There are an infinite number of financial terms you may have encountered. Here are ten common ones you should probably know.
Self-Employment Tax: Self-employment tax is a 15.3% tax paid on net business earnings. It covers both Social Security (12.4%) and Medicare (2.9%) contributions. For employees with W-2 jobs, these contributions are split with the employer, so the employee pays 7.65% on gross earnings (which is withheld from each paycheck), and the employer matches the amount before sending the total to the government. Since self-employed individuals are both their own “employees” and “employers” they pay the entirety of the amount (15.3%) on net business earnings. These taxes are in addition to income taxes, so make sure to set aside enough to cover them as you earn money.
Income Tax: Income taxes are taxes imposed at the Federal, State, and sometimes Local levels on taxable income accumulated by someone during the year. The income tax rate generally increases as taxable income increases, and payments can be made through withholdings from W-2 jobs or quarterly estimated payments from individuals. You can also simply pay the income tax you owe at the end of the year, but if you owe more than $1,000 for Federal tax purposes, you’ll also pay a penalty for not paying throughout the year (unless you paid at least what you owed the year before). When you file your income tax return each spring, you’ll either owe money (if you didn’t pay enough during the year) or you will get a refund (if you paid too much during the year).
Deductible Business Expense (taxes): For tax purposes, a deductible business expense is one that can be used to reduce your taxable income. Business expenses must be ordinary (common and accepted in your industry), necessary (helpful and appropriate for your trade or business), and effectively connected to your trade or business to be deductible. There are some special rules that complicate some business deductions as well.
Deductible (insurance): Deductible can have two definitions, depending on whether we are talking about insurance or taxes. For insurance purposes, a deductible is the amount you must pay before the insurance company pays for your expenses. (For example, with a $500 health insurance deductible, you would need to accumulate $500 worth of medical expenses, then your insurance would cover expenses that exceeded that amount for a period of time – generally a year.)
Mutual Fund: A mutual fund is an investment vehicle that gathers money from a variety of investors, pools the money together, and invests the total in a variety of products according to the stated goals of the mutual fund. Because it is invested in a variety of products, it is generally more diversified than a portfolio of direct investments. And because the fund includes money from many individuals, the fees to manage the fund are often lower than fees you would pay to a financial investor. The goals of the fund can be to maximize income, preserve cash, or track an existing metric. These funds are called index funds, and they invest exactly in the same companies contained in the metric (for example, the S&P500, which invests in the 500 largest companies in the United States). An Exchange-Traded Fund (ETF) is an investment similar to a mutual fund, although the actual ETF is traded (not just the companies it invests in). ETFs offer many of the same benefits (and sometimes have lower costs) than mutual funds.
Stock: A stock (or share) is a piece of ownership in a company. (Owning this type of investment is sometimes called an equity investment because you invest in the “equity” of the company, which is the value of the assets after all liabilities are paid.) If you are a stockholder or shareholder, you (in theory) benefit from the company’s success. When you hold the stock, the value generally goes up when the company does well; if you sell your stock for more than you purchased it for, you make money on the investment. The company may also decide to pay dividends on the stock (especially if it is an older company that doesn’t necessarily need the extra cash to invest in new technology or products). These dividend payments go to you as the owner and are another way of making money on your investment. But, of course, the value of your stock can go down as well; if you sell your stock for less than you paid for it, you lose money on the investment. To get a stock, you can make a direct investment in the company through a broker or purchase a mutual fund that holds stock (equity) positions.
Bond: A bond is also a type of investment, but instead of being ownership of the company (like a stock), it functions more like a loan. You give the company (or the government) money, and the company (or government) promises to pay you back, including interest. The interest is stated at the time you purchase the bond, so you generally have a good idea of what you’ll get over time, assuming the company (or the government) can meet its obligations in the future. Except that you also hold the bond: the piece of paper giving you the right to receive that amount of money. That piece of paper has value as well, and you can sell the bond if the value of it increases. (The value of the bond may change when interest rates change, or when people think a loan to a company [or the government] is more or less risky.) To get a bond, you can make a direct investment in the company (or the government) through a broker or purchase a mutual fund that holds bond positions.
Individual Retirement Account (IRA): An IRA is a savings vehicle that allows individuals to contribute up to $6,000 per year ($7,000 if they are 50 or older). The funds are invested, they accumulate over time, and individuals may withdraw the funds once they reach a certain age. (Depending on the IRA, they may withdraw them early, but they may pay a penalty or taxes on the withdrawl.) The difference between a Traditional IRA and a Roth IRA comes down to timing: When do you pay taxes on the contributions? For a Traditional IRA, you do not pay taxes on the funds in the year you contribute them. (That’s why you get a deduction for these contributions.) Instead, you pay taxes when you withdraw the funds in retirement, and for some folks, their tax rates in retirement will be lower than the tax rates they are paying now, so a Traditional IRA makes sense. A Roth IRA has the opposite timing. For a Roth IRA, you do pay taxes on the funds in the year you contribute them. (That’s why there is no tax deduction for Roth IRA contributions.) But, when you withdraw the funds in retirement, they are tax-free. This is a good option for folks who are paying very little in taxes now, but still can afford to save. For both Traditional and Roth IRAs, the money grows tax-free over time. Once it is invested, any earnings are added to the IRA and not considered taxable income to the owner of the IRA (at least not until they withdraw the funds in retirement).
SEP-IRA: A SEP-IRA (Simplified Employee Pension) is a special retirement plan available to self-employed individuals. The contribution limit to a SEP is 25% of the net earnings of a business, which may be higher than the contribution limit for a Traditional or Roth IRA. A SEP-IRA can exist in addition to other types of retirement savings (for example, another IRA or a 401(k)), as long as the individual’s overall contributions and deferments are below the annual limits. To form a SEP, it’s generally a good idea to hire an advisor to make sure the plan qualifies for the retirement benefits and is administered accurately.
401(k): A 401(k) is a retirement plan that allows employees to make pre-tax contributions to their retirement. It also facilitates employer contributions, sometimes matching the employee’s contribution. (In a not-for-profit setting, retirement plans are called 403(b)s instead of 401(k)s, but they generally work the same way.) A self-employed individual can form a Solo 401(k), and they make both individual contributions (up to the annual limit) and business contributions (up to 25% of net business income or the overall contribution limit). To form a Solo 401(k), it’s generally a good idea to hire an advisor to make sure the plan qualifies for the retirement benefits and is administered accurately.
This information is provided for educational and informational purposes only and is not intended to be used as tax, legal, or accounting advice.