the tax benefit happen?

For an employee, health-insurance and retirement tax benefits are often handled before the tax return ever starts.

• An employer-paid health-insurance benefit may be excluded from taxable wages.
• An employee-paid share may already be subtracted through payroll.
• A traditional 401(k) contribution may already be reflected in the taxable wage amount reported on the W-2.

In other words, the W-2 may already contain the answer. The employee should not subtract those same amounts again on the tax return.

For this page, picture Lena operating her business as a sole proprietor. There is no employer issuing her a W-2 for that business activity and doing those payroll subtractions. So when a separate tax rule allows a deduction for health insurance, retirement, or another self-employed adjustment, Lena may have to claim the deduction directly on the tax return.

The rules are not identical to the employee rules. Eligibility, limits, and calculations can be different.

But the organizing principle is the same:

Check where the tax benefit already happened. If no employer already handled it through the W-2, the sole proprietor may need to handle it on the return.

1. Health insurance: the tax benefit can move from the employer to the taxpayer

On the Health Insurance and HSAs page, we saw that employee health-insurance costs can receive tax benefits before the return begins. Employer-paid coverage may be excluded from taxable wages, and an employee-paid share may already be reflected through payroll.

Suppose Lena leaves an employee job and begins working for herself as a sole proprietor.

At her old job, the W-2 wage amount already reflected the tax treatment of her employer health coverage and payroll deductions. Lena did not need to recreate those calculations on her return.

Now Lena buys her own coverage for her self-employed activity. There is no employer W-2 doing that work for her.

If Lena meets the separate self-employed health-insurance rules, she may be able to deduct the health-insurance premiums she pays for herself and her family on the way to AGI.

That can include qualifying medical, dental, vision, and certain long-term-care premiums, subject to the current rules.

Employee: the tax benefit may already be built into taxable wages on the W-2.
Sole proprietor: if the separate rules are satisfied, the taxpayer may have to claim the deduction on the return.

A simple example

Suppose Lena pays $7,200 during the year for qualifying health-insurance coverage and otherwise meets the rules.

If the full amount qualifies, the deduction reduces income on the way to AGI:

Income before this adjustment             $70,000
Less: self-employed health insurance       (7,200)
                                          -------
Income after this adjustment              $62,800

If Lena’s marginal federal income-tax rate is 22%, a $7,200 deduction would produce approximately $1,584 of federal income-tax savings. The deduction does not make the insurance free.

There are limits

A few important ones to recognize are:

• the deduction can be limited by the income from the business connected with the health plan;
• the deduction can be affected if the taxpayer was eligible for certain employer-subsidized health coverage, including coverage through a spouse’s employer; and
• the health plan must be established, or treated as established, under the business. For a sole proprietor, the policy can still be in Lena’s own name.

You do not need all of those mechanics here. The durable idea is that a qualifying sole proprietor may receive a separate deduction for health-insurance premiums because there is no employer handling that benefit through payroll.

2. Retirement: being self-employed does not mean losing retirement tax benefits

The same “where did the tax benefit happen?” idea applies to retirement.

An employee’s traditional 401(k) contribution is generally handled through payroll before the taxable wage amount reaches the return. The employee sees the result on the W-2 and does not subtract the same contribution again.

A self-employed person may instead establish a retirement arrangement such as:

• a SEP;
• a SIMPLE plan; or
• a one-participant 401(k), often called a solo or individual 401(k).

The exact contribution and deduction rules differ by plan, and some of the calculations can become more complicated than they first appear.

Self-employment does not eliminate retirement tax benefits. The rules are different, but the taxpayer may now have to calculate and claim the tax benefit rather than having an employer build it into the W-2.

For a self-employed person’s own qualifying retirement contribution, the deduction generally happens after the business profit has already been calculated, on the way to AGI. That is different from saying the contribution is simply an ordinary Schedule C business expense.

For the Traditional-versus-Roth timing framework and broader retirement concepts, see Retirement.

3. HSAs do not have a special self-employed rule

An HSA is a little different.

Being self-employed does not create a new kind of HSA deduction. If Lena has HSA-eligible coverage and otherwise qualifies, she follows the same HSA rules discussed on the Health Insurance and HSAs page.

If she makes a qualifying HSA contribution directly, the deduction can reduce income on the way to AGI.

The fact that Lena is self-employed changes her practical situation—there may be no employer HSA contribution or employer payroll system—but it does not create a separate “self-employed HSA.”

4. One more self-employed deduction: part of self-employment tax

Sole proprietors also encounter self-employment tax, which is how Social Security and Medicare taxes are generally collected on self-employment earnings.

We are going to give self-employment tax its own full treatment later. There is a lot more to understand before the calculation is useful.

For this chapter, remember just one connection:

A self-employed taxpayer can generally deduct the employer-equivalent portion of self-employment tax when figuring AGI.

Why does that deduction exist?

Think about an ordinary employer first. An employee pays the employee share of Social Security and Medicare taxes. The employer pays an employer share, and that employer-paid payroll tax is generally a business expense.

A sole proprietor is different because there is no separate employer paying an employer share for the owner. The self-employment tax system effectively puts both sides of the Social Security and Medicare tax on the self-employed taxpayer.

The deduction for the employer-equivalent portion makes the income-tax treatment somewhat more comparable to the employer situation. It allows the sole proprietor to subtract that employer-equivalent amount when figuring AGI.

But the treatment is not identical:

An employer’s payroll-tax expense reduces the business’s income. The sole proprietor’s deduction for the employer-equivalent portion of self-employment tax is a separate deduction for AGI. It does not reduce Schedule C profit or the self-employment tax itself.

That last distinction is one reason we are not doing the full self-employment-tax calculation here.

5. Why aren’t these just Schedule C expenses?

The taxpayer may be self-employed, but that does not mean every cost connected with being self-employed belongs inside the business.

For example:

• Lena’s advertising expense may be a business expense that reduces Schedule C profit.
• Lena’s own qualifying health-insurance premium may create a separate deduction for AGI.
• Lena’s own qualifying retirement contribution may create a separate deduction for AGI.
• the deductible employer-equivalent portion of self-employment tax is also a separate deduction for AGI.

Why does the location matter?

Because a business expense reduces the business profit itself. A deduction for AGI happens after that business profit has already been determined. That can matter for other tax calculations—including self-employment tax—which is one reason we will return to this distinction later.

This is also a no-double-benefit issue. Do not move an amount into Schedule C merely because that would produce a better result if the law places it somewhere else.

6. Now try it

Lena operates her business as a sole proprietor. During the year she has:

• $5,000 of advertising costs for her business;
• $6,000 of qualifying health-insurance premiums for herself;
• a qualifying contribution to her self-employed retirement plan;
• a qualifying direct HSA contribution; and
• a deductible employer-equivalent portion of self-employment tax.

Classify each item as either inside the business or a deduction on the way to AGI. Do not calculate any amounts.