Running your own business (or being self-employed) is a major part of the American Dream and a great way to quickly move towards financial freedom. This also leaves the heavy lifting of tax planning and setting up a retirement plan squarely on your shoulders, as if running a business wasn’t complicated enough. Keep reading as we share the four ways to minimize taxes, today, on your business income while saving for a secure retirement.
You may love your business, or you may not; either way, saving taxes today is a great way to stay on track for financial freedom and a secure retirement. While I know choosing the right retirement plan can be confusing and overwhelming, don’t put off this important part of being a successful business owner. If you work until you are 80, it should be because you love what you do rather than because you still can’t afford to retire.
There are multiple options available when it comes to choosing a retirement plan for your small business. Which plan is the best will depend on your business, how much you need to be saving for retirement, and your overall household income. Current tax rates and policy may also play a role in which retirement plan you utilize from year to year.
The good news is business owners have more options to minimize their taxable income through proactive tax planning. You also have the ability (in many cases) to shelter more income in retirement accounts.
Keep reading as we outline the four most common retirement plans for self-employed individuals: IRA, SIMPLE IRA, SEP IRA, individual 401(k), and defined-benefit plans. These small business retirement plans permit contributions ranging from $6,000 to nearly $300,000, per year, and the numbers can easily be doubled for married couples who work together. My husband and I both work here at DRM Wealth Management, which allows us both to contribute to our firms retirement plan.
Traditional and Roth IRA Rules
The Roth IRA and traditional IRA are best for those looking to save a modest amount of money each year. These accounts can also be funded in addition to one of the other retirement plans listed below. For 2021, the maximum contribution to a Roth IRA or traditional IRA is $6,000 or $7,000 for those who are 50 years or older. There are income limitations when contributing to a Roth IRA, so business owners with higher incomes may be ineligible. Income limits apply to traditional IRAs only if someone in the household has access to a retirement plan at work. For example, if your spouse has a 401(k) at his or her job.
You can contribute to an IRA (traditional or Roth) up to the tax-filing deadline for the prior year. So, for 2020, you can contribute as late as May 17th, 2021.
SEP IRA (Simplified Employee Pension Plan)
The SEP-IRA is one of the most popular retirement plans for small business owners. Your maximum contribution in 2021 is $58,000, and your actual contribution is based on 25% of employee pay or 25% of your net earnings from self-employment income. The SEP-IRA works best when you have few to no employees.
Setting up a SEP-IRA is easy and with minimal paperwork. Accounts can still be opened for 2020. Contributions can be made by October 15th of the following year. So, I’ve seen many small business owners set up SEP-IRAs when they received surprisingly large tax estimates for the prior year.
I should also point out that there are no catch-up contributions allowed for SEP-IRAs for business owners over the age of 50, or below that age, for that matter.
Individual or Solo 401(k)
The Solo 401(k) (also often called an Indy K or Individual 401(k) plan) is quickly becoming the best option for many business owners. While many large firms (shockingly) don’t offer these plans, the cost complexity of implementing a Solo 401(k) has come down dramatically over the past few years. The Solo 401(k) offers the opportunity to make the largest contributions, as well as the widest array of tax-planning opportunities for high-earning couples.
On paper, the maximum contribution limit to the Solo 401(k) is similar to a SEP-IRA, but it is easier to be allowed to make the max contribution. As a business employee, you can contribute $19,500 in 2021, plus an additional $6,500 catch-up contribution for those 50 and older. The employee contribution can be 100% of your salary compared to the 25% contribution limit on the SEP-IRA. From there, the business can make a profit-sharing contribution equal to 25% of your salary, for a grand total of $58,000 in 2021 ($64,500 if you are at least 50 years old.
The Solo 401(k) can also be set up as a Roth 401(k). However, only the employee contribution will go into the Roth bucket; the employer contribution will still be made pre-tax.
I have used Solo 401(k)s as part of tax-minimizing strategies for many of my married couples where one spouse is self-employed. Maxing out the Solo 401(k), beyond what would typically be feasible from the business income alone, can lead to some substantial tax savings. This strategy works great when the higher earner is a W-2 employee, which severely limits that earner’s options to minimize taxes.
I am surprised that more business owners aren’t aware of the Defined Benefit Plan. It is essentially a way to both lower your current taxes and create your own personal pension. The only explanation I can come up with for why this isn’t more widely used is that the average financial advisor just doesn’t have the tax-planning expertise necessary to design and implement these plans properly. Or perhaps, advisors’ firms just don’t allow them to even use these plans.
The Defined Benefit Plan is typically combined with a 401(k) plan, allowing for a maximum contribution of $294,500 between the two plans. These numbers can easily be doubled for a business run by spouses or one that includes other family members as employees. Simply put, you are able to get more benefit from a combined 401k and defined benefit plan the more income you have and the higher your tax brackets are.
I’ve found these plans work the best for firms when the income is skewed toward the business owners (and their families). Solid cash flow, and the ability to save more than $100,000 towards retirement accounts, are essential to starting this personal pension plan. Below this amount, one could likely get similar benefits with the Solo 401(k) and other tax-efficient investment strategies). While this may seem like a huge number, keep in mind it is a pre-tax number. In California, this might only cost $50,000 to put $100,000 into your retirement accounts, which I hope is a no-brainer.
Setting up a defined benefit plan is more costly and complex than the other retirement accounts mentioned in this post. Your defined benefit pension plan should be set up with a financial planner, actuary, and guidance from your CPA. The plan can be designed to maximize contributions and benefits to you and your most valued employees. The ongoing contributions will need to be made to the plan but can be frozen if the business hits an iceberg, as many did during the COVID recession.
The benefits of the defined benefit plan can be staggering for family businesses. Huge contribution limits can be multiplied when spouses, parents, siblings, and even children are added to the plan—just something to consider.
Hopefully, you are already contributing to some type of retirement account. See what you can do to increase contributions or max out those accounts. Once you reach that level, work with your fabulous financial planner to see what is next on your tax-minimizing strategy to help you keep more of your hard-earned money. The consensus is that tax will be going up in the future, and I hope your income is also increasing with time. While part of my job is to help my financial-planning clients pay the least amount of taxes legally possible, having enough income to be in the top federal tax brackets is a good problem to have.