401K Drawbacks: Don’t Forget That Money Is Taxed When You Use It

401k drawbacks

More and more people are focused on growing their 401K retirement savings. That’s a great thing. You need to have money when you retire. You want to have a diverse array of retirement income options. Maxing out your 401k contributions is a wise thing to do. However, there are 401K drawbacks. You shouldn’t forget about those as you plan for your future.

401K Money Is Taxed When You Withdraw It

People frequently seem to forget that one of the biggest 401K drawbacks is that you have to pay taxes on that money. You don’t pay taxes when you deposit it. People love that part. In fact, contributing to your 401K plan is a great tax benefit when you’re still working.

However, when you reach your retirement and start using that money, you’ll have to pay taxes. That can be a huge shock if you haven’t planned for it in advance. The money is taxed as though relative to your income. Therefore, if you’ve done a great job of setting yourself up with a high level of retirement income, you could find that you have to pay more than a third of your 401K withdrawal money to taxes.

On the plus side, if you’re in a lower income bracket post-retirement than you were before you retired, then you may have set yourself up for some success. You’ll still need to pay taxes on that money, of course, but the hit might not be as big as it would have been if you didn’t set that money aside. There are clearly pros and cons.

Plan Ahead for Withdrawing Your 401K Money

The big question isn’t whether or not to set aside money in your 401K. If you have the option, the benefits outweigh 401K drawbacks. The issue is that you simply have to plan ahead. Make sure that you’re fully aware of how much money you’re going to have to pay to taxes when the time comes.

The biggest problem is if you fail to think about taxes when you mentally plan for your retirement years. If you just look at what’s in your 401K and assume that’s how much money you’ll have when you retire then you’re going to be in for a shock. Make sure that you’re thinking realistically about how you’ll use that money each year and what amount of it will go to taxes.

Other Tips for Minimizing 401K Drawbacks

You might want to look now to see if you should have a Roth 401K instead of or in addition to your traditional 401K. That money gets taxed ahead of time, which means that you won’t have to worry about paying taxes on it once you’re in retirement. If you have the ability to maximize contributions to both types of accounts now then you’ll set yourself up well for financial success in retirement.

Then, once you’re in retirement, make sure that you use the Roth 401K money first. Or for that matter, use any money that isn’t taxable in retirement. You want to withdraw as little money as possible that will require you to pay taxes. Pay attention to your tax bracket and the impact that withdrawals will have on that. As long as you plan in advance, you can minimize 401K drawbacks and make the most of your money.

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LLC vs. Sole Proprietorship: Which One Makes More Financial Sense?

llc vs sole proprietorship

Should I select an LLC vs. sole proprietorship? That’s the question that I’ve been asking myself lately as I look at small business planning.

You see, I’ve been an independent contractor / freelancer for a long time. However, I’ve recently started thinking that it makes financial sense to separate my personal and business money. Of course, there are many different ways to do that, but setting myself up as a business seems to be a good next step.

Most likely I’m going to go with a sole proprietorship. I had that kind of business a long time ago and it seemed to suit me just fine. Nevertheless, I don’t just want to jump in willy nilly, so I’m carefully exploring the differences between LLC vs sole proprietorship to make sure I go down the right path.

LLC vs. Sole Proprietorship: Liability

There are many different ways to structure a business. I’ve narrowed it down to LLC vs sole proprietorship. The main difference as I’ve always understood is about my own personal liability. An LLC is a “limited liability corporation” which means that I as an individual have limited liability in comparison to if I were a sole proprietor. In other words, if someone sues my business and I lose, the costs can only affect my business, not my personal finances. In contrast, as a sole proprietor, I’m personally still responsible for the costs of the business. The same is true for creditor issues. It’s worth taking that liability into consideration.

LLCs Cost More to Set Up

Although that limited liability is nice, it comes with a price. It doesn’t really cost much at all to set up a sole proprietorship business. In contrast, there are a lot of fees involved with setting up an LLC. You have to register with the state so there are fees associated with registration and filing documents. Oftentimes, LLCs are also subject to ongoing annual fees. In other words, if you don’t pay each year, then you don’t maintain your LLC registration. You don’t have those costs associated with setting up a sole proprietor business. In general, LLCs are subject to a lot more regulations, which can mean more paperwork, which can mean more time and money.

