Many business owners and professionals will be shocked when they see their 2013 income-tax bill as taxes overall will likely rise 10 to 15 percent.
ATRA, or the American Taxpayer Relief Act of 2012, added a new top income tax rate of 39.6 percent for ordinary income. Add to that the 3.8-percent Medicare surtax under the Affordable Care Act of 2012 (ObamaCare) and the combined rate becomes 43.4 percent.
The top federal rate for long-term capitals gains taxes and qualified dividends went from 15 percent to 23.8 percent. Additionally, one owes state income taxes.
How can you reduce the tax bite? The simple answer is, among other things, consider a qualified plan for your business or professional practice.
Why a qualified plan? Because the contributions qualify for an income tax deduction under Section 401(a) of the Internal Revenue Code. This plan can be a 401(k), Profit Sharing, Cash Balance, Traditional Defined Benefit Plan, or a combination. Your particular circumstances determine which is right for you.
Consider the advantages of qualified plans:
c Contributions are fully deductible against 2013 taxable income.
c All plan assets grow on a tax-deferred basis.
c Plan assets are protected from the claim of judgment creditors.
c Contributions could help reduce your taxable income below the ObamaCare thresholds.
c Plan assets are eligible for a tax-free rollover to your IRA at retirement or plan dissolution.
In the accompanying chart, compare the tax advantages of a $100,000 contribution with a qualified plan. The advantage to you, the business owner, is approximately $50,000.
What about different contribution levels? Contribute $50,000, and the immediate tax benefits are half as much; put in $200,000 the benefits are twice as much, and so on.
Add to the tax savings the tax deferral on the growth, the asset protection features, etc., and it's hard to ignore the advantages.
How much can I contribute to my plan?
Considering that contributions to your plan directly reduce taxable income, you may want to maximize the advantages of the plan. Of course, don't do so at the peril of company cash flow or altering your lifestyle. With that in mind, let's examine plan contribution limits.
So often my new clients are under the misconception they are limited to a $17,500 annual contribution and deduction. Not true.
With earned income in 2013 and being under age 50, you may contribute up to $17,500 to a 401(k) arrangement. Age 50 and over, there is an additional catch up contribution of $5,500bringing your total to $23,000. However, your company can make additional contributions to bring your total annual addition to your account up to $51,000 ($56,500 for those age 50 and older).
Many new clients have the mistaken belief that they are only allowed the salary deferral of $17,500 ($23,000 for persons age 50 and older) plus some small Safe Harbor piece. This is clearly the mark of a bundled one-size-fits-all plan offered by the payroll companies, mutual fund companies or others.
Don't be fooled. There are significant advantages available in custom designed plans. Have an existing 401(k)? Have it reviewed by an independent pension consulting firm, not a so-called money manager or investment advisor.
While they may be good at managing money, actual administration issues are admittedly outside their scope.
Often clients say, I have the 401(k) plan, I make the $51,000 contribution annually, but it is no longer a significant deduction. What else is available for additional deductible contributions?
When the confines of the 401(k) contribution are no longer adequate, it is time to consider a Cash Balance Plan or a Defined Benefit Plan.
A defined benefit plan is the traditional type of program one thinks of when considering retirement. Had we gone to work for the military, Post Office, etc., stayed there 30 years, we would have retired on 75 percent of our salary. They defined the benefit received at retirement.
Suffice it to say that this type of arrangement, in many circumstances, can generate additional income tax deductions of up to $200,000 for you annually. Have a partner or spouse? They can get similar benefits, too.
Of course, that is the most you can do; you certainly can do anything less. Defined Benefit Plans and Cash Balance Plans are designed for you, the business owner, as a way to increase your annual tax deductible contributions and set aside for the future.
In defined benefit plans, one may have ancillary benefits, or benefits in addition to the retirement benefit. Like what? you may ask. Typically life insurance.
Consider that all of us have life insurance and we pay the premium with after-tax, non-deductible dollars. We are paying the premium anyway, so add the premium to the pension plan's contribution. The premium is now deductible.
More interestingly, the insured benefit passes to our beneficiary income-tax-free. If our beneficiary is the spouse, it passes estate-tax-free. And regardless of the beneficiary, the insured benefit passes outside of probate.
There is the tax deduction, among other tax benefits, and because of that employees do have to participate. But that does not negate the other plan benefits. Order a customized design for yourself, look at the numbers in black-and-white, get your CPA, enrolled actuary, or attorney involved in the decision-making process, and see if these ideas have merit for your situation.
Implementing these plans is much easier than you may think.
While the plan has to be signed by fiscal year-end, you have until the deadline for filing the tax return, including extensions to make the contribution.
That can be early fall if you go on extension, so there is plenty of time to take advantage of the benefits.
William H. Black Jr. has been in the pension administration business for 34 years and has spoken nationally and internationally on retirement plans. He works for Miami-based Pension Services Inc., which administers both defined contribution and defined benefit plans. He can be reached at [email protected] or 888-412-4120.