Small business owners face unique challenges that can complicate financial planning for retirement. The good news? You have the wealth. All you need to know is what to do with it so that the hard work you’re putting in now pays off later. Today, I’m going to take you through a crash course on how to choose a tax-deferred retirement plan for business owners.
Good tax planning is about keeping what you earn for retirement.
Without proper planning, small business owners risk paying more in taxes and having less to spend when they retire. According to a study by SCORE, more than a third of small business owners do not have a retirement plan in place.¹ Those who do have accounts tend to fall short of the maximum contribution limits and miss out on tax benefits.
Contributions to retirement savings plans become tax-deferred wealth.
Why? Here’s how it works: The money you put in these retirement plans grows without being subject to taxation. But, when you withdraw the funds, what you withdraw is taxed as income. So, taxation is “deferred.” Because retirees tend to pull in less annual income and occupy a lower income bracket, taxation will be far less severe.²
Your future is not secure until you’re on track to support yourself and your family in retirement.
Let’s explore the various small business retirement plans that allow you to grow savings while maintaining a tax advantage.³
1. 401(k) plans allow you to defer taxes on the wages you contribute.
Two tax advantages of sponsoring a 401(k) plan include the fact that both the employee and the employer contributions can be deducted from federal income tax returns within limits, and employer and employee contributions and investment gains are not taxed until distribution.⁴
2. A traditional 401(k) lets employees of a business save for retirement with pre-tax money.
Contributions reduce your taxable income this year, and you don’t need to pay taxes until you withdraw the money. For 2024, employees can contribute up to $23,000, with an additional $7,500 available for catch-up contributions for those over the age of 50.⁵
3. Solo 401(k) plans are available to self-employed individuals with no full-time employees.
The contribution limits are higher because they combine both employee and employer contributions of up to $69,000 in 2024 ($76,500 including catch-up contributions).⁶ Recent changes now allow benefits for non-owner employees, such as spouses and children, making it accessible for more types of businesses, including LLCs and those with significant annual revenue.⁷
4. A Safe Harbor 401(k) plan simplifies compliance issues.
Safe harbor 401(k)s come with a similar set-up process, and contribution limits are similar to traditional 401(k)s. Still, by requiring mandatory employer contributions that are immediately vested (owned by the employee at once rather than over time), compliance is simpler.⁸
IRAs offer tax-deferred retirement plans for business owners and employees.
Unlike 401(k)s, which are designed for employers, IRAs can be created by anyone. They also come in a variety of different forms with different tax treatments.⁹
1. Traditional IRAs offer tax-deductible contributions.
Available to anyone under age 70 with earned income, you can contribute up to $7,000 in 2024, with a $1,000 catch-up contribution for those aged 50 and over, depending on income and participation in other retirement plans.¹⁰
2. Simplified Employee Pension Plans (SEP IRAs) allow high contribution limits.
Any business, including self-employed individuals, can take advantage of SEP plans.¹² Business owners must make contributions for all eligible employees, and these contributions must be equal as a percentage of pay to the ones made for the owner: up to 25% of compensation, or $69,000 for 2024.¹³
3. Savings Incentive Match Plans for Employees (SIMPLE IRA) offers easy setup and maintenance.
The SIMPLE IRA model is designed for small businesses with 100 or fewer employees. It’s easy to set up and maintain and has lower administrative costs. In 2024, employees can contribute up to $16,000 with a $3,500 catch-up contribution for those aged 50 and over.¹⁴
What about tax-exempt retirement plans?
I’ll be covering these more in-depth in a later article, but when we look at tax-exempt plans, we start with Roth IRAs and Roth 401(k)s. While these accounts provide tax-free qualified distributions, they are only available to individuals with earned income below certain thresholds.
How are they “exempt” from taxation? Well, contributions to a Roth IRA are made with after-tax dollars, so qualified distributions in retirement are not taxed.¹⁵
Altogether, the right tax-deferred retirement plan for business owners may be preferable in many circumstances simply because of those earned-income thresholds.
Defined Benefit Plans offer high contribution potential.
