Accountants are always looking for savvy ways to help their small-business clients save on income taxes. Some strategies are more complicated than others, while some are simpler. One notable area that offers a lot of potential for income tax savings is in a client’s retirement plan.
If they do not have one, accountants are well equipped to help their client establish a plan. If your client does have one, now is a perfect time to take it out and look it over. It is important to not only ensure that clients have maximized their contributions, but also that they have maximized their tax savings. In other words, are they in the right plan? This is an important question because it is often overlooked.
If your client had a taxable income of $100,000 or greater and you couldn’t find further deductions, perhaps a review of their business retirement plan may reveal some tax savings gems. While they may be maximizing their existing plan contributions, you should review if their current plan best fits their tax and savings needs. Time is of the essence as most of these tax-saving strategies have to be implemented prior to year-end. One strategy, often overlooked, is the One-Participant 401(k).
Sole business owners with no common-law employees, except perhaps a spouse, that have a SEP, SIMPLE, or profit-sharing plan, may benefit more from a One-Participant 401(k) Plan. This plan can allow your client to increase their retirement nest egg while deferring more in taxes given the same level of taxable income.
The chart below shows a few examples. In Example 1, the owner is over 50 years old and can take advantage of an age-based catch-up. Examples 2 and 3 are shown without a catch-up. The catch-up is an additional $6,000 for people over 50 years old in a One-Participant 401(k). Example 3 is shown as a corporation using W-2 income, since the One-Participant 401(K) can be utilized by businesses structured as a sole proprietor, corporation or partnership. The math process to determine the maximum One-Participant 401(k) contribution of a sole proprietor is more complicated than that of a business with a corporation structure.
| Owner | Projected 2017 net profit, or W-2 income (Example 3) | One-Participant 401(k) | Typical profit-sharing plan | SEP Plan | SIMPLE IRA Plan |
| Example 1: Sole proprietor | $200,000 | $60,000 | $37,887 | $37,887 | $21,041 |
| Example 2: Sole Proprietor | $150,000 | $46,020.99 | $28,021 | $28,012 | $16,655.75 |
| Example 3: Corporation | |||||
| Owner: | $100,000 | $43,000 | $25,000 | $25,000 | $15,500 |
| Spouse: | $25,000 | $24,250 | $6,250 | $6,250 | $13,250 |
Source: Ascensus based on 2017 tax codes. No common law employees allowed.
Small-business owners may prefer the One-Participant 401(k) for their business if they want to:
- Make both employee and employer contributions (and possible tax deductions), thereby maximizing contributions and tax deferral (not permitted in SEP plans).
- Vary their contribution, like a SEP plan, they can decide annually whether and how much to contribute based on cash flow.
- Benefit from catch-up contributions if they are age 50 or over and are self-employed (not permitted in SEP plans).
- Add their spouse to the plan. The One-Participant 401(k) can virtually shelter most of the income of a lower earning spouse while adding money to the spouse’s retirement account.
- Optimize W-2 compensation and possibly lower FICA taxes.
Looking for bigger savings
The maximum contribution into a One-Participant 401(k) participant’s account is $54,000 for 2017. If the participant is 50 years of age or older, they can make a catch-up contribution of $6,000 for a total contribution of $60,000 into their account. But what if you need bigger tax savings for your small-business clients? This is where a defined-benefit plan optimized for the small business owner may be appropriate. In a nutshell, a defined-benefit plan is another type of qualified retirement plan that allows your clients to make larger contributions of $100,000 or more. A defined-benefit plan can be combined with a One-Participant 401(k) where the owner may be able to contribute over $200,000. If your small-business owner clients have been busy growing their businesses and haven’t saved much in personal cash for retirement, combining the One-Participant 401(k) with a defined-benefit plan may help your client to shelter over $2,000,000 of W-2 income over a 10-year period.
The chart below gives examples of how much your client may be able to contribute to a defined-benefit plan given their age and income. This is in addition to contributions they can also make to their One-Participant 401(k).
Defined benefit maximum annual contribution estimates by owner age and income
| Age: | 35 | 40 | 45 | 50 | 55 | 60 | 65 | |
| Income | ||||||||
| $50,000 | $13,800 | $17,800 | $27,700 | $33,600 | $41,100 | $41,600 | $36,400 | |
| $100,000 | $27,700 | $35,700 | $55,000 | $67,200 | $82,200 | $83,200 | $72,800 | |
| $150,000 | $41,600 | $53,600 | $82,500 | $100,900 | $123,400 | $124,800 | $109,200 | |
| $200,000 | $55,500 | $71,500 | $110,000 | $134,700 | $164,600 | $166,400 | $145,600 | |
| $250,000 | $64,700 | $83,400 | $128,300 | $157,000 | $192,000 | $194,200 | $182,000 |
Source: Dedicated Defined Benefit. This chart makes the following assumptions: retirement age -- the later of age 62 or five years of participation in the plan; business start date -- Jan. 1, 2016; entity type -- corporation; contributions might differ for sole proprietors; income type -- W-2.
The One-Participant 401(k) is an often-overlooked solution for small-business clients with no common-law employees. Combined with a defined-benefit plan, it can enable your client to defer a lot in taxes while at the same time building up their retirement nest egg.
If your client already has a retirement plan but needs additional tax deductions, you may want to consider reviewing and optimizing their retirement plan for maximum tax deductions given a similar level of compensation. For clients that have full time common-law employees that do not qualify for the One-Participant 401(k), similar strategies can be employed using a combination of perhaps a safe-harbor 401(k) and a cash balance defined-benefit plan to maximize their retirement contributions and tax deductions.
