If you’re a business owner then I’m going to assume that taxes are one of your biggest frustrations.
You’ve hustled, you’ve built a great brand, you’re gaining a lot of traction, and your income is starting to show it. Congratulations!
But with that success comes the inevitable – more taxes. Wouldn’t it be great if there was a way to reduce that tax liability?
And wouldn’t it be great if that same tax reduction strategy also helped you to save for your retirement?
You see where I’m going with this? I’m here to tell you there is a way to both reduce your taxes AND save for retirement both at the same time. And setting up a retirement plan for your business is the best way to do this. Let’s take a look at the different retirement plan options you have as a business owner:
IRA stands for Individual Retirement Account. As its name implies, an IRA isn’t actually a business retirement plan since any individual can open one up.
You can put up to $5,500 per year into an IRA ($6,500 per year if you’re 50 or older). The benefit of an IRA is that any contribution to it reduces your taxable income.
Here’s a very basic example:
Assume you earn $50,000 per year and your tax bracket is 20%. If you didn’t make an IRA contribution then you would pay $10,000 in taxes ($50,000 x 20% = $10,000).
If, however, you were to put $5,000 into your IRA, then your taxable income would only be $45,000 ($50,000 income minus your $5,000 IRA contribution). Now your tax bill is only $9,000 ($45,000 x 20% = $9,000).
To find your potential tax savings simply multiply the amount of your IRA contribution by your marginal tax bracket. What you’ll find is that the higher your tax bracket, the greater the benefit of an IRA becomes.
The benefits don’t just stop there. In addition to receiving tax savings when you make the contribution, your investment then grows tax-deferred, which means you don’t pay taxes on growth or interest until you pull the money out for retirement.
Keep in mind that when you invest in an IRA it’s designed to be an investment for your later years. With few exceptions, you cannot access money in your IRA until age 59.5 without incurring an early withdrawal penalty of 10%. You do eventually pay taxes on IRA distributions once you start pulling funds out after age 59.5.
Conventional wisdom says tells us that it’s best to get tax deductions from IRAs when you’re in your high income earning years, and then pay taxes from IRA distributions when you’re retired and in a lower tax bracket. Generally speaking, this might be true, but conventional wisdom has no way of predicting where tax brackets will be when you’re retired.
You should consider using an IRA as a business owner when:
Your income doesn’t justify putting more than $5,500 per year into a retirement account.
You have a lot of employees that would make other retirement plan options more costly (more on this later).
You prefer to keep things as simple as possible, meaning you don’t want to deal with a company retirement plan.
A Roth IRA is just like a traditional IRA, except it’s the opposite. Confusing? Yeah, probably. Here’s what I mean:
A Roth IRA is similar to a traditional IRA in that:
Contribution limits are the same – $5,500/year ($6,500 if 50 or older).
They’re available to any eligible individual.
All growth and interest is sheltered from taxes.
Opposite of a traditional IRA in that:
You don’t get any tax deductions for contributions that you make.
When you pull funds out of your Roth IRA in retirement they’re completely tax-free.
One other great benefit of a Roth IRA is that you have access to some of the funds prior to turning 59.5. You can always access your Roth IRA contributions at any time without paying taxes or penalties. You just can’t touch the growth. That’s the part that would be subject to taxes and early distribution penalties.
Keep in mind that there are income limitations for Roth IRAs. Read here to learn how to make Roth IRA contributions when your income is too high.
You should consider using a Roth IRA as a business owner when:
When you’re in a relatively low tax bracket.
When you want to “lock in” your tax bracket now, knowing that you won’t pay taxes when you withdraw your money.
When you want the flexibility to be able to withdraw contributions from your account penalty-free and tax-free at a later time.
When you love the idea of tax-free income in retirement!
SIMPLE IRA stands for Savings Incentive Match PLan for Employees IRA. Wow. That’s a lot. Can you see why we just refer to it as a SIMPLE IRA instead?
A SIMPLE IRA is not an IRA that can be set up by an individual. A business owner must choose to open up a SIMPLE IRA through his or her company in order for it to be valid. These accounts allow plan participants to defer up to $12,500 per year to their accounts ($15,500 per year for participants 50 or older).
In addition to employee contributions, SIMPLE IRAs then allow for business owners to provide matching contributions to their employees. As a business owner, you must either:
Make a contribution of 2% of each eligible employee’s salary into the employee’s SIMPLE IRA. This must be regardless of whether the employee makes any contributions on their own.
