Retirement Plan Deductions
Like large businesses, as a sole proprietor you are also able to set up a qualified retirement plan for yourself and your employees. There are tax incentives for employers that establish and maintain qualified retirement plans such as: Simplified Employee Pension (SEP) plans; Savings Incentive Match Plan for Employees Individual Retirement Account (SIMPLE IRA) plans; and other qualified plans (also called H.R. 10 plans or Keogh plans when covering self-employed individuals), including 401(k) plans.
One tax incentive is that you can deduct contributions you make to the plan for yourself and your employees from your gross income on your federal income tax return. You can also deduct additional trustee fees not covered by contributions. Limits apply to the amount deductible; for example, it cannot be more than half your self-employment tax calculated on Schedule SE. The maximum compensation used for figuring contributions and benefits is currently $245,000.
Special rules apply to the use of retirement funds by qualified individuals who suffered an economic loss as a result of the Kansas and Midwestern disasters. See Publication 4492-A (Information for Taxpayers Affected by the May 4, 2007, Kansas Storms and Tornadoes) and Publication 4492-B (Information for Affected Taxpayers in the Midwestern Disaster Areas) at www.irs.gov for more details if this may apply to you.
SEPs provide a simplified method for you to make contributions to a retirement plan for yourself and your employees. Instead of setting up a profit-sharing or money purchase plan with a trust, you can adopt a SEP agreement and make contributions directly to a traditional individual retirement account or a traditional individual retirement annuity (SEP-IRA) set up for yourself and each eligible employee.
You can deduct up to 25% of all participants’ compensation, provided that you make contributions by the due date of your tax return (including extensions). Your eligible contributions are the smaller of $49,000 or 25% of each participant’s compensation, and you can set up the plan anytime up to the due date of the employee’s tax return.
If the SEP is maintained on a calendar year basis, you deduct the yearly contributions on your tax return for the year within which the calendar year ends. If you file your tax return and maintain the SEP using a fiscal year or short tax year, you deduct contributions made for a year on your tax return for the applicable year.
Generally, you can set up a SIMPLE plan if you had 100 or fewer employees who received at least $5,000 in compensation last year. Under this plan, employees can choose to have contributions deducted from their wages and you contribute matching or non-elective contributions. The current limit on salary reduction contributions is $11,500. There are two types of SIMPLE plans: the SIMPLE IRA plan and the SIMPLE 401(k) plan.
You may deduct contributions made to this kind of plan as long as each contribution is made within 30 days of the applicable month’s end. There is an annual limit of 3 salary reduction contributions. Matching or non-elective contributions must be made by the due date of your income tax return (including extensions).
An employee can make a salary reduction contribution up to $11,500, $14,000 if he or she is 50 years old or older. An employer can make either dollar-for-dollar matching contributions, up to 3% of each employee’s compensation, or fixed non-elective contributions of 2% of each employee’s compensation. Your eligible deduction amount would be the same as your contribution amount.
This kind of plan can be set any time between the beginning of the calendar year and the 1st of October. If you are starting your business after this date, you can set up the plan and start making contributions as soon as administratively feasible.
The qualified plan rules are more complex than the SEP plan and SIMPLE plan rules, but there are advantages such as increased plan flexibility and increased contribution and deduction limits.
Under a 401(k) plan, employees can have you deduct contributions from their wages before tax (after tax in the case of a Roth IRA). These amounts and the earnings on them are generally tax free until plan distributions are received.
Contributions for a Defined Benefit Plan must be paid in quarterly installments and are due 15 days after the end of each quarter. The maximum amount contributed must be the smaller of $195,000 or 100% of the participant’s highest 3-year average compensation. Your deduction is based on actuarial assumptions and computations. The plan must be set up by the end of the tax year.
Contributions to a Defined Contribution Plan must be made by the due date of your income tax return (including extensions). An employee can contribute elective deferrals up to $16,500 or $22,000 if age 50 or over. An employer can contribute by money purchase or profit sharing in the maximum amount of the lesser of $49,000 or 100% of the participant’s compensation. Your deduction can be up to 25% of all participants’ compensation plus the amount of elective deferrals made. This plan can be set up anytime by the end of the tax year.
Please Note: Participants who are age 50 or over at the end of the calendar year can make catch-up contributions in addition to elective deferrals and salary reductions. The catch-up contribution limitation is currently $2.500 for SIMPLE plans and $5,500 for other plans. And certain plans subject to Department of Labor rules may have an earlier due date for salary reduction contributions and elective deferrals.
In addition to being eligible to make tax return deductions, retirement plan participants (including self-employed individuals) who make contributions to their plan may qualify for the retirement savings contribution credit. The credit is based on a maximum contribution of $2,000. Use Form 8880 (Credit for Qualified Retirement Savings Contributions) to calculate the credit.
Another tax credit may be claimed for part of the ordinary and necessary costs of starting a SEP, SIMPLE, or qualified plan. This credit equals 50% of the cost to set up and administer the plan and educate employees about it, up to $500 per year for each of the first 3 years of the plan (including, if you wish, the tax year before the tax year in which the plan becomes effective). In order to be eligible to claim this credit, you must have had 100 or fewer employees who received at least $5,000 in compensation from you for the preceding year, and at least one participant must be a non-highly compensated employee. Also, the participants of this new plan generally cannot be substantially the same employees in plans administered by you or your company for whom contributions were made or benefits accrued within the previous 3 years.
This credit is part of the general business credit, and can be carried backward or forward to other tax years if it cannot be used in the current tax year. If you elect to take the credit for a certain tax year, you cannot deduct the part of the startup costs equal to the credit claimed for that year. Use Form 8881 (Credit for Small Employer Pension Plan Startup Costs) to take this credit.
Additional information can be found at www.irs.gov in Publication 560 (Retirement Plans for Small Business), Publication 590 (Individual Retirement Arrangements, IRAs), Publication 575 (Pension and Annuity Income), and Publication 571 (Tax-Sheltered Annuity Plans, 403(b) Plans).