Professors typically develop tremendous expertise in their fields and, as such, are often called upon to consult, write books, and be expert witnesses, among other opportunities, on top of their job with a university. This often means extra consulting income for these individuals, which can become an issue at tax time. To be better prepared to deal with the tax implications of this money, Briaud Financial Advisors wants to share some strategies to leverage your consulting income.
The nature of consulting income
This revenue is called 1099 income, named after the IRS form on which it is reported. It is different in character from W2 income, which is the more typical salary or wages people earn. Why this can become an issue during tax preparation is due to the fact there is no tax withholding on 1099 income, as with salaried employment. Consequently, newcomers to this type of income are often surprised at tax time when they realize they have not accounted for the tax implications.
Many people with 1099 income will need to make estimated tax payments to the IRS throughout the year or modify their withholding through their employer to adjust for this. Before you do so, consider the strategies outlined here.
Leveraging your consulting income to reduce taxes
To us, extra income and the associated taxes represent a planning opportunity to find ways to maximize savings growth and reduce tax liability. Income-generating activities like consulting on a project, writing a book, providing expert witness testimony, etc., often only involve one person, the academic. This opens up a wide range of possibilities with regard to deferring that income into retirement accounts, thus saving current and future taxes and super-charging savings.
Defer more of your salary
The first way to reduce taxes is simply defer more of your salary into the 403(b) and 457 plans available through the university. The extra consulting income can then be spent to offset the reduction in salary.
Establish a retirement plan outside of the university
The second way to reduce taxes is to establish a retirement plan outside of the university. This is typically recommended when an individual has already maximized the deferrals they can make through the 403(b) and/or 457 plans, or they don’t like the investment options offered by either or both of those plans. These options are:
- Traditional IRA
- Contribution Limit = $6,000 per person ($7,000 if you are over 50) in 2019.
- Complications: If you earn more than a certain amount you are limited or are not able to make a tax-deductible contribution to this IRA.
- SIMPLE IRA
- Contribution Limit = $13,500 per person ($16,500 if you are over 50) in 2020 plus 3% of salary.
- Complications: The $13,500 (or $16,500) is only allowed to the extent that you haven’t made payments into other defined contribution (i.e. 403(b), 401(k), etc.) plans. You are limited to 3% of salary after you have maximized your 403(b), as recommended above. In addition, the plan needs to be in place for 2 years before you are able to dissolve it.
- Solo or Individual 401(k)
- Contribution Limit = $19,500 per person ($26,000 if you are over 50) in 2019 plus 25% of salary as an employer contribution
- Complications: again, the $19,500 (or $26,000) is only allowed to the extent that you haven’t made maximized contributions to other defined contribution plans (i.e. 403(b), 401(k), Simple IRAs, etc.) . You are limited to 25% of salary after you have maximized your 403(b), as recommended above. There is another option … the SEP IRA.
- SEP IRA
- Contribution Limit = nominally 25% of earnings. There are special rules for calculating the contribution amount if you are self-employed.
- Complications: you or a CPA have to calculate the contribution amount each year after determining your net profit, and you have to make the contribution before April 15th (or October 15th if you get an extension on your tax return). Setting up an account is typically easy, and the investment options can be flexible.
- Note that if you have employees you may have to make a SEP IRA contribution for them as well. We encourage you to talk to a CPA to see if this impacts you.
The Roth Effect
You may be thinking, what about a Roth IRA? These after-tax (no immediate tax benefits) selections are available on most of the options above and can be a good choice depending on your current salary and beliefs about the future tax landscape. While you wouldn’t save taxes initially, you will never be taxed on the growth. This can also be a tax-efficient way to leave money to your heirs
Now that we covered tax reductions and savings options as they relate to potential consulting income, you might want to consider how all this additional money will serve your retirement plan. See our article for strategies to consider depending upon where you are in your career journey.
Despite some added complexity, most would agree that additional income is a good problem to have. We typically recommend professors maximize their 403(b) and 457 options and then contribute to a SEP IRA once net profit is known. This keeps the accounts, investments, relatively straightforward. It is quite likely that the SEP IRA can be created at the same custodian that houses your university retirement plans.