Although tax season may not be a crowd favorite, there are instances where individuals and employers can benefit. Taking preemptive measures and planning year-round in anticipation of everyone’s favorite day, Tax Day, there are situations that allow for lowering taxable income. In our previous edition, we discussed strategies for individuals and in this edition, we are going to delve into the strategies geared towards small business owners. Business owners have the opportunity to lower their taxable income and to motivate and entice their already hardworking employees.
Mitlin Financial Inc. - An SEC Registered Investment Advisor - SEP IRA
Is this going to be a good year financially? Did you have a new product or service that was a huge success? Do you think you will pay too much in taxes due to that success? Would you prefer to pay less in taxes and keep more for yourself and save for retirement at the same time?
Setting up a retirement plan could alleviate some of the stress of your tax bill and put you on the right path for retirement. As a small business owner, your business is typically set up in one of two ways. You may be established as an independent contractor or 1099 employee, which is typical in some service businesses, or you may be a corporation. Small businesses that are set up as corporations are very often S- Corps. Under either circumstance, you can take advantage of setting up a retirement plan, which will lower your tax burden while putting monies away for your financial future.
Retirement plans can be set up and funded by a small business regardless of their business structure. The type of plan, the amount you can contribute and your overall tax deduction may differ based upon your structure. Let’s take a look at one of the most popular options that would be available, the SEP IRA.
The SEP IRA allows a business owner to defer a maximum of 25% of their income into the retirement plan each year, which in turn will lower your tax liability. The 25% maximum applies to those business owners who are on payroll and paying themselves via W-2, which is the least common method for independent contractors. Paying yourself via W-2 will allow you to defer a maximum of 25% of the compensation listed on your W-2 for the year.
Those business owners that are simply using a Schedule C to determine their income for the year, which is most common for 1099 employees, have a maximum contribution of 20% of net income. Schedule C or 1099 employees are synonymous with the same type of employment status and are treated the same for retirement plan purposes.
It does not matter whether you are limited to 20% or 25%, the maximum dollar amount you can contribute for 2018 is $55,000. This amount changes annually, visit the IRS website for current limits. Keep in mind, a SEP IRA simply needs to be set up and funded before your tax filing deadline. The contributions are not mandatory and can change from year to year based upon your annual success. This gives you a lot of flexibility from year to year and plenty of time to review your year-end tax situation prior to contributing.
As an example, if you are an independent contractor (1099) in the 25% tax bracket who had a net income of $200,000 and set up a SEP IRA. The SEP IRA would allow you to make a maximum contribution of $40,000 (20% of your net income). This would lower your taxable income from $200,000 to $160,000. In turn, your tax bill will be reduced by $10,000. Essentially the $40,000 contribution made to your SEP IRA only cost you $30,000.
The SEP IRA will work the same way for those businesses set up as corporations. The only difference will be that they will be able to contribute 25% of their W-2 wages. Keep in mind that you if you are paying yourself via W-2, you can only include the W-2 wages to determine your maximum contribution. Shareholder distributions are not included as compensation for calculating your SEP IRA contribution.
You need to be aware that if you have employees this may not be the best option because you will be required to contribute for employees that have been with you three years or more. The percentage used to determine your contribution would be used for your employees as well, which may create a financial burden.
Mitlin Financial assists our clients in setting up retirement plans for them and their businesses. We would be more than happy to assist you with any questions that you may have on this topic, including which retirement plan would be best for your business. Feel free to contact us, Mitlin Financial, at (844) 4-MITLIN x12 if you or someone you know needs assistance in reviewing their options.
This article represents the opinion of Mitlin Financial Inc. It should not be construed as providing investment, legal and/or tax advice.