For business owners, one of the best opportunities for reducing their tax burden is to contribute to a pension or profit sharing plan. Many types of plans are available; some are fairly complicated, require setting up a separate trust, may require a lot of time and expense to administer, and have stringent reporting requirements. Some may be more suited to larger businesses having numerous employees.
However, there is a widely used plan particularly suited to small businesses, the Simplified Employee Pension (SEP). This type of plan, which allows the business owner to sock away up to $49,000 for 2011 ($50,000 for 2012), is relatively easy to set up and does not require annual filings with the IRS. The company simply adopts a SEP agreement and sets up individual retirement accounts for the owners and eligible employees. You have until the extended due date of the 2011 tax return (Sept. 17 for calendar year corporations and partnerships, Oct. 15 for proprietorships) to determine the amount of contribution and to set up and fund the accounts, and the deduction can be taken on the 2011 tax return.
Under the SEP rules, all eligible employees must be covered. These include any employees who have reached the age of 21, have worked for you in at least three of the past five years, and who have received at least $550 in compensation for the year. Employees covered by a union agreement and whose retirement benefits were bargained for in good faith by the union and the employer can be excluded. A separate SEP-IRA account is set up for each eligible employee. Each eligible employee must be given a copy of the SEP-IRA plan, and be treated equitably whenever a contribution is made (including any contribution made on behalf of the owners). While the employer is not obligated to make a contribution every year, when a contribution is made it must be made at the same rate for each employee. The maximum amount that may be contributed for employees is 25 percent of his or her annual compensation, up to an annual cap of $49,000 for 2011 ($50,000 for 2012).
For those who are self employed generally owners of proprietorships and partnerships the rules are a little different with respect to calculating and deducting the contribution. Self employed individuals can contribute a maximum of 20 percent of their net business income (from which self-employment tax has been deducted), up to a cap of $49,000 for 2011 ($50,000 for 2012). The deduction is taken as an adjustment to income and does not reduce self-employment income. However, if the self-employed business owner has employees, contributions made to employees' accounts are deductible as a business expense and reduce self employment income.
For small business owners fortunate enough to be making a fair amount of income, and who have the cash available, a SEP can be a good and fairly simple way to defer tax and save up a significant amount of retirement money.
Some business owners may not want to bother with setting up any kind of pension plan, or they may not have enough business income or available cash to make it worth the effort. For those, and for individuals who just want to put away a small amount each year and have the benefit of a tax deduction, the traditional individual retirement account (IRA) is still a way to reduce your 2011 tax burden (deferring it to future years) since contributions to an IRA for 2011 may be made as late as April 17. While the IRA has been around for several decades, here are a few reminders as to the qualifications and limitations.
To qualify for a traditional IRA contribution, an individual must have received compensation, which includes earned income as well as alimony. Compensation does not include investment income, capital gains, rents or pension income. He or she must be younger than 70-1/2 during the year of contribution.
A qualifying individual may contribute up to a maximum of either $5,000 per year to an IRA ($6,000 if age 50 or older by the end of the year) or that individual's compensation for the year, if less. The contribution may be made any time from January 1 until the tax filing deadline (not including extensions) for the tax year involved. So an IRA contribution for the 2011 tax year may have been made any time from Jan. 1, 2011 to April 17, 2012.
The tax code has some special provisions for married folks. If one spouse has compensation and the other doesn't, one spouse can "borrow" compensation from the other one. For example, if one spouse has compensation of $40,000 and the other one earns nothing, each can make an IRA contribution of $5,000.
If you are an active participant in a qualified retirement plan maintained by an employer, there may some limitations on how much of your contribution you can deduct, depending on your overall income. For those filing as single, the deduction is phased out beginning when the modified adjusted gross income (AGI) reaches $56,000 (all figures are for 2011). For married taxpayers filing jointly, the phase out begins at $90,000. If one spouse is an active participant in an employer's retirement plan and the other spouse is not, the other spouse can still make a deductible IRA contribution. The deduction for the spouse not an active participant in a retirement plan is phased out for modified AGI beginning at $169,000. Modified AGI means certain items normally excluded from taxable income, such as foreign earned income and student loan interest, are added back to make this calculation.
Those running into such limits might consider contributing the non-deductible portion to a non-deductible IRA, or to a Roth IRA. While not providing current tax savings, they are a way to defer or avoid, respectively, tax on future income earned on amounts contributed.
For assistance in exploring these options, please consult your tax advisor.
Russ Law is a certified public accountant and manager for Kafoury, Armstrong & Co. Contact him at 689-9100 or through www.kafoury.com.
