Reaching new (deferral) limits

Many business owners are looking to both enhance their retirement as well as reduce their current tax obligation by deferring as much income as they can into a retirement plan. Let's consider some of the options for tax year 2007.

Traditional IRA – maximum contribution is $4000 ($5000 if 50 years old or older), but many business owners incomes make them ineligible (phase out starts at $83,000 for married filing jointly).

Roth IRA – also allows a maximum contribution of $4000 ($5000 if 50 years old or older), but begins to phase out at $156,000 for married filing jointly. The Roth also is not tax deductible so while the business owner's retirement is enhanced, this option does nothing to reduce current taxes.

SIMPLE IRA – As a small business (less than 100 employees) you can establish a SIMPLE. The advantage to the business owner is a maximum deferral of $10,500 ($13,000 if 50 years old or older) and easy, low cost administration. All employees are eligible for the plan after meeting certain minimum requirements and the employer must elect to contribute 2% of their earnings or match 3% of their contributions.

SEP – The Simplified Employer Pension or SEP allows a small employer many of the advantages of the 401(k) without as much headache. The employer can contribute up to 25% of payroll up to $45,000 per participant but the percentage must be the same for all employees. The employees are usually unable to contribute (there are certain exceptions). This option works very well for one or two person business, but contributing 25% of payroll can quickly become a burden.

Safe Harbor 401(k) - A Safe Harbor 401(k) has three components:

1. Employee Deferrals – what each employee chooses to contribute, can be as high as 100% of earnings up to $15,500 ($20,500 for ages 50+)
2. Safe Harbor – the business must either make non-elective contributions as a percentage of the employee's income or match a percentage of the employee's 401(k) contribution.
3. Profit Sharing – The business can elect to share profits with the employees provided they do so in a manner that meets fairness requirements.

The Safe Harbor still limits the maximum employer contribution at 25% of payroll and $45,000 per employee, but allows for a lot more flexibility in how the profit sharing component is distributed.

If the owners spouse is also active in the business and well paid then the family unit could possibly double its retirement deferral (and FICA tax too).

Keep in mind that this comes at some expense and headache. Every 401(k) plan is unique and customized. There must be a written plan document and the employer has a fiduciary responsibility to the plan. 401(k) plans have to file their own tax returns (form 5500) and must be tested routinely to assure it meets certain standards for fairness (as defined by government regulation). Thankfully these are all tasks a Third Party Administrator (TPA) can handle.

Climbing Mt. Hood by Brother O'Mara

Comments

[doug mitchell]

Hey Art. Ironically, I was having a conversation about the safe harbor 401k last night with an MD friend of mine. I would like to chat about the methods of stashing as much cash away as possible as a self-employed dude at some point in the future.

Nice work!