It is almost tax time! For some, that statement can be nerve-wracking. If you are an employer (or self-employed), this time of year typically means compiling a monstrous stack of paperwork and receipts. It can also mean consulting with a CPA (certified public accountant) to get your filing completed.
Although you may be envious of those with a W-2 and simple filing, there are many advantages and tax strategies for those who are self-employed. It is important to implement these retirement tax strategies as soon as possible (preferably before year end) to get the most benefit from these savings on your 2021 tax bill. If you are searching for ways to snag some extra savings on your tax-bill, look no further than your own retirement account.
Being Strategic with Your Retirement
Aside from building your nest egg, there are additional benefits to saving for retirement that you may not be aware of. Depending on your retirement method, there can be tax savings on your return just for contributing to your own retirement! You can also strategize your retirement plan to save yourself on taxes in the future (at retirement age) and pay them ahead of time resulting in tax free income in retirement.
Tax planning for retirement doesn’t have to be complicated. Here’s what we mean.
Types of plans:
Below we have included a few different types of retirement plans to consider. If you have questions about this information, don’t hesitate to reach out to us for help.
A cash balance plan is a great option for business owners/employers. This is a pension plan where employers can contribute a set percentage of their employee’s annual income that translates into an annuity at retirement age.
A cash balance plan, a type of defined benefit pension plan, promises an employee an employer contribution equal to a percent of each year’s earnings and a rate of return on that contribution. The benefit is always expressed as a total account balance (Bureau of Labor Statistics).
This particular plan works best for the following groups:
- Doctor’s offices and other independent practices with small offices.
- Real estate agents and brokers with their own agency/employees.
- Individuals who work both a full time job and own a business on the side.
- Small businesses with fewer employees or subcontractors.
Those with fewer employees are likely to benefit more from a cash balance plan compared to companies with many employees who may benefit more from a 401(k) or 403(b) plan.
The Cash Balance plan can be a great vehicle for tax savings and offers many benefits to employers.
Similar to other retirement plans, the annual contribution limit goes up every year as you approach retirement age. A huge benefit to this plan is the generous contribution limit compared to IRA/401ks. An individual over the age of 60 can contribute up to $200,000 pre-tax in a cash balance plan.
For comparison, those with a 401(k) can only contribute up to $64,500 (including both the employee contribution and any employer match- if offered). This is a great tool for those who may be starting their retirement savings later in life but want to maximize their contributions.
By contributing to your cash balance plan with pre-tax dollars, you can offset your taxes owed by a significant amount. For example, if your annual income is $350,000 and you were to contribute the maximum contribution of $200,000, your new taxable income is now only $150,000.
This is a great tool for those who want to save in taxes now and defer taxes to retirement. It is best to speak with a trusted financial professional, such as those at Artesys, when trying to determine what plan is best for your situation.
Self Employed IRA (Traditional vs. Roth)
If you are self-employed looking for a retirement plan, a popular option is a Self Employed IRA (SEP-IRA). These accounts are easy to open. All it requires is filling out a form from the IRS, or going to a trusted financial institution to start your account.
This plan allows self-employed individuals to contribute up to a maximum of 25% of their net income with a limit of $58,000 per year (for 2021). It is not to be confused with a Traditional or Roth IRA, as they are different plans that offer different benefits.
The main benefit of the SEP-IRA is the contribution limit, which is much higher than its Traditional and Roth counterparts. The limit for both traditional and Roth IRAs is currently $6,000 per year. With a Traditional IRA (and SEP-IRA), you will be contributing pre-tax dollars, resulting in a lower tax bill as this will lower your taxable income. With a Roth IRA, you will be contributing after-tax earnings but will enjoy tax-free income at retirement.
Both Traditional and SEP-IRAs do not have any income eligibility requirements, although with a Roth IRA, your income cannot exceed the thresholds set in place by the IRS:
In 2021, for married filers who submit a joint tax return, the amount you can contribute is reduced for those who make more than $198,000 and is completely phased out if they make $208,000 or more. For single filers, the range is $125,000 to $140,000 for 2021 (Internal Revenue Service).
The SEP-IRA is also an option for employers with a small number of employees who want to set up retirement benefits. Employers can set up any of the three IRA plans to help their employees save for retirement. You can also choose to match employee contributions in a Traditional or Roth account.
In a SEP-IRA, employees cannot contribute (only the employer can), and the contribution must be the same for all employees. These contributions are tax deductible for the employer.
401k vs 403b
You are probably somewhat familiar with the terms 401(k) and 403(b) as an employer. These accounts are both tax-advantaged retirement accounts offered by employers (employees cannot set one up for themselves). The difference between the two accounts lies in what type of business you are operating.
A 401(k) plan is offered by a private, “for profit” company (applies to the majority of businesses), whereas a 403(b) plan is offered by a non-profit company as well as government employees.
A key difference between the two plans are legal regulations that apply to 401(k) accounts that do not apply to 401(b). Although both plans can offer company match, many 401(b) providers choose not to as to avoid losing ERISA exemption.
When deciding what plan is best for your company, you should consider how many employees you have. 401(k) and 403(b) plans are typically the best choice for those with a larger number of employees.
Some similarities between the plans include the contribution limit which is $20,500, the retirement age of 59.5, and both plans offer Roth options. These plans also allow for employers to match employee contributions and offer “catch-up” contributions up to $6,500 per year for employees aged 50 and over.
- Cash Balance Plans are a great tool for maximizing tax savings for employers (up to $200,000 a year in tax deductible contributions).
- Both Cash Balance and IRAs are the best choice for employers with a smaller number of employees.
- 401(k) and 401(b) are good choices for companies with more employees, they offer higher contribution limits than IRAs and allow for company matching.
- Roth plans allow for after-tax contributions, which results in tax-free retirement income while Traditional and Cash Balance plans allow you to contribute pre-tax resulting in less taxes owed at the end of the year.
Every business has unique needs and will benefit differently from retirement plans. There is no “one-size-fits-all” account and it is important to weigh the pros and cons of each retirement option. No matter what retirement account you are considering, it is always best to contact a trusted financial professional, such as Artesys, for help with deciding what is best for you and your business.
Have a Happy New Year!