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Key Year-End Tax Strategies, Part 3: Retirement Plansby
In this final article on year-end tax tips, I am going to explore the different retirement plan options for businesses and individuals, along with the rules associated with each one.
Typically, I like to have a chance to see my clients periodically throughout the year. At the end of every quarter, I do a complete tax analysis, where I project out income, make adjustments to salaries, and look at the overall picture. There are so many things that we can do in June that we can’t do come January. So, it’s important to meet with clients more than just at tax time.
As year end approaches, and if all else fails, we can always recommend retirement plans for our clients as a last resort.
Retirement Plans for Businesses
Simplified Employee Pension IRAs are extremely popular among the self-employed. You can contribute 25 percent of your net income as a sole proprietorship or as an active partner in a partnership. If you are a shareholder in an S corporation or C corporation, you can contribute 25 percent of your compensation, up to $53,000.
When a client’s income is high, I like to recommend a safe harbor 401(k) plan. In a safe harbor plan, the client can contribute $18,000 of their salary deferral into the plan, or $24,000 if age 50 or older. On top of that, they can contribute 25 percent of their compensation into the plan, up to $53,000.
Now, you are probably saying don’t you have to do the same for your employees as you do for yourself? In a safe harbor plan, you need only match the participating employee’s plan by 3 percent of compensation.
The other good part of the safe harbor plan is that you can use a Roth option for your salary deferrals into the plan. So, conceivably, you could put $18,000 (or $24,000 if you are 50 or older) into the Roth option of the 401(k). The Roth option transcends normal Roth IRA rules on adjusted gross income (AGI).
The downside to a 401(k) plan is that it can be expensive to start and maintain. I refer my clients to a financial planner to do their 401(k) plans, and when they gripe about the cost (which just happens to be the exact amount of maximum tax credit that you get for opening a retirement plan), I am quick to point out the tax savings they will receive.
When clients can’t get around the cost of a 401(k) plan, I move them in the direction of what I like to refer to as a “poor man’s 401(k),” which is a SIMPLE IRA. In a SIMPLE, you can defer up to $12,500, or $15,500 if you are 50 or older, into the plan. You can then match the contributions by 3 percent. The benefits of a SIMPLE plan, for your bargain-hunting clients, are that it offers them a way to defer some taxes, and the cost to open and maintain a SIMPLE is minimal.
When a client is looking to defer a lot of money into a retirement plan, I recommend a defined benefit plan (DBP). In a DBP, the actual amount of the contribution the client can make is determined by an actuary. The calculation is based on what the benefit will be in the future, as well as the age of the client. There are maximums. For instance, a client can pay himself $210,000 a year and his contribution to the DBP can also be $210,000. For ultra-wealthy clients, I use a DBP in conjunction with a 401(k) plan.
The downside to a DBP is that if the company has an off year and can’t make its contribution to the plan, there is a 10 percent excise tax, per month, until the contribution is made.
Retirement Plans for Individuals
Individuals are more complicated, in my opinion, when it comes to retirement planning. To put it in simple terms, if a client is not covered by a retirement plan at work, she can nest away up to $5,500 into an IRA. For clients age 50 or older, they can put $6,500 into the plan.
Now here is where it gets complicated. If you are covered by a retirement plan, you can now deduct your IRA contributions if you’re married and your household income is less than $184,000. If neither you nor your spouse has a work-sponsored retirement plan, you can deduct your IRA contributions no matter what your income.
For singles and heads of household who are covered by a workplace retirement plan, the income phase-out range remains unchanged at $61,000 to $71,000. The income limit for taking a full deduction for your contribution to a traditional IRA when you are not covered by a workplace retirement plan went up by $1,000 in 2016 to $117,000. The deduction completely phases out when your income goes above $132,000 (also up by $1,000 in 2016).
See what I mean? Fun with phase-outs.
I have a client who has made nondeductible contributions to his IRA since 1994. In 2012, he then converted the nondeductible IRA to a Roth IRA. Here is the problem: He didn’t keep his deductible and nondeductible IRAs separate. So, when he converted to a Roth IRA, one portion of the contributions was taxable on the conversion, and the other portion was nontaxable. His accountant at the time considered the entire conversion as taxable.
I had the pleasure of going in and undoing all of that. My bill was outrageous, but I had to segregate the basis and earnings of the nondeductible and deductible IRA contributions. The requested refund was $15,000.
When it comes to a Roth IRA, a client can put the same amount into it as a traditional IRA; however, there are AGI phase-outs.
With all of these phase-outs, contribution limits, AGI limitations, etc., I took the time to make you a little cheat sheet.
|Limit on employee contributions to 401(k), 403(b), or 457 plans||$18,000|
|Limit on age 50+ catch-up contributions to 401(k), 403(b), or 457 plans||$6,000|
|Traditional IRA and Roth IRA contribution limit||$5,500|
|Traditional IRA and Roth IRA age 50+ catch-up contribution limit||$1,000|
|SIMPLE 401(k) or SIMPLE IRA contribution limit||$12,500|
|SIMPLE 401(k) or SIMPLE IRA age 50+ catch-up contribution limit||$3,000|
|Maximum annual additions to all defined contribution plans by the same employer||$53,000|
|Highly compensated employee||$120,000|
|Deductible IRA income limit, active participant in workplace retirement plan, single||$61,000 – $71,000|
|Deductible IRA income limit, active participant in workplace retirement plan, married filing jointly||$98,000 – $118,000|
|Deductible IRA income limit, spouse is active participant in workplace retirement plan||$184,000 – $194,000|
|Roth IRA income limit, single||$117,000 – $132,000|
|Roth IRA income limit, married filing jointly||$184,000 – $194,000|
Actually, I can’t take credit for the table. I did modify it, but all of the grunt work was done by Betterment, a financial services company.
Whether your client is a business or an individual, guiding them with the right retirement plan is an excellent way to look out for their financial interests, help them with their year-end planning, and keep them coming back to you.
When it’s all said and done, putting money into a retirement plan is a great way to avoid taxes.
Craig W. Smalley, EA is the CEO and Founder of CWSEAPA®, PLLC, located in Orlando, Florida, with clients all over the country in every industry. He has been admitted to practice before the IRS as an Enrolled Agent, and has a Master's Certificate in Taxation from UCLA. He has been in practice since 1994, specializing in individual, partnership...