Retiring sounds fun, right? And so does saving on taxes now. Luckily, as a business owner, there are ways you can feed these two birds with one scone.
You’re probably familiar with the phrase: “pay yourself first.” But what does that really mean in practice? How much of your earnings should you set aside for savings or retirement? And what benefits, other than peace of mind, do you gain by saving a portion of your income rather than spending it now?
How a retirement plan can reduce your business taxes
Saving money, like flossing, is one of those tricky “responsible adult” habits. Even though all of us understand why we should be saving more money, making it a routine practice does not come easily.
Fortunately, for entrepreneurs and small business owners, there’s another incentive to put those earnings away now: tax deductions. A retirement plan such as an IRA or 401(k) allows you to reduce your taxes for the current filing year and possibly build some tax-free interest long-term, provided you follow certain rules and restrictions.
Employers typically offer these plans, and as a business owner, you’ll need to be proactive in setting up retirement for yourself. If you’re a business owner, you have several options.
Different ways to save as a small business owner
Below is a sampling of a few retirement choices for the self-employed entrepreneur. Each can reduce your annual taxable income. Whichever route you follow will depend on a variety of personal factors, including your income level, age, future financial objectives, and current needs.
Simplified Employee Pension Individual Retirement Account (SEP IRA)
An IRA, or Individual Retirement Account (the “A” can also stand for Arrangement or Annuity), lets you save up to $5,500 this year, and claim a full deduction on your tax return—so long as neither you or your spouse are already covered by a retirement plan.
An SEP IRA is a form of Traditional IRA, in which you deposit (or, in retirement-speak, contribute) money into an account pre-tax and then pay your taxes when you withdraw at retirement. Contrast this with a Roth IRA, which shelters your assets tax-free after you make an initial payment to the IRS.
Pros: Easy to use and understand, flexible
Cons: Low annual contribution limits, 10% tax penalty for withdrawing before the age of 59½
How much you can contribute now: $5,500 ($6,500 if you’re 50 or older)
A SIMPLE (Savings Incentive Match Plan for Employees) IRA is very similar to an SEP IRA, but has three key differences:
- A higher contribution limit ($12,500)
- A larger tax penalty for withdrawing early (25%)
- An earlier deadline for claiming tax deductions (October 1 of the filing year)
SIMPLE plans are a go-to option for businesses that employ 100 or fewer people, but they can be advantageous for high-earning entrepreneurs as well.
Pros: Like an SEP IRA with higher annual deferrals…
Cons: …and bigger penalties.
How much you can contribute now: If you haven’t already set one up, you can’t contribute to a SIMPLE IRA and claim deductions for the current year. However, you can save up to $12,500 ($15,500 for ages 50 and up) for next year if you establish an account by October 1st.
One Participant 401(k)
A one-participant 401(k) plan—also referred to as an individual 401(k), solo 401(k), or self-employed 401(k)—is one of the most powerful tax reduction vehicles available to individuals. By using a 401(k), you can save money by contributing as both your own employer and employee. Confused? Here’s what that means:
- You can deduct 100% of your net self-employment earnings, up to $18,000. This is your elective “employee” deferral.
- You can make a maximum contribution of 25% of your net earnings, on top of that elective amount. This is your nonelective contribution, which you make as an employer.
As a business owner, you will need to follow federal rules to determine the maximum total amount you can save in elective deferrals and nonelective contributions. The IRS defines nonelective contributions as your net earnings minus one-half of your self-employment business tax and employee contributions. In other words, the amount you’re allowed to put away is limited not only by how much you make but by your other self-employment responsibilities.
Another fact to keep in mind: you cannot withdraw from 401(k) until you reach a certain age or experience another “triggering event” such as becoming disabled.
Pros: Offers potentially huge savings decades ahead
Cons: More complicated than an IRA, significantly restricts access to savings
How much you can contribute now: You’ll need to set up your solo 401(k) by the last day of your fiscal year, so you may be out of luck for filing in 2016. Once you’ve established your 401(k), however, you can defer up to $18,000 ($24,000 if 50 or older) as well as 25% of your income—unless it exceeds $53,000.
Getting started with a tax-saving retirement account
Whichever plan you choose to reduce your taxes, there are a few general principles you should follow to ensure you’re saving wisely.
- Set a goal. A specific dollar amount will guide your decisions and expectations as you consider various plans and shape your retirement strategy. Financial experts have come up with myriad formulas and calculators you can find through a simple online search, but you’re better off seeking personalized advice from a professional who will take factors such as your financial status, family situation, hobbies, and residential profile into account.
- Recognize milestones. After you’ve embarked on your retirement strategy, periodically review your choices and acknowledge your successes. Milestones, such as your first $10,000 or $100,000, are important steps on the way toward retirement. By memorializing these milestones with small purchases like new shoes or a night out, you can keep yourself motivated and enjoy yourself in the present.
- Automate your savings. You can set up some plans, such as a 401(k), to automatically withdraw predetermined amounts from your bank account monthly, weekly, or even daily. When automated, incremental savings alleviate the strain of making large contributions once a year or once a quarter and eliminate the pressure on you to remember to pay yet another bill. And chances are you won’t even miss the money when it’s deducted before it gets a chance to hit your bank account.
- Don’t be afraid to ask for help. You may be self-employed, but that doesn’t mean you have to plan for your retirement alone. If you have questions about maximizing your savings and tax deductions, don’t hesitate to reach out to a qualified retirement benefits professional–if you’re already an indinero client, ask your team, otherwise contact an indinero financial consultant who can guide you on the right path as well.