Dear Karen: I always thought I’d be retired by now, but I work part-time for a salary and am also self-employed. I teach, design, produce and sell quilts. I only bring in about $5,000 a year for my quilting. I’m trying to figure out if I can set aside all my quilting money into a retirement account, avoiding income and self-employment taxes.

Answer: There is a way to avoid self-employment taxes, in theory. It’s called incorporation. But the costs of incorporating and the annual filing and fees would be greater than your self-employment income, so that’s not a viable option.

Self-employment taxes are probably unavoidable. They are the employer side of Social Security and Medicare, and can only be reduced by reducing income. But income taxes themselves are paid on net income (after expenses), so there may be room for a good accountant to help you reduce these.

Your taxes will also be affected by what type of retirement plan you choose. You can set up a 401(k) for your small business, allowing you to set aside up to $17,500 in earnings plus an extra amount assuming you’re over 50. You’d still owe self-employment taxes. Or a traditional IRA, with a limit of $6,500 (including the over 50 bonus).

Either of these actions will reduce your current income because the money is set aside before tax. (You would owe the tax when you withdraw the money.) Finally, you can set up a Roth IRA with after-tax money. This allows you earn interest and capital gains on the investment without paying any more tax. Thus, it reduces your future tax. Uncle Sam likes to give you choices: pay now or pay later. Just pay.

Dear Karen: My husband and I are retired and have rolled over our company 401(k)s to IRAs. A friend (“Rick”) is advising us on investments, and seems to have some good ideas. At least it seems he’s done well for himself picking stocks. My husband says Rick is an active investor and he prefers passive investing. Isn’t that just avoiding making decisions? I’d rather take the bull by the horns and ride it!

Answer: Every year, many investors beat the market. It can be done! However, there are few – think Warren Buffett – who can consistently outperform the average over a decade or two, or even more than a few years. If your friend “Rick” is Warren’s confidante (and maybe a decade or two younger), you might consider listening to his advice for a portion of your investments.

If you want to stay with Rick, you need to understand and agree with how he chooses your investments. Technical investors use charts and graphs to analyze how the market (or a specific stock) has performed. They try to forecast future prices based on historical price and volume data, looking at the general direction of the market and the movement of market and certain securities. Many investors see this as the equivalent of reading tea leaves, but some advisors make their living this way.

Fundamental investors analyze the economy, the industry, financial statements, and estimates of growth in earnings and dividends. These investors try to get a complete picture of the health of a company, an industry, and an economy. They then attempt the best placement for an investment at any given time.

Both of these are active investment approaches. Active investing has the additional burden of transaction costs. Investors typically buy and sell frequently based on changing condition. These costs are charged against the investment. Most studies show that, over the long haul, active investing does not compensate for the extra cost except in very narrow areas such as emerging market stocks.

Nevertheless, most advisors believe they can beat the market to some extent. A passive approach is characterized by not attempting to outperform the market. Passive investors belief that capital markets are mostly efficient and reflect all or nearly all information in securities prices. It is implemented by a portfolio heavy in index funds and ETFs. A small percentage of advisors are totally passive investors, though somewhat more use a passive strategy for part of the portfolio.

For the bulk of your money, my bet is on your husband’s passive strategy. Call the Rick funds your “play” money to reinforce the idea that they could either gain a lot – or disappear.

For whatever approach you choose, it is important to have a diversified portfolio in terms of stocks, bonds, and cash. When the financial industry or technologies, or whatever, hit the skids, consumer stocks or another industry is holding its own. When stocks tank, bonds are there to prop up one end of your portfolio. A fee-only financial advisor can help you build an appropriate asset allocation and make sure the rest of your life is in line with your goals.

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