What are Tax Implications of Your Money-Making Hobby when you are preparing for early retirement?
There’s no doubt that a moneymaking hobby can dramatically reduce the amount of time until retirement. Not only can you sock away more money, you can also use that income during your retirement. This reduces the amount that you need to save prior to retirement. Since hobbies are enjoyable, it’s a win-win situation.
But like most other income, income from your hobby is also taxable. Taxes are a considerable expense, so they should be minimized, when possible.
This is a touchy issue for the IRS. Many people try to deduct losses for activities that are primarily conducted for enjoyment. It’s easy to get yourself into trouble.
Hobby Tax Tips
1. For tax purposes, understand what “hobby” means. The IRS considers a hobby to be an activity that is done primarily for enjoyment, not for making a profit. If your activity is considered to be a hobby, you can’t use the tax deductions available to legitimate business. However, you will be taxed for profit and can deduct your expenses in the same year.
• For example, if you bought $1,000 in rare coins and didn’t earn any income, you couldn’t deduct the $1,000 from your other income. However, if you sold the coins for $1,200, you would be taxed on the $200 profit, provided you sold the coins in the same tax year they were purchased.
2. Hobbies are terrible for tax purposes. It’s important to create a business for your hobby. Think business, not hobby. If you expect to make a profit, and your expectation is considered to be reasonable, then you can consider your hobby to be a business. There is more information available from the IRS here.
• There is no advantage to not declaring your hobby a business if your intention is to earn income. When it comes to the IRS, remove the word hobby from your vocabulary.
3. Consider hiring your non-working family members. Remember that no income tax has to be paid below a certain income threshold. Paying your children or non-working spouse a salary to help you with your business is a great way to avoid income taxes.
• Paying your spouse keeps the money in your collective pockets. Paying your children provides a great way to save money for college, tax-free. Ideally, you would be in the position to pay both.
4. If your goal really is early retirement, consider investing the profits in tax-deferred retirement accounts. Depending on how much income you earn, your options will vary. But at the very least, an IRA makes a lot of sense. You can shield your income from taxes, at least temporarily.
• A Roth-IRA requires after-tax income, but the earnings are tax-free. A traditional IRA uses pre-tax income, but the earnings are taxed.
IRAs are great, but remember the money is out of your hands until the standard retirement age. If you want to retire early and need that money, be sure to invest the money wisely. Avoid spending the extra income on other things.
Learn how to run a business wisely. There are a plethora of books and other sources that will provide the information needed to run a business effectively. Maximize your income for the amount of time you want to dedicate to your hobby. Don’t hesitate to get expert tax advice, too.
A moneymaking hobby can be an important part of any early retirement plan. Think about the things you like to do and make a list of ways you can make money from those activities. But take the steps to avoid paying more taxes than necessary.