Tax Guy: How to choose a retirement plan for your small business
Have you procrastinated about setting up a tax-advantaged retirement plan for your small business? If the answer is yes, you are not alone. Even so, this is not a good situation. You are paying extra income taxes every year that you could easily avoid. However, you still have time to set things right and line yourself up for major tax savings for this year and beyond. This column explains the basics about your tax-smart retirement plan options.
When you cut through all the technical details, you’ll discover that tax-advantaged retirement plans come in two basic varieties:
- Defined-contribution plans, which come in several different flavors.
- Defined benefit pension plans.
With a defined-contribution plan, you can make annual deductible contributions to your account. The maximum annual contribution is specified by the tax law, with periodic inflation adjustments. Contributions are completely discretionary, which means you need not contribute anything in years when cash is tight.
Your account balance at retirement age will depend on: (1) how soon you begin contributing, (2) how much you contribute, and (3) the rate of return earned on investments held in your account. The sooner you start contributing, the sooner you will start reaping annual tax savings. Your account’s earnings are allowed to accumulate tax-free until you begin taking withdrawals. Even better, there’s no limit on how much can be accumulated in your account. For the same reasons, the more you contribute each year, the better. Defined-contribution plans include simplified employee pension (SEP) plans, Simple IRAs, profit-sharing plans for small corporations, and 401(k) plans for small businesses including those with only a single owner.
The distinguishing feature of a defined-contribution plan is that the maximum amount that can be contributed to your account each year is calculated based on a percentage of your compensation or self-employment income for that year — subject to the following annual maximum contribution limits.
- For a SEP plan, 20% of self-employment income or 25% of salary if you are an employee — subject to a maximum of $ 54,000 for 2017.
- For a 401(k) plan, up to $ 54,000 for 2017 or $ 60,000 if you will be 50 or older as of Dec. 31, 2017.
- For a Simple IRA, up to 100% of self-employment income or salary — subject to a maximum of $ 12,500 for 2017 or $ 15,500 if you will be 50 or older as of year-end plus 3% of self-employment income or salary.
- For a self-employed defined contribution Keogh plan or a corporate profit-sharing plan, 20% of self-employment income or 25% of salary — subject to a maximum of $ 54,000 for 2017.
Bottom line on defined-contribution plans: SEP and Simple IRA plans are super easy to set up. If you earn healthy bucks, the SEP alternative will permit relatively generous annual deductible contributions, but the 401(k) alternative may permit even bigger deductible contributions. If your earnings are modest, SIMPLE-IRAs allow larger annual deductible contributions. If you have employees who don’t stick around too long and you don’t want to cover them, consider the self-employed defined contribution Keogh plan/corporate profit-sharing plan option. Those plans allow you to avoid having to make contributions for short-timers.
Defined benefit plans
Under a defined benefit pension plan, contributions to your account are based what is needed to fund a “target” level of annual benefits after you reach retirement age. The annual benefit is usually based on a percentage of earnings during your last few years of work. You (if you are self-employed) or your company (if you are employed by your own corporation) make annual deductible contributions to your account in amounts sufficient to fund the promised level of retirement-age payouts.
Contribution amounts must be calculated by an actuary based on: (1) your remaining number of years to retirement, (2) the expected rate of return on investments held in your account, (3) the promised level of annual benefits, and (4) your current account balance.
Here’s the key selling point: very large annual contributions will be required to adequately fund your defined benefit account if you are a high earner and relatively close to retirement age. In this scenario, you have only a few years left to build up an account balance big enough to deliver the promised (hefty) level of annual post-retirement payouts. Therefore, large annual contributions are needed, which translate into large annual deductions, which in turn translate into large annual tax savings for you. For 2017, a defined benefit plan cannot specify a target annual payout in excess of $ 215,000 (this limitation is adjusted periodically for inflation).
If you are self-employed, you make annual contributions with your own money. If you are an employee of your own corporation, the company sets up the plan and makes annual contributions to your account.
Bottom line on defined benefit pension plans: If you are a high earner, age 50 or over, with plenty of available cash (from either your own coffers or your corporation’s war chest), the defined benefit pension plan may be the best choice. The big negative: you are locked into making mandatory annual contributions until your account becomes fully funded. For that reason, you should strongly consider the 401(k) plan option, which also permits large annual deductible contributions for those age 50 and older with the flexibility to make minimal contributions or no contributions in years when cash is tight.
The last word
You now understand the basics about defined-contribution plans and defined benefit pension plans. However, there are lots of additional details not covered here, including some requirements to make contributions for employees, if you have any. Therefore it’s a good idea to consult a retirement plan provider or expert before actually installing a plan — except in the very simplest of situations — like setting up a SEP plan for your one-person business.