Individual entrepreneurs, business owners and professionals often work days, nights and weekends. They may not have the time to develop a financial plan that would allow them to save a significant portion of their income for retirement while reducing their taxes by tens of thousands of dollars each year. But it’s easy to do — and for some, there’s still time to do it and file your 2021 taxes on time if you filed an extension.
Consider this scenario:
You work as a doctor, lawyer, real estate professional, or tech business owner and earned $500,000 in 2021. If you’re married and file a joint return, you and your spouse will pay a marginal rate of 35% income tax in federal income tax only. on a portion of your earnings. At a marginal tax rate of 35%, a $50,000 pension contribution would save you $17,500 in federal income tax.
If you have a calendar year partnership or S Corporation and have filed an extension, you have until September 15 to file the 2021 federal business return. If you have a Schedule C on your Form 1040 and you have filed an extension, you have until October 15 to file your 2021 federal income tax return. This gives you plenty of time to start one or more new retirement savings plans – a way to build long-term wealth – while significantly reducing your tax bill.
Here is a brief summary of some of the retirement plans available to you:
Simplified Employee Retirement (SEP)
A SEP allows a small business owner to create and contribute to a SEP Individual Retirement Account (SEP IRA). Contributions to an SEP are limited to about 20% of your net self-employment earnings (or 25% of your W-2 salary if you have an S corporation) with a limit of $58,000 for 2021 and 61 $000 for the 2022 tax year.
Business owners who have not yet filed their 2021 returns still have time to contribute to one of these plans until the extended due date.
A solo 401(k) retirement plan
This is a retirement account designed for self-employed business owners with no other employees (other than a spouse). Although the deadline for making an “optional deferral” contribution for the 2021 tax year has passed, there is still time to make an election to adopt a plan for the 2021 tax year that would allow the contribution “employer” for 2021.
If you received a sufficient salary or had sufficient net income from self-employment (depending on the type of entity), the “employer” can contribute up to $58,000 for the tax year 2021 and $61,000 for the 2022 tax year. In future years, when an “optional deferral” is possible, a catch-up contribution of an additional $6,500 is available for those age 50 or older.
Cash Balance Plans
Cash balance plans provide an additional option for retirement and tax savings for high-income solo business owners — such as those already maxing out the 401(k) plan or SEP IRA. If you’ve extended your return, you have until September 15 to continue contributing to a cash balance plan for the 2021 tax year (a Schedule C doesn’t get an extra month like other plans).
These plans are different from SEPs and 401(k)s because they are defined benefit plans instead of defined contribution plans and will require a contribution each year. The maximum amount you can contribute depends on your age and the terms of the plan (you work with an actuary to determine the contribution), but over time larger and larger contributions may be allowed. These plans can be combined with a 401(k) to allow for even higher contributions, although you must coordinate overall contributions between plans.
With a combined plan, you could contribute more than $100,000 annually in retirement (and sometimes much more). In addition to helping a solo owner build wealth quickly, a cash balance plan has other benefits. For example, once retired, the owner has the option of taking this savings in the form of an annuity spread over several years or in the form of capital, which can be invested.
Clearly, by contributing to one or more of these plans, solo entrepreneurs and small business owners can generate the savings and investment returns they will need for a comfortable retirement. I recommend to my clients that they contribute at least 10% to 15% per year, which allows them to achieve this goal.
Senior Advisor, Moneta Group
As a CERTIFIED FINANCIAL PLANNER™ Professional and Financial Advisor at Moneta, Maggie Rapplean brings an entrepreneurial spirit that helps her connect with other business owners and next-generation investors, as well as with 401(k) plan sponsors. She focuses on family financial planning, financial planning for women, financial planning for businesses, and financial planning for couples. With nearly a decade of experience, Maggie provides financial education to retirement plan participants and clients with the goal of increasing financial literacy and retirement readiness. She graduated Summa Cum Laude from the University of Missouri – St. Louis, earned her Bachelor of Business Administration degree, and is currently earning her MBA from UMSL.