Have you procrastinated in setting up a tax-advantaged retirement plan for your business? If the answer is yes, you fit right in with many other business owners. Still, not having a plan in place hurts you and your business. Why? You pay more income taxes every year than necessary, giving away money that could serve better purposes.
However, you still have time to set things right and line yourself up for major tax savings for this year and beyond. This article explains the basics of tax-advantaged retirement plans, which are now better than ever thanks to changes in the tax law that permit larger annual deductible contributions.
Once you cut through all the technical details, you will discover that tax-advantaged retirement plans come in two basic varieties:
1. Defined contribution plans (which, as you will see, come in several varieties themselves).
2. Defined benefit pension plans (which only come in one variety).
Defined Contribution Plans
With defined contribution plans, the account receives annual deductible contributions. Tax law specifies the maximum annual contribution (usually with annual inflation adjustments). Small businesses can utilize discretionary contributions, which means they do not need to contribute anything in years when cash is tight.
Your account balance at retirement age will depend on:
• How soon you begin contributing.
• How much you contribute.
• 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 accumulate tax-free until you begin taking withdrawals. Even better, the IRS does not limit how much can be accumulated in your account. Defined contribution plans include defined contribution Keogh plans, corporate profit-sharing plans, and simplified employee pensions (SEPs).
Some defined contribution plans allow so-called salary reduction or elective deferral contributions, which come out of your salary (or deemed to come from your salary if self-employed). These plans also allow additional contributions to be made by your employer (or deemed made by the employer if self-employed). Salary reduction arrangements include 401(k) plans and SIMPLE plans. In any case, the distinguishing feature of a defined contribution plan is the maximum amount that can be contributed to your account each year.
Defined Benefit Plans
With the defined benefit plan, the amount needed to fund a promised target level of annual payments after you reach retirement age determines the contributions to your account. The annual benefit usually comes from a percentage of earnings during your last few years of work. You (if self-employed) or your company (if 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:
• Your remaining number of years to retirement.
• The expected rate of return on investments held in your account.
• The promised level of annual benefits.
• Your current account balance.
For those high earners close to retirement age, very large annual contributions are required to adequately fund the defined benefit account. 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. Large annual contributions translate into large annual deductions, which in turn translate into large annual tax savings for you.
For 2021, a defined benefit plan cannot specify a target annual payout in excess of $230,000. This limit adjusts annually for inflation. If you run your business as a sole proprietorship or single-member LLC, a defined benefit arrangement takes the form of a Keogh defined benefit pension plan. If employed by your own S or C corporation, the company establishes a corporate defined benefit pension plan on your behalf. For high earners, age 50 or over, with plenty of available cash, the defined benefit pension plan may serve as the best choice. However, a defined benefit arrangement is generally more expensive to establish and operate than other alternatives.
Funding your retirement requires careful planning. Contact a Hantzmon Wiebel team member if you have questions or want more information about the best plan in your situation.
© Copyright 2021 Thomson Reuters.
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