Tax Planning is an essential part of being a business owner. As your income grows, the options may seem more complicated, but they are also more valuable. Filing your taxes is not fun, and most business owners are busy, so proactive tax planning tends to get pushed aside. This can often result in higher than necessary tax bills for business owners. I just had two clients highlight this; both were missing out on more than $100,000 of tax deductions. Skipping these valuable tax deductions could cost each business an additional $500,000 in taxes over the next decade.
Business Owners Can Max Out a 401(k) Profit-Sharing Plan
The first business owner had been told by his CPA for years to set up a 401(k) plan. He and his husband’s business have adequate savings and income to fully fund a 401(k) profit-sharing plan. Both men are over 50, so each of them can max out the 401(k) with $58,000, plus the $6,500 catch-up contribution, for a total deduction of $64,500 each. Combined, this is a $129,000 tax deduction. At their income level, maxing out their 401(k) plan could save them more than $64,000 per year in taxes between federal and California income taxes.
In case saving $500,000 in taxes wasn’t motivation enough, maxing out the 401(k) for a decade could make these gay business owners multi-millionaires. Assuming they put $129,000 into the 401(k) each year for the next ten years and earned ten percent per year, the combined balances of their 401(k)s would be more than $2 million.
They were getting good advice from the CPA on setting up the plan. They just needed a little more guidance on how to set up the 401(k) plan for their small business. Ultimately, setting up and running a small business retirement plan can take some work (especially if you have a lot of employees). But in this case, the time spent planning to reduce their taxes took nowhere near the time it would have taken each of them to earn another $64,000 each year.
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Many Business Owners Are Unaware of the Benefits of Cash Balance Plan
A second business owner recently reached out after, as he put it, “I’ve outgrown my CPA. They told me to max out a SEP IRA and call it a day.” With nearly $1 million in gross income, this didn’t sit well with the business owner. He read my article Defined Benefit Plan Can Lower Your 2020 Taxes, which he asked his current financial guy about. His current financial advisor (at a large well-known firm) was unable to offer guidance or help set up a defined benefit plan, so he reached out wanting to know if the plan could still be set up and if he could benefit.
From our initial conversation, he sounded like an ideal candidate for a cash balance or defined benefit plan. He is a small business owner with a high income (generally, at least $290,000), in this case, near $1 million per year. Lowering taxes and saving for a secure retirement are both goals of his. Likewise, he has the desire and ability to sock away large amounts of money to lower his current taxes and save for retirement.
After running the numbers, he can switch from a SEP IRA to a solo 401(k), allowing him to make a catch-up contribution of $6,500 each year. While not life-changing, it does help. Depending on how the defined benefit cash balance plan is designed, he could put away an additional $100,000 on top of his contribution to his 401(k). Total tax-deductible contributions would be around $164,000. The tax savings will be huge over the next decade and will greatly increase his income in retirement.
This business owner wisely asked me why I think more people aren’t talking about this. My response was basically that most business owners aren’t willing or able to save this kind of money each year. Even among those with high incomes, the temptation to spend all your profits without regard to taxes is very tempting. For your financial future and minimizing your current tax bills, do yourself a favor and don’t procrastinate when it comes to tax planning for your small business. The cost to your retirement security and current tax liabilities can be huge.