Many business owners and professionals will be shocked when they see their 2013 income tax bill as taxes overall will likely rise 10-15 percent.
The American Taxpayer Relief Act of 2012 (ATRA) added a new top income tax rate of 39.6 percent for ordinary income. Add to that the 3.8 percent Medicare surtax under the Affordable Care Act of 2012 (ObamaCare) and the combined rate becomes 43.4 percent. The top federal rate for long-term capital gains taxes and qualified dividends went from 15 percent to 23.8 percent. Additionally, one owes state income taxes.
How can you be proactive and reduce the tax bite? The simple answer is, among other things, consider a qualified plan for your business or professional practice. Why a “qualified plan”? Because the contributions qualify for an income tax deduction under Section 401(a) of the Internal Revenue Code. This plan can be a 401(k), profit sharing, cash balance, traditional defined benefit plan, or a combination. Your particular circumstances determine which is right for you.
Consider the advantages of qualified plans:
• Contributions are fully deductible against 2013 taxable income.
• All plan assets grow on a tax-deferred basis.
• Plan assets are protected from the claim of judgment creditors.
• Contributions could help reduce your taxable income below the Obamacare thresholds.
• Plan assets are eligible for a tax-free rollover to your IRA at retirement or plan dissolution.
How Much Can I Contribute to My Plan?
Considering contributions to your plan directly reduce taxable income, you may want to maximize the advantages of the plan. Of course, don’t do so at the peril of company cash flow or altering your lifestyle. With that in mind, let’s examine plan contribution limits.
So often, my new clients are under the misconception they are limited to a $17,500 annual contribution and deduction. This is not true.
With earned income in 2013 and being under age 50, you may contribute up to $17,500 to a 401(k) arrangement. Age 50 and over, there is an additional “catch up” contribution of $5,500 bringing your total to $23,000. However, your company or practice can make additional contributions to bring the total annual addition to your account up to $51,000 ($56,500 for those age 50 and older).
Many new clients have the mistaken belief they are only allowed the salary deferral of $17,500 ($23,000 for those 50 and older) plus some small safe harbor piece. This is clearly the mark of a bundled one-size-fits-all plan offered by the payroll companies, mutual fund companies, or others. Don’t be fooled, there are significant advantages available in custom-designed plans. Have an existing 401(k)? Have it reviewed by an independent pension consulting firm, not a so-called money manager or investment advisor. While they may be good at managing money, actual administration issues are admittedly outside their scope.
Often, clients say, “I have the 401(k) plan, I make the $51,000 contribution annually, but it is no longer a significant deduction. What else is available for additional deductible contributions?”
When the confines of the 401(k) contributions are no longer adequate, it is time to consider a cash balance plan or a defined benefit plan.
A defined benefit plan is the traditional type of program one thinks of when considering retirement. Had we gone to work for the military, post office, etc. and stayed there for 30 years, we would have retired on 75 percent of our salary. They defined the benefit received at retirement. Suffice it to say this type of arrangement, in many circumstances, can generate additional income tax deductions of up to $200,000 annually. Have a partner or spouse? They can get similar benefits, too.
Of course, that is the most you can do, and you can do anything less. Defined benefit plans and cash balance plans are designed for you, the business owner, as a way to increase your annual tax-deductible contributions and set aside for the future.
In defined benefit plans, one may have ancillary benefits, or benefits in addition to the retirement benefit. Like what, you ask? Typically, life insurance. Consider that all of us have life insurance and we pay the premium with after-tax, non-deductible dollars. We are paying the premium anyway, so add the premium to the pension plan’s contribution. The premium is now deductible. More interestingly, the insured benefit passes to our beneficiary income tax-free, if our beneficiary is the spouse, it passes estate tax-free, and, regardless of the beneficiary, the insured benefit passes outside of probate.
There is the tax deduction, among other tax benefits, and, because of that, employees do have to participate. But that does not negate the other plan benefits. Order a customized design for yourself, look at the numbers in black and white, get your certified public accountant or attorney involved in the decision making process, and see if these ideas have merit for your situation.
Implementing these plans for 2014 is much easier than you may think. While the plan has to be signed by fiscal year-end, you have until the deadline for filing the tax return, including extensions to make the contribution. That can be early this fall if you utilize an extension, so there is plenty of time to take advantage of the benefits.
Publication date: 3/17/2014