The year is almost over. Not much time at all to take steps that reduce your taxes. But one last-minute idea to share. An easy trick that can help some self-employed taxpayers save income taxes. That trick? The pension plan tax strategy.
In other words, if you run your own business, even a sideline or part-time venture, you can possibly save significant income taxes by setting up a pension plan for yourself.
Note: To see a complete list of our tax strategy blog posts click here: Tax Strategy Tuesday.
Pension Plan Tax Strategy in a Nutshell
To show the details, let’s look at two situations: One where someone with a regular W-2 job earns $20,000 from a side hustle.
And then, another one where someone works full-time in their own business and earns $200,000. To keep the math simple, I assume this full-time business owner works as a sole proprietor. Also, that she or he employs no other workers.
In both of these situations, the business owner can probably setup one of three attractive pension plan options.
SEP-IRAs Allow for Easy Contributions
A first option to consider: A SEP-IRA plan that will allow the business owner to contribute roughly 20 percent of her or his profit to the pension.
SEP stands for simplified employee pension. With a SEP plan, an employer contributes a set percentage of a person’s compensation to the employee’s IRA. Or to the business owner’s IRA.
The contribution limit? Up to 25 percent of an employee’s compensation. Roughly up to 20 percent of the proprietor’s income.
Example: Someone who earns $20,000 annually in their own small business can probably make a SEP-IRA contribution equal to roughly $4,000. Someone who earns $200,000 annually can probably make roughly a $40,000 SEP-IRA contribution.
401(k) Plans Allow for Larger Contributions
A second option to consider: A 401(k) plan.
A 401(k) plan allows the business owner to contribute as much as 20 percent of her or his profit to the pension plus an elective deferral. An elective deferral equals as much as another $19,500 in 2021 and then as much as $20,500 in 2022. For business owners and employers aged 50 or more, those limits bump up to $26,000 in 2021 and $27,000 in 2022.
Example: If someone earns $20,000 annually in a small business, they can probably make a 401(k) plan contribution equal to roughly $20,000. (The amount someone contributes can’t exceed what they earn.) If someone earns $200,000 annually, they can probably make roughly a $40,000 contribution plus an elective deferral of $19,500 to $27,000 depending on their age.
The maximum 401(k) plan contribution for employees and shareholder-employees equals 25 percent of wages.
Example: Say a business owner makes $200,000 in his business. Further say he operates as an S corporation and that the S corporation pays him $100,000 in wages. In this case, the maximum 401(k) contribution equals $25,000 plus the elective deferral.
Defined Benefit Plans Allow for Giant Contributions
A third option for some taxpayers to consider—especially older taxpayers: A defined benefit plan which allows a taxpayer to contribute amounts unconnected to their current year income. Instead, the defined benefit plan looks at someone’s historical income and what that person needs to accumulate by retirement in order to enjoy some set retirement income amount (or “defined benefit.”)
This may be a helpful bit of information to know: When you hear about some pension plan that promises to pay 50 percent or 75 percent of someone’s average earnings if they’ve worked X number of years? Yeah. That’s a defined benefit plan. And that amount the employer needs to pay into the plan in order to deliver the promised benefit? Subject to certain tax law limitations, that amount equals the contribution.
Example: Say someone earns $20,000 annually in their small sideline business. Further assume they’ve earned this amount for decades and will retire a short ways down the road. The business may be able to setup a defined benefit pension plan and contribute $50,000 a year to a defined benefit pension plan.
Example: Say someone who earns $200,000 annually. And has for decades. A business owner in this situation, if close to retirement, may be able to contribute $150,000 annually. Or $200,000.
A final note: Neither you nor your accountant calculates the defined benefit plan contribution amount. An actuary calculates the pension plan contribution required to fund the retirement income stream.
Possible Tax Savings from Pension Plan Strategy
A big pension plan contribution substantially reduces your income taxes for the year you make the contribution.
If you make a $20,000 contribution and your marginal income tax rate equals 25 percent, for example, the savings equal $5,000.
If you make a $60,000 contribution and your marginal income tax rate equals 30 percent, the savings equal $18,000.
Make a $200,000 contribution if your marginal tax rate equals 50 percent? The savings equal $100,000.
But an important point to remember: The amounts given above represent deferrals. When a taxpayer withdraws the money from a pension plan, she or he will probably pay income taxes then. But probably at much lower tax rates. Most people enjoy higher incomes while they work as compared to during retirement.
Turbocharging the Pension Plan Tax Strategy
You turbocharge your pension plan tax strategy by contributing the most money possible to your retirement nest-egg for as long as you can. That’s the basic optimization technique. And three turbocharging tactics for doing this should often be considered.
Multiple Pension Plans?
First, an individual may be able to start multiple pension plans.
A business that already runs a 401(k) plan may be able to set-up a defined benefit plan, for example.
Or, an entrepreneur who is a partner in a ten-employee software company and who owns a one-person consultancy may be able to add a second pension plan for the second business. If the software company already provides a 401(k) plan, for example, the business owner may be able to setup a SEP-IRA or defined benefit pension plan for the one-person consultancy.