Make a matching contribution of 3% of each eligible employee’s salary, but only if the employee contributed at least 3% of their own salary to the account. For example:
If the employee contributes 0%, then the business owner matches 0%.
If the employee contributes 2%, then the business owner matches 2%.
If the employee contributes 5% or more, then the business owner matches 3%. The match is capped at 3% regardless of how much the employee puts in.
One nice feature of SIMPLE IRAs is that, assuming you select option #2 above, you can actually reduce the matching contribution down to 1% or 2% in any two years out of a five-year period. This is helpful to businesses that might have a down year or two every now and then.
Any contributions to a SIMPLE IRA are pre-tax, meaning money that a participant puts into their account is deducted from their taxable income. Additionally, the participants aren’t taxed on the matching contributions they receive, and the business owner can deduct matching contributions made to employees.
There are a few rules regarding operating a SIMPLE IRA. The biggest one is called the two-year rule. The two-year rule states that once you open a SIMPLE IRA you cannot transfer it to an IRA or roll it over until two years have gone by. If you do then you will pay a 25% penalty in addition to any taxes that may be due from a distribution. So, if you’re going to start one, don’t plan on moving your SIMPLE IRA for at least two years.
You should consider using a SIMPLE IRA as a business owner when:
You’re self-employed and you want to contribute more than an IRA allows ($5,500), but not quite as much as some of the other plan types allow.
You want to offer a matching retirement plan for employees, but you don’t want the hassle of opening a 401(k).
You don’t want to go through the same annual discrimination testing that 401k plans require.
You want some flexibility in making employee matching contributions.
SEP IRA stands for Simplified Employee Pension IRA.
Any business owner can open a SEP IRA, but this is one of those plans when there are clear instances when a SEP IRA isn’t a good idea. But first, let’s start with the benefits of a SEP IRA.
A SEP IRA, like SIMPLE and Traditional IRAs, offers a way to make contributions that lower your taxable income today. SEP IRAs allow for significant pre-tax contributions, too. For 2018, you can contribute up to $55,000 to a SEP IRA.
This is important because if you have the ability to contribute $55,000 then it probably means that you’re making good income and you’re in a high tax bracket. If we look at someone in a 40% tax bracket, then a $55,000 SEP IRA contribution would save them $22,000 in taxes!
How’s that for a win-win? Put away $54,000 for retirement savings and get a $22,000 tax break to go along with it!
The first downside is that you can’t contribute more than 25% of your income (this calculation is slightly different for business owners operating as sole proprietors). Why is that important?
Well, if you’re incorporated then you probably take part of your income as a salary and part of it as a dividend. This helps to avoid self-employment taxes of 15.3% on a portion of your income.
However, your SEP IRA contribution is calculated based only on the salary portion of your income. So, if you’re bringing in $100,000 per year in salary and then another $80,000 per year in dividends then your total income is $180,000. You would think that you could contribute $45,000 to your SEP IRA based on this income (25% x $180,000).
This would be an over contribution though. You’re actually only able to contribute $25,000 to a SEP IRA in this example, which is 25% of the salary portion of your income.
Another limitation of SEP IRAs is the way that employee contributions are calculated. If you have employees, then the same percentage of your income that you contribute to a SEP IRA must be contributed to your employees as well.
You earn $100,000 per year and you have four employees who each earn $50,000 per year. If you chose to have the business contribute 25%, or $25,000, to your SEP IRA, then the business must also contribute 25% of each employee’s salary to their SEP IRA as well.
In other words, you get to put $25,000 into your SEP IRA, which could potentially save you several thousand dollars in taxes. But it’s going to cost you $50,000 in employee contributions to be able to do so!
So, unless you’re trying to set up the world’s greatest employee benefit plan, I would likely recommend against a SEP IRA in situations where you have several eligible employees.
You should consider using a SEP IRA as a business owner when:
You are self-employed, or you have employees that have been with you for less than three years.
You have high income and want to put a significant amount into a retirement plan.
You want a plan that’s easy to set up and maintain.
A 401(k) plan is probably the type of retirement plan that most people are familiar with. Many employees, especially those at larger companies, are offered a 401(k) plan as part of their benefits package.
The great thing about being a business owner is that you get to create your own benefits package! Meaning you can set up a 401(k) plan for your business too.
There are three parts to a 401(k) plan:
Employee deferrals. This is the portion that a plan participant can defer to their 401(k).
