There's no doubt that a money-making hobby can dramatically reduce the amount of time until retirement. Not only can you sock away more money, but you can also use that income during your retirement. This reduces the amount that you need to save before 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. Getting yourself into trouble is easy; many people try to deduct losses for activities that are primarily conducted for enjoyment.
1Understand What A Hobby Means To The IRS
The IRS considers a hobby to be an activity that is done primarily for enjoyment, not for making a profit. If your activity is deemed to be a hobby, you can't use the tax deductions available to a legitimate business. However, you will be taxed for the profits 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. This is provided that you sold the coins in the same tax year that they were purchased.
2Hobbies Are Terrible For Tax Purposes
Creating a business for your hobby is important. Think business, not hobby. Do you expect to make a profit?
If your expectation is considered to be reasonable, then you can consider your hobby to be a business. There is no advantage to not declaring your hobby a business if you intend to earn income. When it comes to the IRS, remove the word hobby from your vocabulary.
3Hire Your Non-Working Family Members
Remember that no income tax has to be paid below a certain income threshold. Pay your children or non-working spouse a salary to help you with your business. This 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.
4Tax-Deferred Retirement Accounts
If your goal 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 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 you should remember that the money is out of your hands until the approved 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 that you want to dedicate to your hobby. Don't hesitate to get expert tax advice, too.
A money-making hobby can be an essential part of an early retirement plan. Think about the things that you like to do, and make a list of ways that you can make money from those activities. But take steps to avoid paying more taxes than necessary.
Jackie Wing is an Alaska native, who enjoys snowboarding more than is probably socially acceptable. She lives in Anchorage with her two dogs Reese and Peanut, or as she likes to call them "Thing 1" and "Thing 2."