Defined Benefit Plans provide a fixed, pre-established benefit at retirement based on factors like salary history and duration of employment. These plans are particularly beneficial for business owners who want to make large contributions and maximize their tax deductions. In 2024, the annual benefit limit is $275,000. ¹⁵
412(e)(3) plans combine annuities and life.
A 412(e)(3) plan is a fully insured defined benefit plan funded by a combination of annuities and life insurance.
Some positives include high contribution limits and exemption from certain funding requirements, ensuring predictable retirement benefits. However, 412(e)(3) plans come with specific and onerous requirements, including the disallowal of policy loans and paying premiums in full to avoid penalties.¹⁷
It’s time to future-proof your wealth.
Schedule a consultation, and we’ll get busy finding a tax-deferred retirement plan for you and your family.
Talk soon,
Jeremy A. Johnson, CPA
References
1. Investopedia. Only a third of small businesses offer retirement plans [Internet]. Available from: https://www.investopedia.com/only-a-third-of-small-businesses-offer-retirement-plans-7497113#:~:text=Key%20Takeaways,packages%20offered%20by%20big%20companies.
2. Internal Revenue Service (IRS). Retirement Plans [Internet]. Available from: https://www.irs.gov/retirement-plans
3. Internal Revenue Service (IRS). Types of Retirement Plans [Internet]. Available from: https://www.irs.gov/retirement-plans/plan-sponsor/types-of-retirement-plans
4. Internal Revenue Service (IRS). Publication 4222, 401(k) Plans for Small Businesses [Internet]. Available from: https://www.irs.gov/pub/irs-pdf/p4222.pdf
5. Internal Revenue Service (IRS). 401(k) Plans [Internet]. Available from: https://www.irs.gov/retirement-plans/401k-plans
6. Internal Revenue Service (IRS). 401(k) and Profit Sharing Plan Contribution Limits [Internet]. Available from: https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-401k-and-profit-sharing-plan-contribution-limits
7. Internal Revenue Service (IRS). One-Participant 401(k) Plans [Internet]. Available from: https://www.irs.gov/retirement-plans/one-participant-401k-plans
8. Internal Revenue Service (IRS). 401(k) Plan Overview [Internet]. Available from: https://www.irs.gov/retirement-plans/plan-participant-employee/401k-resource-guide-plan-participants-401k-plan-overview
9. Internal Revenue Service (IRS). Individual Retirement Arrangements (IRAs) [Internet]. Available from: https://www.irs.gov/retirement-plans/individual-retirement-arrangements-iras
10. Internal Revenue Service (IRS). 401(k) Limit Increases to $23,000 for 2024, IRA Limit Rises to $7,000 [Internet]. Available from: https://www.irs.gov/newsroom/401k-limit-increases-to-23000-for-2024-ira-limit-rises-to-7000
11. Internal Revenue Service (IRS). Simplified Employee Pension Plan (SEP) [Internet]. Available from: https://www.irs.gov/retirement-plans/plan-sponsor/simplified-employee-pension-plan-sep
12. Internal Revenue Service (IRS). SEP Contribution Limits Including Grandfathered SARSEPs [Internet]. Available from: https://www.irs.gov/retirement-plans/plan-participant-employee/sep-contribution-limits-including-grandfathered-sarseps
13. Internal Revenue Service (IRS). SIMPLE IRA Contribution Limits [Internet]. Available from: https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-simple-ira-contribution-limits
14. Internal Revenue Service (IRS). Defined Benefit Plan Benefit Limits [Internet]. Available from: https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-defined-benefit-plan-benefit-limits
15. Internal Revenue Service (IRS). Roth IRAs [Internet]. Available from: https://www.irs.gov/retirement-plans/roth-iras
16. Internal Revenue Service (IRS). Defined Benefit Plan [Internet]. Available from: https://www.irs.gov/retirement-plans/defined-benefit-plan
17. Internal Revenue Service (IRS). Fully Insured 412(e)(3) Plans [Internet]. Available from: https://www.irs.gov/retirement-plans/fully-insured-412e3-plans