Raskin Planning Group

Business Owners Want to Keep More of What They Make: Tax Reduction Strategies for the Small Business Owner

The Problem

2013 Federal Tax Rates have increased significantly for high income earners:

  • The highest marginal income tax rate has increased to 39.6%
  • Personal exemptions may be reduced or not available
  • Capital gains and dividend tax rates are increasing to 20% for those in the 39.6% income tax bracket
  • Net investment income may be taxed an additional 3.8%
  • Medicare taxes are increasing for higher income taxpayers
  • As of April 2013, Congress and the President are debating additional tax increases.

And states may be following the federal government's lead, increasing taxes on higher income taxpayers (Massachusetts is currently discussing this issue).

Government regulations and state and federal mandates can frustrate small business owners who often feel they are targets of an unfair tax system, especially if they have high personal or business income. Despite warnings from their advisors, many taxpayers will be surprised in early 2014 when they will have to actually pay these tax increases. The frustrated owner of the successful medical practice, consulting firm or small service business expects their professional advisors to be proactive and to offer creative and legal tax-reduction recommendations.

Potential Solution

The small business owner has a unique opportunity to defer taxable income into a qualified retirement plan. This strategy offers at least two, but potentially three benefits:

  • Deferring taxable income means reducing current tax liabilities. Contribute $100,000 to a retirement plan and the business-owner could reduce her or her current tax bill by $40,000 or more.
  • Saving into a retirement plan is a tax-efficient way to accumulate assets so the business-owner can actually retire. While some businesses will be sold prior to retirement and generate significant financial wealth for the owners, most business-owners are happy to diversify their assets in a tax-deferred environment. It gives them investment flexibility, sense of security that their wealth is diversified and income potential during retirement.
  • Many small business-owners rely on employees to help generate significant profits and wealth for themselves. Retaining excellent employees is an important goal for any business and helping the employee save for retirement can be an excellent retention tool.

Qualified plans can be creatively designed to meet the needs of any business. Most employers and their advisors are familiar with traditional SEP-IRA's, SIMPLE-IRA's and 401(k) Profit Sharing Plans. These plans limit contributions per employee to no more than $55,000 per year but they give the owner a lot of flexibility. Depending upon the owner's objectives and the demographics of the employee group, the owner might consider other plan designs that allow larger tax-deductible retirement plan contributions.

Many business owners in their 50's or older have mature businesses with good cash flow. They may be done paying for their children's college educations, mortgages may be paid-off and weddings paid-for. If the owner would like to save significantly more than $55,000 toward retirement each year, they might consider a combination plan that includes a cash balance pension and a 401(k) plan. For example, a small business with nine employees and two owners might be able to contribute $481,000 to their plan with more than 87% ($421,000) of the contribution benefiting the two owners. This plan design offers the owners the three benefits of tax deferral, retirement savings and employee retention.

Cash balance pension plans are not appropriate for all employers. The demographics of the group are important and will determine which plan design will best meet the owner's objectives. Cash balance plans might work well when older highly-compensated owners are paired with younger employees that earn less than $115,000. Employers should be confident in their ability and desire to continue making contributions to these plans since they are less flexible than traditional 401(k) or profit sharing plans. Also, they are often more expensive to design and administer than traditional plans.

Next Steps

Small businesses owners with high income should review their retirement plan designs and consider hiring a consultant that specializes in creative qualified plan strategies and solutions. Many employers have "outgrown" their current traditional plans and haven't reviewed them for years. Their current retirement plan providers may not be familiar with the newest and most creative designs. Finally, don't wait until December to think about tax reduction strategies for the current year since good tax strategies are best done early in the year.

Lincoln Financial Advisors Corp does not provide legal or tax advice.

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