The last article talked about the difference between Traditional and Roth IRA with a brief mention of business IRA plans.
A link to that article will be at the end so you can read it if you missed it.
We know that to get a tax deduction, money has to flow out of your possession to someone else. Common examples are to get a mortgage interest deduction or a charitable contribution deduction, you need to spend money from your account and give to someone else.
If you are a business owner to get a tax deduction, the same thing happens. You spend money on office supplies, vehicle fuel, rent, tax return preparation, tax advice, dues and memberships and money flows out of your hands to someone else. You get a tax deduction, someone else gets reportable taxable income.
If those expenses help you run your business better (produce more sales, reduce other expenses, avoid penalties) then that’s generally a good thing.
But what if your tax deduction could benefit you more directly? What if you could get a tax deduction for paying yourself?
There might be more than these next three but when I explain it to a small business owner I see three basic tax deductions for paying yourself. Wages, health insurance and retirement plan contributions.
You may or may not get a tax deduction for paying yourself. If you are a Schedule C tax filer you do not get to pay yourself a wage. You take a Draw and Draws are not a tax deduction.
I have seen other tax preparers list Owners Draws as a tax deduction and that is wrong. If your preparer is doing that just hope that you don’t get selected for an audit, you will not win.
If you are allowed to take a wage (think S corporation or LLC taxed as an S corporation) that deduction lowers your taxable income, yay, but you pick it up as taxable W2 income. But at least it’s a business tax deduction for paying yourself.
If you are paying for health care premiums through the business, it’s another deduction that benefits you. Money does flow out to someone else, but at least you have healthcare coverage.
Now let’s talk one of my favorites. You contribute to your own retirement fund and you get a tax deduction. Basically, you get a tax deduction now, for paying yourself income in the future.
There are lots of rules surrounding this contribution. If you have employees you may have to contribute for them too, that’s not a bad thing. There are various vesting rules to be aware of and follow.
Are you a small business owner or self-employed and could contribute to such a plan?
Very often a person who is in this situation didn’t know that they could setup and even contribute to such a plan.
How much can you contribute? Depends on the type of plan. All plans have an upper threshold. Many are tied to a percentage of wages or net profit.
For example, if you have a SEP IRA plan in place generally speaking its 25% of gross wages or net profit. There are some adjustments but that’s a ballpark figure to work with as a start.
Some plans such as SEP IRA or SIMPLE IRA are relatively low administrative cost. Others such as a 401K plan come with additional administrative costs. Some plans such as a cash balance plan have very high contribution limits but also a lot of administrative costs.
So which plan is right for you? Depends on your goals, your available cash and even to a certain extent when you set it up.
Very common small business plans are SEP IRA, SIMPLE IRA, 401K, Solo401K. Some have to be setup by October 1 to count for the current year. Some that involve payroll deductions essentially stop with the last payroll of the year, others that do not involve payroll deductions can continue into the next year with tax deductions reaching back into the previous year such as SEP IRA and Profit Sharing.
Some plans such as SIMPLE IRA and 401K type plans involve employee payroll tax deductions and possibly matching employer contributions.
Other plans such as a SEP IRA can only have contributions from the employer, the employee is not allowed to contribute even if they wanted to.
So which one is better? Again, it depends on your unique situation, goals and resources and why it’s important to work with someone who can give both the tax advice and help set up the plan itself.
That’s why I’m here to help since I can do both.
Generally speaking these are all pretax deductions. To get a tax deduction now the contribution generally has to be a pretax contribution.
Recent legislation (SECURE ACT 2.0) has created some Roth options for SEP IRA and we are waiting for more guidance on that soon.
For the 401K plans, if your plan allows it you could have Roth contributions from the employee side.
For a business owner, it’s the gross wages that are the tax deduction. The deductions from gross wages are strictly on the employee side, so if your plan allows for it, the employee contribution can be a Roth contribution while the employer matching contribution would be a pretax contribution.
Now that you know a little bit more about getting tax deduction for paying yourself let’s set up a call to see if you qualify and how much you might be able to contribute.
Here are some links to other useful information on these plans.
The information in this and other articles is intended to be educational in nature only. Not tax, legal or investment guidance for you specifically. Each person’s situation is unique and you must seek appropriate professional guidance that can address your unique situation.