Employer contribution. This is the amount that the company can contribute to each participant’s account, in addition to the employee’s own deferral.
Employer profit sharing contribution. This component of a 401(k) is less common, but it’s an additional contribution on top of the employer match.
The employee deferral portion is pretty straightforward. A participant can defer up to $18,500 per year ($24,500 per year if 50 or older) to their 401(k) account. All of the contributions are pre-tax and help to save the participant money on their taxes.
The employer contribution is a little bit more customizable, depending on what your goals are as a business owner.
Is the goal to attract employees and make them happy? You can
A loan provision allows a participant to access up to 50% of their 401(k) account balance, with a maximum loan of $50,000. This loan comes out tax-free, and then the participant makes payments back to themselves with interest.
401(k) plans do have annual compliance and discrimination testing. This testing is done to ensure that business owners aren’t setting up plans that only benefit the high-income earners in the company (typically themselves). Thankfully, with good planning, a 401(k) plan can provide high contributions to the business owner while still providing a good benefit to non-owner employees.
You should consider using a 401(k) as a business owner when:
You want the ability to save large amounts for retirement.
You have a high income and want to cut down significantly on your tax bill.
You want to provide a retirement benefit as a way of attracting and retaining employees.
Roth 401(k) Plan
A Roth 401(k) is almost the same as a Traditional 401(k), with one important difference. Rather than employee deferrals being made on a pretax basis, they are instead made on an after-tax basis.
In other words, employees don’t get any upfront tax benefit for putting money into a Roth 401(k). The benefit comes with tax-free growth of earnings and then the account balance can be withdrawn tax-free from a Roth 401(k) on the back end.
Think of the difference between an IRA and a Roth IRA. The same is true of a Traditional 401(k) versus a Roth 401(k).
Note – Even if a plan participant is making contributions to a Roth 401(k), the employer match will go into a Traditional 401(k). This is something that participants need to be mindful of when they go to rollover their account balance or withdraw funds. Their account will be a mix of pretax and post-tax money.
You should consider using a Roth 401(k) as a business owner when:
You want to be able to save money into an account that can be withdrawn tax-free in retirement.
You want to be able to defer large amounts to retirement savings.
You want to offer employees the ability to save money to a Roth account (this can be especially beneficial to lower income employees).
Defined Benefit Plan
If you read through the options above, but even a 401(k) plan or SEP IRA won’t allow you to save as much as you would like, then there are other options out there.
We won’t go into all the details here because they can get somewhat complicated, but high income earning business owners can consider a defined benefit plan if they want additional tax savings compared to those offered by other plans.
Establishing a defined benefit plan is like creating a pension plan for your company. Here’s a general outline of how the process works:
You work with an actuary that helps you create a benefit formula based on your age, income, earnings history and more.
This benefit formula calculates the amount that you need to save each year to generate a defined income benefit (hence the name) when you retire.
You invest a certain amount each year that, based on the actuarial calculation, is predicted to keep your plan balance sufficient to pay that defined income in the future.
In practice, many defined benefit plans don’t actually provide a set income amount in retirement. Many defined benefit plan participants end up rolling their defined benefit balance into the IRA when they’re done working.
These plans allow for contribution ranges that vary dramatically, but a contribution of $200,000 to $300,000 per year to the business owner(s) isn’t uncommon. This full amount is a deduction on the company’s tax return, and it’s a significant contribution to the business owner’s retirement plan!
While they offer tremendous benefits, you still must be mindful of these details before opening a defined benefit plan:
They can be costly to administer.
You must keep them open and funded for a minimum of three years. Otherwise, the IRS might view the plan as a temporary tax shelter.
You have less investment flexibility than you would in a 401(k) or IRA plan.
That being said, if you can operate within the rules of a defined benefit plan, and if you have the business cash flow to justify using it, a defined benefit plan can be an excellent retirement plan option.
You should consider using a Defined Benefit Plan as a business owner when:
You want to save significantly more than a 401(k) plan or SEP IRA allows.
You want to provide a retirement savings benefit to your employees.
Your business has excess income
You are older and make more than most of your employees (these details impact the calculations of how much you can put into your defined benefit plan).
Surprisingly, this list isn’t even exhaustive. In addition to different types of IRAs, 401(k)s, and defined benefit plans, there are profit sharing plans, ESOP plans, money purchase plans and more!
And while all of these retirement plans have different rules and details, there’s one thing that they all have in common – they all have the potential to lower your tax bill while also helping you to save for retirement at the same time.