A retirement plan might not be on your radar if your startup has yet to become cashflow positive — but if anything you’re in one of the demographic groups that urgently needs the tax benefits now more than ever.
Unfortunately, the self-employed face what some see as the most complicated tax situation come this April — this is an area with the most cryptic writing in the Tax and Jobs Act that was passed the Friday before Christmas.
Until that law was signed, self-employed people used to be able to deduct just about everything but the kitchen sink from their taxes.
Now, however, that has been capped at about 20% of income, after which point the rest of the money gets taxed as individual income.
File That Paperwork
One way to do an end run around this is to change the legal organization of your company — except that if you didn’t file paperwork for this before the end of 2017, you won’t get a change in tax benefits come April.
Talk to your accountant about what you can do to right size your taxes come this April: If you didn’t have a retirement plan already set up by the last day of 2017, you may not be able to tap into the tax deferral until the following year’s tax return.
That said, here’s a look at three types of retirement plans that can help frugal entrepreneurs looking for some relief on their next tax return.
Retirement Plans for Entrepreneurs
Maximum contribution in 2017: Up to $5,500 for those under 50 and $6,500 for those over 50, but see the catch below
Who can contribute: Anyone 69.5 years of age or younger
What’s the catch: That maximum contribution includes all retirement plan contributions to both the traditional IRA and Roth combined — but fortunately doesn’t include rollovers.
Simplified Employee Pension (SEP)
Maximum contribution in 2017: $41,000 or up to 25% of your net earnings, whichever is smaller
Who can contribute: Self-employed business owners only (but when there are employees who also want to participate, they get put into SIMPLE plans)
What’s the catch: This might not be the best plan for anyone intending to retire early; withdrawal of funds before age 59.5 might be subject to a 10% penalty along with applicable income taxes.
Solo 401(k) (a.k.a. Individual 401(k), Self-Employed 401(k) or Solo K)
Maximum contribution in 2017: $54,000 for those under 50, and $60,000 for those age 50 and up, but may not exceed 50% of a person’s net income earned through self-employment (a threshold that often gets confused)
Who can contribute: See below.
What’s the catch: As the second-newest type of retirement plan included in this article, this plan still isn’t offered by every single financial institution in existence. Plus, you might have to pay a special fee just to open the account.
Maximum contribution in 2017: $5,500 for those under 50; $6,500 for those 50 and up
Who can contribute in 2017: This one has the most complicated eligibility rules, but they include people who file as single and earn less than $133,000 annually; married couples who file jointly and together earn less than $196,000 annually; married individuals who file separately and have not lived with their spouse for a year while earning less than $133,000 annually; and married individuals who live with their spouses but are filing separately and have less than $10,000 annual earnings.
What’s the catch: That maximum contribution figure includes both what you contribute to a traditional IRA and a Roth.
Roth or IRA?
Most financial planners recommend you make full use of pre-tax retirement contributions before contributing to a Roth IRA — but reverse that if you believe your tax savings on the Roth will be greater when you retire. That might amount to an either-or decision in most cases.
Once you reach 70.5 years of age and can no longer contribute to an IRA, but still want to invest, you can keep contributing to a Roth.
Sadly, none of the plans eliminate taxes, they just postpone them — with the sole exception being the Roth. The Roth inverts things, so you’re taxed before you contribute but then don’t pay taxes when it’s time to withdraw the money. This usually ends up being the biggest tax saving of all, assuming your investments appreciate in value.
And this brings up another important detail that is also misunderstood: You’re not allowed to postpone all of these taxes forever. IRS regulations state that once you reach the age of 70.5, you are required to start withdrawing at least a small percentage — known as a required minimum distribution — so that this money might be taxed as income, at your bracket. That is distinct from the capital gains tax rate.
You generally have to start taking required minimum distributions from retirement plans when you reach age 70½ — except that Roth IRAs do not require withdrawals until after the death of the owner when it passes to the chosen beneficiaries who in turn will also have to take the withdrawals.
You can learn the differences between all of the different types of retirement accounts on the IRS’ website — it’s worth bookmarking so that you can check back next year for the 2018 contribution limits.
Fellow frugal entrepreneurs, do you have a retirement plan already set up? What are your biggest concerns about the Tax and Jobs Act?