One of the more powerful tax-saving strategies for small businesses is investing in retirement plans. Setting up and contributing to retirement accounts not only promotes financial security for the future but also provides immediate and often large tax benefits. Don’t drag your feet setting these up; there are deadlines for setup you don’t wat to overlook. Let’s look at some of these options:
401(k) Plans
These plans enable employees and employers to make pre-tax contributions, shielding large amounts of income from tax. In 2023, employee contributions are capped at $22,500, with a combined limit of $66,000 or 100% of the salary. Business owners over 50 can make an additional catch-up contribution of $7,500 for a total combined limit of $73,500. These, of course, are limits and any amount below these limits are also allowable- providing flexibility in how much (or how little) income you are able to shield in a given year.
Tax savings at this level do not come without complexity. For businesses to fully realize these tax savings, they need to structure the plan in such a way as to not limit what they can contribute. A safe harbor match is a method of automatically satisfying non-discrimination tests (tests that have the potential for limiting a business owners personal contribution), thus allowing high-earning employees to maximize their 401(k) contributions. In a typical safe harbor match, the employer matches 100% of the first 3% of each employee’s contribution and 50% of the next 2%, though other alternatives are available.
Furthermore, employers can opt to add a profit-sharing plan, which allows them to make discretionary contributions based on the company’s profitability. This not only motivates and rewards employees but can also be an effective way for a business to increase its contributions beyond the usual 401(k) limits, potentially reaching the $66,000 combined limit faster.
No employees? No problem. You may find a Solo-401(k) is the right option for you. These are designed for self-employed individuals with no full-time employees, offering high contribution limits. Unlike a traditional 401(k) used by companies with multiple employees, the solo version allows the individual to contribute as both employee and employer, potentially maximizing their retirement savings.
Defined Benefit Plans
Defined benefit plans, also known as pension plans, can offer significantly higher contributions than 401(k)s, especially for owners nearing retirement. These plans can shield incredible amounts of income from taxes, and can be an excellent choice for those with very high incomes and enough free cashflow to fund them.
While these plans require annual funding and can be more expensive to administer, they offer guaranteed retirement benefits and substantial tax deductions. The contribution limits are actuarially determined, but for a business owner in their 50s or 60s, it could be well over $200,000 annually.
From a tax perspective, the contributions made to a defined benefit plan are generally tax-deductible for the employer, reducing the business’s overall taxable income. Additionally, any investment earnings in the plan grow tax-deferred until they are distributed at retirement. This allows for the potential of significant growth over time.
Administratively, defined benefit plans may involve higher costs due to the actuarial calculations necessary to ensure the plan is adequately funded to meet future payout obligations. These plans also require annual IRS filings and periodic plan testing to ensure compliance with non-discrimination rules. These costs, however, are often overshadowed by the tax savings- making this the premier tax saving option for the business owner with the cash to afford it.
SEP-IRA and SIMPLE IRA
Simplified Employee Pension (SEP) plans and Savings Incentive Match Plan for Employees (SIMPLE) IRAs are popular options for small businesses. With a SEP-IRA, employers can contribute up to 25% of an employee’s income or $66,000 (whichever is less) in 2023. SIMPLE IRAs have lower limits but offer the opportunity for employee contributions and a mandatory employer match.
One aspect worth emphasizing is the flexibility of SEP-IRA contributions. Unlike some retirement plans, contributions to a SEP-IRA are not mandatory every year. This can be particularly useful for businesses with variable profits, as contributions can be adjusted based on yearly performance.
For the SIMPLE IRA, it’s worth noting that in 2023, employees can contribute up to $15,500, with an additional $3,500 allowed for those aged 50 or over as a catch-up contribution. The mandatory employer match is either a dollar-for-dollar match of employee contributions up to 3% of the employee’s compensation or a fixed contribution of 2% of compensation for all eligible employees, regardless of whether they contribute to the plan.
Both types of plans offer tax-deductible contributions and tax-deferred growth. In addition, they have relatively straightforward administrative requirements compared to 401(k) and defined benefit plans, making them an appealing choice for many small businesses.
It’s also worth mentioning the differences in deadlines for establishing these plans. A SEP-IRA can be set up and funded as late as the business’s tax filing deadline, including extensions. On the other hand, a SIMPLE IRA must generally be established by October 1 of the year for which the contributions will be made.
Consult a Professional
Retirement plans, with their varied tax savings, benefits, administration costs, and customization options, can be complex. Therefore, the prudent approach is to consult with a professional in the field. Engaging with a qualified financial advisor or tax professional is highly recommended for guiding businesses and individuals through this intricate process.
Qualified advisors are able to provide comprehensive, personalized advice based on individual circumstances and needs. They can help navigate the nuances of the tax code, understand the implications of various contribution levels, and provide ongoing support as financial situations evolve. In essence, they can assist in devising a robust retirement plan that optimizes both current tax savings and future retirement income.
