Retirement money

guest commentary by David Potts

If you are making money by the sweat of your brow, that is you work for a living, you generally have to pay income tax, and at a higher rate than Warren Buffet’s approximate 17% tax rate. If you are self-employed making $50,000 net income from your business efforts, your incremental income tax rate, including self-employment tax and state income tax, might be 37%. Ouch!

About the quickest way to reduce your income tax without cheating on your tax return is to participate or contribute to some type of tax deductible retirement account. There are many types of retirement accounts to choose from, but if you are looking for a tax deduction we have to exclude the Roth varieties.

Roth accounts are the retirement accounts where your contributions are not tax deductible today but the money you withdraw in your retirement years is withdrawn tax free. But if you are self-employed paying a third of what you make in taxes, then you might need to make a deductible contribution in a tax deductible retirement account in order to reduce your income tax enough to have any cash left over to save for retirement. After excluding the Roth IRAs and 401(k)s, there are still several different varieties of retirement accounts to choose. Because of this variety of retirement account choices you would be wise to meet with your CPA or a financial planner to determine which type of retirement plan is right for you and your business.

Everybody in America should understand what an IRA, or Individual Retirement Account , is so I won’t take space to explain IRAs except to note that individuals that meet the requirements can contribute a maximum amount of $5,000 a year, unless you are over 50. Individuals over 50 can contribute an additional $1,000 each year for a total contribution of $6,000. However, if you are a business owner you can do better. Here is how.

When it comes to retirement plans and their requirements, the Internal Revenue code is full of big words and phrases like qualified retirement plans, non-qualified retirement plans, money purchase pension plans, defined benefit plans, profit sharing, integration, discrimination, and ZZzzzzz. And the more sophisticated the retirement plan the more detailed the record keeping required and the higher the cost to administrate. And because of this cost and sophistication many small businesses choose not to adopt or implement retirement plans.

But there are plans small businesses may choose that are affordable and easy to administer. One of the greatest deterrents for a small business to implement a retirement plan, besides the cost of administration, is that if the business owner wants to save for his retirement, he has to contribute significant money to this retirement plan for his employees account and he just can’t afford it, especially if he has several employees. It was for this very reason that Congress designed the SIMPLE IRA plan.

The Savings Incentive Match Plan for Employees is about as simple a retirement plan as you can establish, unless you have no employees. (If you own a business without employees, look at the Simplified Employee Pension plan — SEP — instead of the SIMPLE.) In a nutshell, the SIMPLE plan is available for any business with 100 or fewer employees. Employees can choose to participate in the SIMPLE plan if they are 21 years old, earned at least $5,000 in any two prior years and are expected to earn at least $5,000 this year. The bulk of the contribution to a SIMPLE retirement account comes out of the employees pay check in the form of a salary deferral. It works a lot like a 401(k) plan without the sophistication and the annual requirement to file a plan “tax” return.

With the SIMPLE plan, the employer is only out 2% of the compensation of eligible employees or, instead of the 2% contribution, the employer may choose a 3% matching contribution (or as low as 1% in two out of five years).  Restated, the employer can contribute 2% of compensation to the employee’s account whether they contribute or not, or choose to contribute up to 3% of compensation only to the accounts of employees that participate. The employee and the business owner can contribute up to $11,500 in 2011 (or $14,000 if the employee is older than 50) in their SIMPLE account. The employee’s contribution reduces their income tax but not their Social Security and Medicare taxes and the employee immediately vests 100% in their account balance.

Pay attention now. If you want to establish a SIMPLE plan this year, it must be established by Oct. 1. There’s not much time to left to establish a SIMPLE plan. For most other qualified retirement plans you have until Dec. 31 to establish the plan.

Whether you choose a SIMPLE plan, a SEP, or any other type of retirement account it’s a wise choice. The tax saved as the result of the contribution to your retirement plan reduces your income tax liability and the income earned in the retirement plan grows tax free.

Or you might go ahead a spend everything you make now on an expensive car or jewelry for your spouse. You can always count on Social Security benefits to live on when you reach 62.

About Potts
David Potts is a certified public accountant also accredited in business valuation. Owner of Potts & Company, Certified Public Accountants for more than 25 years, his practice focuses on small and medium size businesses and their owners in the areas of taxation, accounting and bookkeeping, business valuation and business advisory services. He is a Fort Smith native and a graduate of the University of Arkansas. You can follow more of his thoughts at ThePottsReport.com. Although every effort is made to provide you accurate and timely tax information, it is general in nature and not specific to your facts and circumstances. Consult a qualified tax professional to discuss your particular case.

Also, feel free to e-mail topic suggestions or questions to [email protected]