As Americans slowly gather their 1099s, W2s, and receipts for their annual visit with their CPA, nearly everyone is looking for a way to reduce their tax liability, especially small-business owners. While your CPA may help you with new equipment purchases and depreciation write-offs, be sure your CPA has also considered one of the most effective tax reduction strategies: retirement planning.
While many types of retirement accounts can accept contributions up to the tax filing deadline of April 15, the accounts themselves must be established prior to the year-end for the contributions to count for that year. However, because you’re currently working with your tax adviser, now is a perfect time to look at the various types of retirement accounts that work for your business structure and determine what will allow you to contribute the most amount of money for your future.
If you are a sole proprietor with no employees, your options are greater since you do not have to worry about others when creating your plan. Typically, sole proprietors look to Simplified Employee Pensions (SEP IRAs) or Individual 401(k) plans.
With a SEP IRA, setup and maintenance costs are minimal, and you can contribute as much as 25% of your net income, up to a cap of $56,000 in 2019. The amount of compensation you can use to calculate the 25% limit is limited to $280,000 in 2019. Like most retirement accounts, SEP IRA contributions are tax-deductible, and investments grow tax-deferred until retirement, when distributions are taxed as income.
Individual 401(k) plans have the same high contribution caps but come with more setup and maintenance costs and filing requirements. However, for some small-business owners, there are some distinct advantages. Individual 401(k) plans allow individuals 50 or older to make a catch-up contribution of $6,000, bringing the total contribution to $62,000. Furthermore, the elective deferral for employees is $19,000 ($25,000 for 50 and older). Only the employer’s contributions are limited to 25% of gross income for corporations and 20% of net income for sole proprietors or partnerships.
For example, when you first started your business, you may have opted for a sole proprietorship, and you put your retirement savings in an IRA with an annual contribution limit of $6,000. In years two through four, your business was making around $30,000, so you opened a SEP IRA, allowing you to contribute $7,500 toward your retirement. Let’s say you’re now in year seven and your business is bringing in $48,000. If you reorganized as an S-Corp and opened an Individual 401(k), you could defer up to $19,000 from your salary and make a profit-sharing contribution up to $12,000 for a total contribution of up to $31,000. If you remained with your SEP IRA, you’d only be able to contribute up to 25% of your net income, $12,000, toward your retirement.
As you can see, when your small business becomes more profitable, you may want to consider changing business structures to allow for greater retirement plan contributions. In turn, this should lower your taxable income. If you have questions regarding your small-business retirement plan, the experts at Henssler Financial will be glad to help: