A hobby can be a great platform to start a business. But there are things to consider before you invest in a new venture. Money Girl has the scoop on how to start a business. Plus—tax rules you need to know.
A podcast listener named Matt W. 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 401(k) 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?”
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.
How to Fund 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. Matt’s hitting that target with just his 401(k) 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 upfront on contributions to a Roth IRA.
However, you generally can’t withdraw any earnings from a Roth IRA before age 59½ 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.
Related Content: Your Guide to the Roth IRA, Part 1
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. Withdrawing retirement funds prematurely means you’ll 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, a Roth IRA does offer the most flexibility for withdrawing your contributions if you decide that’s the right move for your financial situation.
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Do You Have a Hobby or a Business?
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 years you don’t make a profit. That reduces your other taxable income and can slash your tax liability.
But to qualify as a business, you generally have to show that you earned money in 3 out of the last 5 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!
Related Content: Tips to Make Extra Money at Home
How to Turn a Hobby Into a Business
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.
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 (LLC)—so you can protect your personal assets and keep your taxes as low as possible.
More Information: Get Help Choosing Your Business Structure
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.
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