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Using Retirement Plans to Reduce Taxes - Sep 17, 2008

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Saving for Retirement can Reduce Taxes

Three of the most difficult issues owners of successful small businesses must face are attracting key employees, properly managing income taxes and planning for retirement. Key employees are typically attracted by the overall compensation plan of the business. Four basic types of employee compensation exist - 1) Direct compensation, 2) Non-cash fringe benefits, 3) Deferred compensation plans, and 4) Retirement plans. Typical within "retirement plans" is the ability to obtain a current business income tax deduction for contributions into the plan, but deferral of the ordinary income recognition to the employee until a later time when the funds are paid. Fortunately, there are at least two retirement planning tools available which can accomplish the goals of attracting key employees, reducing (or managing) the current income tax liability and saving for retirement. The two most popular planning tools available are the SIMPLE IRA and the SEP.

Simple IRA

A SIMPLE IRA is a "Savings Incentive Match Plan for Employees" "Individual Retirement Account". It is a great option for companies with 100 or fewer employees who receive $5,000.00 or more in annual compensation if the company does not have any other type of retirement program. The advantages of this plan are low administrative costs, current deductibility of employer qualified contributions, and exclusion from income for employee contributions.

Eligible Companies - Companies with 100 or fewer employees who earn $5,000.00 or more in annual compensation.

Eligible Employees - Employees who earned $5,000.00 or more in compensation during any of the two preceding years and who are expected to earn at least $5,000.00 in the current year. Employees covered by union contracts and nonresident alien employees may be excluded.

Employer Benefits - Every year, employers must make either a dollar-for-dollar match up to three percent of employee compensation OR a two percent of employee compensation nonelective contribution for each eligible employee. Under the two percent option, the employer must make a contribution for every eligible employee even if they do not contribute. The employer contribution is currently deductible.

Benefit to Employee - Employees may contribute up to $10,500 annually to their IRA account. Employee contributions are not subject to federal income tax withholding but remain subject to social security tax, medicare tax, and federal unemployment tax. Employer contributions are excluded from the employee's income until received.

SEP

A SEP is a "Simplified Employee Pension" plan. It is a great option for self-employed business owners to make both employee and personal contributions without the complexity of other retirement plans. The advantages of this plan are ease of administration, flexible contribution limits, and current income tax savings.

Eligible Businesses - Businesses with a self-employed business owner are eligible. This generally includes sole proprietorships and partnerships.

Eligible Employees - Employees who are at least 21 years old, have been employed by the business for three of the last five years, and who have received at least $500.00 in compensation in the current year are eligible. Employees covered by union contracts and nonresident alien employees may be excluded.

Employer Benefits - Employers may deduct contributions made to both the employees SEP accounts as well as their own SEP account. The deduction for contributions to the SEP is limited to the lesser of $46,000 (in 2008) or 25 percent of the employee's compensation for the year. SEP contributions in excess of the deduction limit may be carried over to the following year.

Employee Benefits - Employer contributions are excluded from the employee's income until received.

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