retirement savings tax hacks

In today’s post (and corresponding podcast episode) we talk to Joshua Zirilli, CPA about some of the retirement options available to small business owners and how they can be used to save on taxes. We want to make sure you read to the end because Joshua is going to explain a strategy to turbocharge your retirement savings that is unfamiliar to most people.

What do you wish your clients knew about saving for retirement?

One thing that I wish more of my customers understood about saving for retirement is that the amount you save is not a 1 to 1 reduction in your take home pay.  This is due to the tax savings. Here’s an example:  If you are in the 22% tax bracket and contribute $6,000 to your tIRA or 401k, that’s $500 per month, your take home pay is only reduced by $390 per month, so it effective only costs you $4,680 to save $6,000 since you save $1,320 in federal taxes.              

So here are some of the retirement options available that will help you get these tax savings:

Simplified Employee Pension (SEP), or SEP IRA

Contribute as much as 25% of your net earnings from self-employment, up to $57,000 for 2020.

Many CPAs like this plan because you can set it up for the prior year as late as the due date (including extensions) of your income tax return for that year (i.e. you can still set up and fund a SEP for tax year 2019 – possible to extend until October 2020).  So it’s a way to help business owners save on their taxes even after the tax year ends.

One downside is that if you have employees, you typically have to make contributions to their account that are equal to your contribution percentage.     

Savings Incentive Match Plan for Employees (SIMPLE IRA Plan)

You can put all your net earnings from self-employment in the plan: up to $13,500 in 2020, plus an additional $3,000 if you’re 50 or older, plus either a 2% fixed contribution or a 3% matching contribution.

Downside – lower contribution limits, need to establish the plan by Oct 1 of current tax year, and have to match employee contributions.

401(k) plan – Can be traditional or Roth

Make annual salary deferrals up to $19,500 in 2020, plus an additional $6,500 if you’re 50 or older either on a pre-tax basis or as designated Roth contributions.

Contribute up to an additional 25% of your net earnings from self-employment for total contributions of $57,000, including salary deferrals.

Tailor your plan to allow access to your account balance through loans and hardship distributions.     

One of my favorite retirement plans is a one-participant 401(k) plan is sometimes referred to as a “solo-401(k),” “individual 401(k).”  It is generally the same as other 401(k) plans, but because there are no employees other than your spouse who work for the business, it is exempt from discrimination testing.  This plan typically allows you to save more than you could with a SEP or SIMPLE IRA since it allows for both salary deferrals and employer contributions.

Most of the major brokerages (Vanguard, Etrade, Fidelity) offer solo 401k plans.

Other defined contribution plans

Profit-sharing plan: allows you to decide how much to contribute on an annual basis, up to 25% of compensation (not including contributions for yourself) or $57,000 (for 2020 and $56,000 for 2019).

Money purchase plan: requires you to contribute a fixed percentage of your income every year, up to 25% of compensation (not including contributions for yourself), according to a formula stated in the plan.          

Defined benefit plans

Traditional pension plan with a stated annual benefit you will receive at retirement, usually based on salary and years of service.

Benefit may also be defined based on a cash balance formula in a hypothetical individual account (a cash balance plan).

Maximum annual benefit can be up to $230,000 (for 2020 and $225,000 for 2019).

Contributions are calculated by an actuary based on the benefit you set and other factors (your age, expected returns on plan investments, etc.); no other annual contribution limit applies.

Retirement accounts available to all taxpayers:

Kyle discussed these next accounts in the 10th podcast but I will briefly mention them again.

Traditional Individual Retirement Account (tIRA); account is funded with PRE-TAX money and grows TAX-DEFERRED; withdrawals at retirement 59.5 are taxed as ordinary income; good choice if you expect your tax bracket in retirement to be lower than your current tax bracket

Roth Individual Retirement Account (rIRA):  account is funded by AFTER-TAX contributions and grows tax free; withdrawals at retirement 59.5 are made tax-free; good choice if you expect your tax bracket in retirement to be higher than current tax bracket

For 2020, you can contribute up to $6,000 ($7,000 if 50 or older) to tIRA.

Whether or not you get a tax deduction depends on your modified adjusted gross income and whether or not you are covered by a retirement plan at work.

Brokerage Account:  account is funded with AFTER-TAX contributions; you pay tax on earnings each year, but often at preferable long-term capital gains tax rates; allows for greatest flexibility (no age restrictions on when you can withdraw money)            

BONUS:  Supercharge your retirement using the TRIPLE tax advantaged Health Savings Account (HSA) – BETTER THAN ROTH IRA!

Health Savings Account:  need to have a high deductible health plan (min deductible $2,800, max oop $13,800 for family plans, cut those in half for single plans)

  • contributions go in tax free (you get a deduction on your tax return)
  • money grows tax deferred
  • withdrawals for qualified medical expenses can be done tax free (otherwise ordinary income + 20% penalty)
  • at age 65, you can use the account like a traditional IRA (ordinary income, no 20% penalty)

I mentioned our firm caters to customers interested in achieving financial independence and possibly retiring early.  Here’s a strategy that I personally use to maximize savings:

  1. fully fund HSA account each year
  2. pay for any medical costs out of pocket (don’t use HSA funds)
  3. save receipts (preferably electronically)
  4. you can then let the account grow and benefit from compounding over time
  5. withdrawal funds TAX FREE at any point in the future (IRS does not have a time limit for when the funds need to be withdrawn).

I hope this information helps you to better understand the retirement accounts that are available for business owners and how saving for retirement can significantly reduce your tax bill.

Joshua Zirilli, CPA

Joshua is the owner of the tax firm Joshua Zirilli CPA in Barnegat, NJ. providing tax, accounting and advisory services to clients both locally and remote across the United States. You can view his website here or he can be reached via email at [email protected] or by phone at (609)467-4111

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