004 | Mastering Level 2 Tax Strategies: Rarely Used Tax Strategies for the Business Owner

Episode 004 | Mastering Level 2 Tax Strategies: Rarely Used Tax Strategies for the Business Owner

Welcome to the Vital Strategies Podcast, your go to resource for expert insights in the ever evolving world of tax, finance, and building wealth.
In today’s episode, we’re going to dig into what we call at Vital level two tax planning. As a reminder, level one tax planning, the IRS gives us guidance, but doesn’t take any investment. These tax savings come through good bookkeeping and administration. Feel free and go back and listen to episodes two and three to get a better understanding of all the opportunities available to you in level one tax planning.
For level 2 tax planning, the IRS gives us guidance, but we have to make a financial investment. We know you’re IRS. In today’s episode, you’ll learn how you can save up to $150,000 in income tax, or more using these strategies. There are several pitfalls to avoid, so listen to the end and make sure you’re steering clear of potential issues and getting maximum tax savings.
You’ll have peace of mind knowing you’re paying less tax so you can focus on building your business. I’m your host, Patrick Lonergan, and I’m thrilled to share today’s topic with you. Let’s dive in.
The information that we’re going to cover today is going 2023 tax year. So, if you’re listening to this in 2024, Keep that in mind.
We’re going to start with opportunities that we can put the least number of dollars into and work our way up to larger opportunities. Starting with one that you may be familiar with, traditional and Roth IRAs. Total contributions from all sources are $6,500 per year, $7,500 if you’re age 50 or older due to a $1,000 catch up contribution.
Now there are no income limits for traditional IRAs, but there are limits for Roth IRAs, which are based on modified adjusted gross income, which is your adjusted gross income with some deductions added back in the limits for 2023, for the Roth IRA are $138,000 for a single filer, or $218,000 for a married couple before the contributions start to phase out.
Now a way around these limits is to do a backdoor Roth conversion. where you make a non-deductible IRA contribution and then convert it sometime later to a Roth. You want to make sure you’re showing the IRS that you’re doing it in two steps and you aren’t just working around the income limits. It always helps to work with a professional to make sure you’re not walking into a problem you weren’t aware of.
One final note is you can’t contribute $6,500 per year to both an IRA and a Roth IRA in the same year. $6,500 is the total contribution you can make between the two accounts. You are allowed to split the amount up any way you like, though, between the two. Anyone with earned income can make IRA contributions, and we think they should.
To combine a Level 1 strategy of putting your kids on payroll and this strategy, we see no reason why you shouldn’t have your kids doing legitimate work, earning at least $13,850, so they pay no federal income tax, and then using $6,500 to fund their Roth IRA. They’ll build an enormous tax free pool of money if they start early and let it compound over time.
Finally, the great thing about Roth IRAs is there’s no penalty for taking out your contribution at any point in the future before retirement age. If you put $100,000 into a Roth IRA and it grows to $750,000 by the time you’re 45 years old, you can take the $100,000 tax and penalty free out of the account.
It is an additional source of liquidity that many people overlook. We don’t like to take the funds out because of the favorable tax treatment, but it is something to consider.
Next on the list, SIMPLE IRAs. SIMPLE stands for Savings Investment Match Plan for Employees. To establish a SIMPLE IRA, an employer must have less than 100 employees and have no other retirement plan.
Eligible employees must have at least $5,000 in compensation during any two prior years, and they must expect to receive at least $5,000 in the current year. Employee contributions are limited to $15,500 per year. $19,000 if age 50 or older due to a $3,500 catch up contribution. Employer contributions, either a dollar for dollar match, up to 3% of an employee’s compensation with a max wage of $330,000, For a total of $9,900 max additional employer contribution or a non-elective contribution of 2% of an employee’s compensation for all eligible employees.
The most that can be deferred through the simple IRA is the $15,500 for the employee deferral and the $9,900 for the employer contribution for a total of $25,400. Now, when we add the catch up [00:05:00] contribution, that gets you up to $28,900. There are better plans out there if you’re looking to maximize your benefit as the owner.
But these are easy to start if you want to get rolling early with a very easy retirement plan for your employees.
Next we have profit sharing plans. The total contribution, and these are employer only contributions, are $66,000 that can be put into the profit sharing plan.
Next, SEP IRAs. SEP stands for Simplified Employee Pension. The total contribution, which is employer only, is the lesser of 25% of the employee’s compensation, or $66,000. There is no SEP IRA catch up contribution. We have had clients with two separate businesses, and they have a SEP IRA in one business and a 401k in the other business, and they can take large deductions utilizing both plans.
