Small Business Tax-Savvy Strategies for Retirement

As a small business owner, you may be thinking that your business is your retirement plan. Down the road, you’ll either keep running it, you’ll have a family succession, or you’ll sell. But if you’re not maximizing tax advantaged retirement plans, you’re leaving money on the table – particularly if your business doesn’t include other tax shelters, like real estate. At the same time, having a retirement plan held in investments can provide flexibility to grow your business, portfolio diversification, and even a measure of peace of mind in taking care of your loved ones.

We get into the details in this short read.

Maximizing a Retirement Plan … Starts with the Plans

Solo 401(k)

Just because you have a small business, 401(k) plan benefits aren’t out of reach. If your one employee is yourself, you qualify for a solo 401(k) plan. You get all the benefits of a company 401(k) and then some. As the employee, you can contribute up to the maximum, which is $19,500 in 2021. If you’re over 50, you can kick in an additional $6,500.

As the employer, you can contribute up to the total amount you can add as both employer and employee of $58,000. The employer amount is also subject to a limit of 25% of your company’s profits. You can choose either a traditional or a Roth 401(k), depending on whether you want the tax deduction now, or you want tax-free withdrawals in retirement.

And if your spouse helps out in the business – guess what? The same rules and contribution amounts apply to them, too. There are several different ways to structure this, from minimal income that is handled via W2 to creating a Qualified Joint Venture. You’ll want to select the structure that works best for the business and your entire financial picture.

SEP IRA

A SEP IRA allows you to contribute for yourself and your employees, up to the $58,000 maximum. There is no Roth option with a SEP, but you can open one on your own separate from the SEP. The percentage you contribute for your employees must be the same for everyone, but the benefit of a SEP is that it can be flexible from year-to-year. If you have a business with variable cash flows, this can be a good solution to give you an edge on tax savings when you need it, without locking you in when times are more difficult.

Simple IRA

A Simple (Savings Incentive Match Plan for Employees) IRA is generally for companies with 100 or fewer employees. It offers the benefit of an employee match but has a little more flexibility in the setup than a traditional 401(k) plan. The percentage has to be the same across all employees, but the employer can decide whether the match is elective (meaning the employee has to contribute above a certain amount to get the match) or non-elective (the firm contributes the specified percentage regardless of employee contribution). Simple IRAs don’t have discrimination testing, and they are 100% vested – no waiting period. Cash Balance Plans, IRAs and 401(k)s are Defined Contribution plans.

For small business owners, the Defined Benefit world also has some significant tax savings. A Cash Balance Plan offers employees a traditional defined benefit pension plan with either a lump sum payout or an annuity on retirement. However, it’s structured like a defined contribution plan, except that employees do not need to select or manage an asset allocation. The employer sets an annual contribution as a percentage of salary (usually between 3- 8%) and pays a set interest rate. The real advantage of the CBP is that it can be structured so that the benefit levels are matched to the company’s needs. This means that high-salaried employees can have a different benefit level than the rank-and-file.

The maximum contribution rates for a CPB are much higher – like several hundred thousand dollars higher – than other types of retirement plans, which means the tax savings is higher too. They are also great for succession planning and for rewarding key employees.

It’s Not Just About the Tax Savings

Setting up the right retirement plan can save a lot of on taxes while helping you invest for growth. These additional funds can help you diversify your overall financial picture or provide a source of funds if necessary to help out the business or make a strategic acquisition (depending on the type of account and subject to penalties for early withdrawal). But they can also act as an effective estate plan. Retirement plans can pass quickly and outside of probate, providing necessary funds while the disposition of the business is sorted out.

The Bottom Line

Focusing on growing your business is at the core of the day-to-day for a small business owner. But thinking about the broader picture by investing in the right retirement structure can save on taxes, help you attract and retain employees, and provide you with freedom and flexibility.

Max Morgan, AIF, Partner