This past week is always a busy one for investment advisors. Despite the fact that Tax Day comes at the same time every year, many wait until this last week to make year-end contributions to their IRA accounts in an attempt to reduce their overall income tax liabilities.
Unfortunately, for many small-business owners the $6,000 contribution they are able to make to their traditional IRA doesn’t do much to reduce their overall tax burden when compared to the capital gains and income taxes they are likely paying.
What is even more unfortunate is how many small business owners don’t realize they have the ability to drastically reduce both the personal and business income taxes they owe by setting up and contributing to a 401(k) plan.
The biggest reason I would guess business owners don’t take advantage of this is the price tag they assume is associated with setting up and administering such a plan. However, those assumptions are often false and can cost the owner a lot in tax savings.
My uncle would have been one of those people had it not been for a casual conversation we had while vacationing at the lake this past summer. As we made small talk about his upcoming plans to retire and sell his successful table renting business, he told me how much he was expecting to get hit by taxes when he sold his business.
As we talked, I asked him if he was putting a ton of his salary in tax sheltered retirement accounts to reduce his overall taxable income. He said he was maxing out both he and his wife’s IRAs. But even with the extra $1,000 catch up provision the most they could put in was $14,000 a year. I then asked him if he had a 401(k) established for his business that he could also contribute to since the contribution limits are so much higher for those types of accounts.
Assuming it was too complicated or expensive he said he had never even considered establishing a 401(k) since he and his wife were the only employees of his company. I explained however that the fact they had no other employees was the biggest reason he should do it. I told him that at virtually no cost he could set up a Solo 401(k) for his business and he could then make contributions both as employer and employee and funnel a massive amount of income into it entirely tax deferred. And since his wife also received income from this business, she too could participate.
Through the use of this 401(k) he could contribute $26,000 or 100% of both he and his wife’s compensation into the plan and that entire amount would be considered deductible from their household income in 2021. In addition, the company could make contributions of up to 25% of their compensation as a deductible expense to the business as well.
I could tell as we were talking that the old saying “if it sounds too good to be true it probably is” was running through his head. But the idea of not paying tax on nearly 100k worth of personal and business income was tempting enough for him to at least make a call to his accountant. A few weeks later he gave me a call to thank me and told me I had saved him somewhere between 10k and 20k in taxes for 2021 and would likely save him a similar amount in 2022 before selling the business.
If you are a small business owner who just took it on the chin from the IRS, a Solo 401(k) might be a solution for you too. For those in the non-profit sector a 403(b) can provide similar benefits as well. While there are requirements you must meet to open up these types of accounts, the benefits to investigating it could be thousands of dollars in tax savings.
While not providing legal tax advice, I am always happy to discuss how these accounts work and how you might be able to benefit from setting one up for yourself and your business.