Don’t overlook that. It’s a fantastic strategy.
Now let’s take a closer look at how powerful a 401k plan, including the solo 401k plan, can be. The employer contribution is $22,500 per year, $30,000 if age 50 or older due to the $7,500 catch up contribution. Total contributions, employee plus employer, are the lesser of $66,000, or $73,500 with the catch up contribution, or 100% of the employee’s compensation.
There is also a lot of flexibility in 401k plans. You can design the rules of the plan with lots of different options. You can design the plan for an employee that if they don’t stay for a period of time, their employer contribution isn’t vested. So they’d lose out on those dollars. Now we think you should run a great business that people love to work in, but this can be a strategy that if your employees don’t hang around, you’re not giving money to people that weren’t productive members of the team.
For example, if you want to put your kids on payroll, this is another opportunity for the flexibility to come in. You can have the minimum age of the 401k plan be zero years old, so all of your children are able to put money into the plan. You can also have a Roth component to your 401k. This eliminates the income limitation that would slow you down from getting dollars into the Roth IRA.
It would also allow your children to defer all of their income into the Roth component of the plan. If we want to take the Roth funding one step further, a 401k plan is a great way to do it. You can do what we refer to as a super backdoor Roth. When you’re setting up your plan, you can design it so it accepts after tax contributions. Then the plan would need to have one or both of these next options available. The plan would allow for in service distributions, which would allow you to roll these funds out of the plan into the Roth IRA, or the plan is designed to allow you to move those after tax contributions to the Roth component of your 401k plan.
We think this is a fantastic strategy.
Next on the list are defined benefit plans, or pension plans, also known as cash balance plans. These plans allow for huge deferrals. Next week, we have an entire episode dedicated to this topic because it’s such a powerful tool that is underutilized for business owners.
Here’s a quick overview of how the contributions are calculated for these types of plans. Actuaries take a look at the IRS guidelines, the client’s age, and their W 2 income to calculate how much money can go into the plan. For 2023, the income limit is $330,000 for that calculation. The older someone is, the larger their contribution will be in, because the goal is to have enough money into the plan to allow for an income stream to be taken out of the plan for the client’s life expectancy, based on the wage that they’re currently making.
So if someone’s 65 years old making $265,000 a year, They may be able to put close to $750,000 into the plan, tax deductible, that would be a tremendous savings. If their spouse is also in the business making the same wage, they may be able to double that contribution. They could put up to a million and a half dollars into the plan.
Cash balance plans can be a tremendous tool to defer taxes. Contributions also have to be made to employees of the company, but the plans can be designed to have maximum benefit for the owners.
Total contributions. The contribution limits for these plans are actuarially determined and not fixed like defined contribution plans like the 401k and the other items on the list we’ve discussed.
The limit on annual benefits received at retirement is $230,000, or 100% of the average compensation for the highest three consecutive years. Whichever is smaller. Now, there are pitfalls to avoid when deciding which retirement plan you should set up for your business.
The first one is the simple IRA. It can cause problems, and we’ve seen it happen. When you’re looking to upgrade your retirement plan, they need to be cancelled 60 days before the year end. That means by November 2nd is the latest date you can cancel the current calendar year. Now, these plans can’t be canceled mid-year, so you’d be stuck with it for the entire next year if you decided to cancel it on November 3rd.
Another pitfall is deciding between a SEP IRA and a 401k. You can contribute the same amount to each plan, but the SEP is limited to 25% of your compensation, so you might not be able to get as many dollars into the SEP as you would the 401k. I would hate to see your contributions limited just because you set up the wrong plan.
We have also had clients that have set up their own cash balance plan that have come to us because they’re overwhelmed with all the administration. You’re busy running your business, just like hiring a bookkeeper to manage your books. You should have a third-party administrator that has managed hundreds, if not thousands, of plans to handle the administration of your cash balance plan.
A couple other level two strategies that we’ll explore in depth with their own episode will be selling your business to an ESOP, which is an employee stock ownership plan, and also look into the benefits of film tax credits. If you have a large income tax bill and want to offset that for one particular year, the film tax credit can be a great way to do that.
Thank you for listening to the Vital Strategies podcast. For links to the resources mentioned in today’s show, see the show notes of this episode. And don’t forget to rate and review the show, letting us know how these tips are helping you pay less tax and build more wealth.
Feel free to submit your questions, suggestions for topics, as well as your success stories at vitalstrategies.com/questions. For all of your tax savings resources visit our website at vital strategies. com. We’ll see you again next week for another episode where we help you pay less tax so you can grow your wealth and live a great life.