LLC vs. Sole Proprietorship: Taxes

I currently pay taxes as a self-employed person. If I choose to set up my business as a sole proprietor then I will still pay taxes as a self-employed person. Therefore, for better or worse, my tax situation isn’t going to change. Things seem a little bit more complicated if I decide to set up an LLC. An LLC can be a partnership or a corporation, but it can also be solely-owned. In the later case, it would be taxed like a sole proprietorship.

Therefore, there doesn’t seem to be a huge tax difference for me personally by doing LLC vs sole proprietorship. That said, if I opted to file as a corporation, that could make a difference, which is something worth exploring more. If I do an LLC, I’ll have to file separate business and personal taxes, which I wouldn’t have to do if I set up as a sole proprietor.

Separating Business and Personal Finances

The main reason that I was planning to set myself up as a business is because I want to separate my finances. However, I’m leaning towards doing a sole proprietorship, which actually doesn’t require me to separate my finances. An LLC strictly requires that you keep your business and personal expenses entirely separate. In contrast, you don’t have to do that with a sole proprietorship. You are the business. Therefore, that part wouldn’t actually be different than what I’m doing now as a freelancer. Of course, I still want to separate them, but in the eyes of the government, they wouldn’t need to be.

A sole proprietorship is the right thing for me. My business finances are pretty simple. I don’t run a lot of risk regarding liability. And I don’t want to spend the extra money to become an LLC. But anyone making this decision should certainly look at both options with an eye towards what makes financial sense for them.

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Should You Pay Taxes with a Credit Card?

pay taxes with a credit card

You can pay your taxes with a credit card. Should you?

Every single year when I do my income taxes, I think about the things that I should do differently. For one thing, I always buy tax software. However, I could use the IRS eFile tool for free. I’m a creature of habit and making the switch challenges me. Nevertheless, it would be a financially smart thing to do.

I also typically pay taxes with a credit card. I’m aware that it’s doesn’t make the most financial sense. I do it anyway. That’s something I really need to look at it if I truly want to stick to my frugal living goals.

It’s Convenient to Pay Taxes with a Credit Card

Sometimes I pay a little bit more for convenience. That’s part of frugal living. I’m not trying to get the cheapest thing all of the time. I’m just trying to “trim the fat” to make sure that where I spend money is where it makes sense to do so. Sometimes convenience makes sense.

It’s definitely convenient to pay taxes with a credit card. I see what I owe. I enter the credit card information. It’s all done. I don’t have to worry about whether or not I have enough money in the bank to cover it. If I don’t, then I’ll move money around later to pay that card off. You can’t do that if you pay with a check; you have to have the money right then and there.

I Like My Credit Card Rewards

I have a good cash back credit card. My rewards accrue all throughout the year. I don’t touch them. Then, come December, I have a nice chunk of cash back money that I can use. December is a tough month financially for almost everyone. I also have several big annual bills that come due around then. Plus, as a freelancer, it’s almost always my slowest income month. Therefore, I love using those rewards.

When I pay taxes on a credit card, I get a nice bit of cash back. I don’t need it in the spring, but I’m really happy that it’s there come December. Therefore, I do like that aspect of paying taxes with a credit card.

The Rewards Don’t Outweigh the Fees

Here’s the thing, though. If you pay taxes with a credit card, then you’re charged a fee. You can’t pay the IRS directly with a credit card, so you have to use a processing service. The fee varies depending on the service you use. According to the IRS, the fee is sometimes deductible. However, that’s not always the case.

In my experience, the fee almost always costs more than the rewards I get back on my credit card. If you have an excellent cash back card then you might still get a little extra money. At the very least, it might even out. However, if you’re trying to pay with a credit card just to get cash back, then you should be aware that you probably aren’t doing yourself any financial benefit.

If you’re using a cash back rewards card, try to use one that’s got at least 3% cash back. Moreover, check with the processing service to see if the fees differ depending on the card that you use. For example, the fee is sometimes higher for American Express, so you might want to pay with a different card to keep costs down.

If You Don’t Pay the Credit Card Immediately, Then You Really Pay

It isn’t cheap to use your credit card. I usually pay my balance in full each month. Therefore, I don’t pay a lot of money in interest. However, if something goes awry, those interest charges can add up fast. If you do pay your taxes with a credit card, make sure that you don’t rack up a bunch of interest fees by failing to pay that card balance off quickly.

You can set up a payment plan with the IRS. Therefore, if you don’t have the money to pay your taxes right now, then you shouldn’t go straight to a credit card. Save money by working directly with the IRS instead, where the fees will be considerably lower.

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