Site icon WCG CPAs & Advisors

Retirement Planning within an S-Corp

WCG

By Jason Watson ()

This KB article is outdated. Please refer to our complete Taxpayer’s Comprehensive Guide to LLCs and S Corps at-

wcginc.com/kb/19

Or..

wcginc.com/book

Thanks!

There are lots of options with retirement planning within your LLC or S-Corp, and this article only covers the basics. A three-way conference between us, you and your financial advisor is truly the best answer.

401ks versus SIMPLEs versus SEPs versus other retirement plans can get a bit crazy to say the least.

Individual 401k
The Solo K or i401k is a great plan for a one-person show, or a one-person show with a spouse who also works for the company. Due to special tax rules, you can contribute more to this type of plan than other comparable retirement plans. Under the usual rules for defined contribution plans such as SEPs and profit-sharing plans, the deductible contribution is capped at-

But the deferrals into your solo 401k do not count towards the 25% cap, and this rule extends to your spouse. Contributions are discretionary, so you can cut back on the match, or skip it entirely during a down year.

SIMPLE 401k
If you have employees beside your spouse, a SIMPLE 401k might be a good option. Under a SIMPLE 401 plan, an employee can elect to defer some of his or her compensation. But unlike a traditional 401k plan, the employer must make either-

No other contributions such as profit sharing, can be made and the employees are totally vested in any and all contributions. You can only have 100 or fewer employees, and no other retirement plan is allowed. SIMPLE 401ks are also not subjected to discriminatory testing of highly compensated employees like traditional 401ks (although there are safe harbor provisions to get around this). And, they are much cheaper to administer ($300 to $500 per year versus $1,200).

Contributions are $12,000 in 2014 plus $2,500 for catch-up.

Traditional 401ks with Safe Harbor
Congress and the IRS want to ensure that retirement plans do not favor highly compensated employees (HCEs). To be a highly compensated employee you must either own more than 5% of the company or earn more than $115,000 in salary. From there, there are three tests. One is that you cannot defer more than 2% above the average deferral of non-HCEs (ADP test). Another test looks at matching contributions (ACP). Lastly, the top-heavy test ensures that HCEs don’t have more than 60% of the entire plan’s value.

As a small business owner, it is easy to fail any of these tests. But help is on the way through the Safe Harbor provision. You can defer the maximum, and also have the company match it, without the HCE testing, What’s the catch? There’s always a catch. A Safe Harbor plan must-

Make a dollar-for-dollar matching contribution for all participating employees, on the first 4% of each employee’s compensation (this is the most popular option), OR

Contribute 3% of the employee’s compensation for each eligible employee, regardless of whether the employee chooses to participate in the plan

Two 401k Plans
Another twist. Let’s say you have a side business and a regular W-2 job where you max out the 401k plan. You cannot contribute to your side business i401k since your other 401k is max’d, but your business can make a profit sharing contribution up to $51,000. Here is the word for word example from the IRS (occasionally they illustrate things fairly well)-

Greg, 46, is employed by an employer with a 401(k) plan and he also works as an independent contractor for an unrelated business. Greg sets up a solo 401(k) plan for his independent contracting business. Greg contributes the maximum amount to his employer’s 401(k) plan for 2013, $17,500. Greg would also like to contribute the maximum amount to his solo 401(k) plan. He is not able to make further elective deferrals to his solo 401(k) plan because he has already contributed his personal maximum, $17,500. He has enough earned income from his business to contribute the overall maximum for the year, $51,000. Greg can make a non-elective contribution of $51,000 to his solo 401(k) plan. This limit is not reduced by the elective deferrals under his employer’s plan because the limit on annual additions applies to each plan separately.

Good ol’ Greg. A non-elective contribution is in contrast to a matching contribution. This means that a contribution can be without the employee making a contribution. This is key since in our example, Greg has max’d out his deferral contribution at his regular job, so he cannot make a deferral with his side business. But the company can make a non-elective contribution.

Roth IRAs and Roth 401k Option
If you want your retirement savings to grow tax free, you need a Roth IRA or Roth 401k. Tax-free growth is generally preferred, and you can accomplish this outside of the company. However, there are some problems, or at least potential problems.

A Roth IRA is only available to those who earn less than $188,000 per year for married filing joint taxpayers ($127,000 for single taxpayers), and a Roth IRA has very low contribution limits of $6,000. What can be done? Two things- a Roth 401k, which grows tax free, can accept company profit sharing and has much higher contribution limits of $17,500. But, the administration costs of a Roth 401k can be as high as $1,400 per year. Yikes. But some fund providers such as Vanguard will heavily discount the fees if you have other retirement and investment accounts set up with them.

Another Roth like option involves two steps. First, you create a SEP, which is a Simplified Employee Pension. The company can contribute 25% of an employee’s salary (and that includes your salary) or $51,000 (for 2014), whichever is more restrictive, to the SEP. A SEP contribution is an instant reduction of income and subsequent taxes and the administrative fees are only $40 per year. Very cheap.

But here is the real elegance of a SEP. You create a SEP in 2014 and take your deduction. You convert the SEP into a Roth IRA in 2015, and this in turn creates a taxable event but no penalty. You then create another SEP in the same year to counter the tax consequence of the conversion. Imagine putting $51,000 into a Roth IRA each year- amazing. Frankly the ability to convert might not last long, but we’ll take advantage of it as long as we can.

If you have employees, a SEP can be very limiting since contributions are strictly based on salary of all eligible employees.

Personal Defined Benefit Plan
This plan is somewhat exotic, but might be a good option for those business owners in their 50s but who didn’t save as much as they would have liked. The IRS allows a maximum annual contribution about $255,000 for people in their 50s. We say “about” because the calculation is based on current age and years to retirement. For younger owners, this is not an attractive option.

Total holdings in the plan are limited to $2.3 million to $2.4 million, enough to cover the maximum allowed payment in retirement of $200,000 a year. The IRS also has strict required minimum contribution rules and a steady source of income is fairly important.

Other Considerations
Another concern is controlled groups. If you think you are clever and create a holding company to only offer retirement savings plans to certain employees (like your family), the IRS says No. There are controlled group rules where a holding company that controls another company must offer the same retirement programs for both companies.

Two general types of controlled groups might exist- a parent-child and brother-sister. The parent-child is where one company owns another. That’s simple. It gets a bit more complicated with brother-sister where various individuals own multiple companies. By definition, a brother-sister controlled group exists when five or fewer individuals, estates or trusts own a controlling interest (80% or more) in each organization and have effective control.

Don’t get too wrapped up in controlled groups- just understand the basic premise of what you offer in one must be offered in others if a controlled group exists.

There are also several options and combination of options, and we can work with your financial advisor to settle into the best plans.

Exit mobile version