Ways to fund a business start up and the tax rules to follow.
Money Girl
274 MG How to Turn a Hobby Into a Business
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I'm Laura Adams, the author of Money Girl's Smart Moves to Grow Rich. If you haven't gotten a copy of the paperback or ebook, they're available wherever books are sold. You can also download two chapters for free on my blog by the same name SmartMovesToGrowRich.com. I received a question from a podcast listener named MattW, who asks, "In my free time, I enjoy modifying vans and want to turn this hobby into a business. However, most of my extra money is tied up in retirement accounts. I contribute 7% to my 401k because my employer matches that full amount. And I also max out a Roth IRA, which is as much as I can afford to save. I don't intend to withdraw money from these accounts because I understand there are penalties. But going forward, should I stop funding them and use the money to start a business instead?" This is a great question. I'll give Matt some ideas about how to start a business venture and cover important tax rules you need to know about turning your hobby into a business. First of all, congratulations to Matt for doing such a great job saving for retirement. He's contributing 7% and his employer is contributing another 7% in matching funds for a grand total of 14%. That's a really sweet deal. Additionally, he's maxing out a Roth IRA, which is another $5,000 for retirement. We don't know the total percentage of income that Matt's setting aside, but I recommend that you always invest a minimum of 10% to 15% of your gross income for retirement. Now, Matt's hitting that target with just as 401k contributions and employer matching funds that total 14%. So, one option for Matt to fund his business is to suspend making Roth IRA contributions for now, which would give him $5,000 over the course of a year. Another option for Matt to start a business is to dip into his Roth IRA. You can withdraw your contributions from a Roth for any purpose without having to pay income tax or an early withdrawal penalty. That's because you pay tax up front on contributions to a Roth IRA. However, you generally cannot withdraw any of your earnings from a Roth IRA before age 59.5 without being taxed and paying a 10% early withdrawal penalty. Earnings are the funds that you've made on your contributions. For example, if you contribute $5,000 to a Roth IRA, but the account value rises to $5,300, you have $300 in earnings. That $300 growth is treated differently because you haven't paid tax on it yet. But as you've heard me say before, I don't recommend withdrawing money from a retirement account unless you have plenty of money saved somewhere else. What's drawing retirement funds prematurely means you're going to miss out on years of account growth and the huge tax savings that were designed to help you accumulate as much wealth as possible. However, it's good to know that a Roth IRA does offer the most flexibility for withdrawing your contributions. If you decide that's the right move for your financial situation. For more about Roth IRAs, be sure to listen to the previous two podcasts titled Your Guide to the Roth IRA, Part 1, and Part 2, which are episodes number 272 and 273. This is a great time to turn a hobby into a money-making side hustle or even a full-time career. But there are important tax rules to understand as you make the transition. When you're considering going pro with your hobby, you need to be clear about whether your activity is a hobby or a business in the eyes of the IRS. According to Uncle Sam, you've got a hobby when you don't intend or expect to make a profit, and you've got a business when you do. You get the most favorable tax treatment when you have a legitimate business. You can even deduct your overall business losses in the years you don't make a profit. That reduces your other taxable income and can really slash your tax liability. But to qualify as a business, you generally have to show that you earn money in three out of the last five tax years, including the current year. If you don't meet the criteria, you can still make money from a hobby, but there are more restrictions about deducting expenses, so it's not as beneficial. These restrictions were created to keep hobbyists from getting loads of tax breaks for stuff they buy just to have fun. When you start making money from your hobby on a regular basis and feel confident that you've got a viable business, you'll want to make it official. It's not against the law to mingle your business and personal finances as a sole proprietor, but it's easy to register a business name, get a federal or employer identification number, and open a business checking account. I'll put links to resources where you can easily accomplish these tasks. In the transcript for this show, just visit the Money Girl page at quickandertietips.com and look for episode number 274, called "How to Start a Business from Your Hobby". Having completely separate personal and business records makes it much easier to monitor the status of your business, file taxes, and even sell the business down the road if that's something you want to do. It's a good idea to use a tax accountant whenever you have a fairly complex situation, like having a business or owning rental property. Ask a professional for advice on the best legal entity to establish for your new business, such as a corporation or limited liability company, which is LLC, so you can protect your personal assets and keep your taxes as low as possible. Before you start a business from a hobby, make sure there's enough market demand to make your efforts pay off. Consider whether putting long hours into the work and commercializing it would completely spoil the enjoyment for you. Also, think carefully about whether you can afford to start a business. Depending on your business idea, you might be able to bootstrap it to get started, and then add money later on to expand as you start having success. No matter what, continue to save a minimum of 10% of your annual income for retirement. Keep up the habit of saving for the future because your new venture might make millions, but if not, you'll be glad to have a retirement cushion to fall back on. You spend it over here. AT&T customers switching to T-Mobile has never been easier. We'll pay off your existing phone and give you a new one free, all on America's largest 5G network. Visit T-Mobile.com/carrierfreedom to switch today. Pay off up to $650 via virtual prepaid mastercard in 15 days. Free phone up to $830 via 24 monthly bill credits plus text, qualifying port and trade and service on Go 5G next to credit required. 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As kids practice, they get positive feedback, awards, and explanations for wrong answers. IXL figures out what your kids need more help with and recommends more topics to practice. Their videos, lessons, sample problems, and learning games, too. One subscription to IXL gets you all subjects and all grade levels. Membership started just $9.95 a month. It's no wonder IXL is used in 95 of the top 100 school districts. I think the positive feedback that IXL gives is really crucial when it comes to learning. So make an impact on your child's learning. Get IXL now, and money girl listeners can get an exclusive 20% off IXL membership when they sign up today at IXL.com/moneygirl. Visit IXL.com/moneygirl to get the most effective learning program out there at the best price. For more money tips, tools, and advice, get my weekly updates when you sign up at smartmoose2growrich.com. Also, be sure to connect with me across the web on Pinterest, Facebook, Google+, or Twitter. 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