Note: An employer’s pension plan or plans need to not discriminate in favor of owners and highly-compensated employees. Further note that tax laws group employers or businesses with the same or nearly identically ownership into a single employer. In the case where an entrepreneur operates a one-person consultancy and owns 100 percent of a software company, tax laws say the employer for pension purposes is the combination of the two businesses. Also tax laws can group businesses that don’t share ownership if the firms represent an affiliated service group. Given these complexities, you want to get your tax advisor’s help in situations where a business owner operates or controls multiple entities.
Adding Family Members to Plan?
A second idea to turbocharge a pension option. In some cases, an employer may be able to double, triple or quadruple pension plan contributions by adding (legitimately) a spouse or other family members to the pension plan. If a business owner’s spouse works in the business, for example, he or she should be paid wages. And if a pension plan exists, he or she should probably participate.
Caution: A business owner usually doesn’t save money by adding family members to the payroll only to get a bigger pension deduction. The reason? The extra payroll taxes triggered usually more than eat up any tax savings from the extra pension deductions.
Plans for Last Wind-down Years?
A third tactic for situations where an owner winds down a small business. In some situations, the wind-down of a business creates a unique opportunity. If the last few years of a business’s life require only the owner to work—maybe a sale occurred, for example—that may be a perfect time to setup a new hyper-generous pension plan for just the owner.
Example: A small business owner sells his firm’s assets in a transaction that results in the owner receiving large payments over the years following the sale of the firm. Very possibly, the seller can set up a pension plan at that point and make large annual pension plan contributions.
Limits to Strategy
Some limits exist for the pension plan strategy.
First, firms should consider the costs.
Employee matching contributions paid to non-owners become very significant.
Fortunately, most SEP-IRA and single participant as well as owner-and-spouse 401(k) plans don’t burden a business with additional administrative costs.
But most small business 401(k) plans and single-participant defined benefit plans cost a few thousand dollars a year. Maybe $1,000 to $2,000 for a small business 401(k), for example, if the plan handles multiple participants? Maybe $2,000 to $4,000 annually for a single-participant defined benefit pension plan?
Elective Deferrals Per Individual
Second, note that tax law limits most individuals’ elective deferrals across all of her or his pension plans to $19,500 in 2021 and $20,500 in 2022. For taxpayers aged 50 or older, the limits equal $26,000 in 2021 and $27,000 in 2022. But the point here: Obviously if an individual works at a full time W-2 job and uses fully uses the elective deferral for that job’s 401(k) plan, she or he can’t also use an elective deferral for a second pension plan.
Non-discriminatory Matching Percentages Required
Third, note that in general the matching percentage used for a business owner needs to, for practical purposes, equal the matching percentage used for any employees who work at the business.
A business however often can set the percentage to zero or some other low amount as long as that percentage gets used for everyone. Also note that some employees can often be excluded from a an employer’s pension. Children for example.
Note: A minor complexity exists with regard to sole proprietor and partner pension amounts: The equivalent owner pension percentage equals the employee percentage divided by one plus the employee percentage. A 25 percent employee contribution equates to a 20 percent owner contribution, for example, because .25/(1.25) equals .2.
SEP-IRA and 401(k) Limits
Fourth, tax law limits the pension plan deductions a business can make to a SEP-IRA or 401(k).
The limit for a SEP-IRA contribution equals $61,000 for 2022 and $58,000 for 2021, and then not more than 25 percent of an employee’s compensation or more than roughly 20 percent of a sole proprietor’s or partner’s compensation.
Higher limits exist for 401(k) plans. The total 401(k) contribution for an individual can’t exceed 100 percent of the person’s compensation. Further, the deduction can’t exceed $58,000 in 2021 and can’t exceed $61,000 in 2022 for folks under age 50. Folks aged 50 or older get limited to $64,500 in 2021 and $67,500 in 2022.
Remember Permanency Requirement
Finally, fifth, an employer needs to run its pension plan for a few years. Here’s why: Pension laws require that pensions be “permanent.”
Therefore, you cannot run one plan for a year, shut it down, start up some new plan a little while later, shut it down, and so on. That behavior probably violates a permanency requirement.
Ask your tax advisor or pension administrator for details. Usually if you operate the pension for a few years, that counts as permanent enough.
Other Information Resources
The Internal Revenue Service provides rich, easy-to-read information about retirement plans at its website (click here.)
Any of the big financial services firms will help you set up a pension plan. Mutual fund giant Vanguard.com works well for SEP-IRA plans and for one participant 401(k) plans because they offer such low-cost investment options. We like (and ourselves use) Guideline.com for small business 401(k) plans with multiple employees because they offer pretty economical, pretty convenient solutions for most small employees. Finally, to get the names of good defined benefit plan providers, ask your tax advisor. He or she will probably know of several vendors in your area or who serve firms your firm’s size.
Finally, and as always, taxpayers want to discuss a strategy like the one described in this blog post with their tax advisor. He or she knows the details of your specific situation. And this traditional plug for our CPA firm: If you don’t yet have a tax advisor who can help, please consider our firm: Nelson CPA.