Small business owners have many concerns, not least of which is retirement benefits for themselves and their employees. Many employers offer a 401(k) plan to their employees to help address retirement needs. While many small business owners take advantage of the deferred compensation available to them under the 401(k) plan, there are ways to increase the benefit and value of these plans.
While employee contributions are limited to $17,500 for 2013, the annual tax deferral limit is $51,000 ($56,500 for those over age 50). The tax deferral limit is the maximum amount that can be contributed to an individuals 401(k) account in a single year, it combines both the employee’s contribution as well as the employer’s contribution. As an example, a small business owner might contribute the full $17,500 deferral available to herself in a year under the 401(k) rules. In addition, the business makes a profit sharing contribution of $33,500 to the owners account, for a maximum contribution to the business owner of $51,000.
For small business owners looking to maximize their savings and minimize their taxes, utilizing a profit sharing option in a 401(k) plan can be a very good decision. Here are some of the benefits for small business owners:
- Employee contributions to the plan are not taxed by the federal and most state governments until they are distributed (usually at retirement age).
- Employer profit sharing contributions are an allowable business deduction. Contributions to the plan are not taxed until they are distributed.
- The small business owner can defer up to $51,000 to his / her 401(k) account in a single year. Significantly more than if they just maximize the $17,500 employee contribution limit.
- The profit sharing contribution is discretionary and can vary by year. If the business has a difficult year, the profit sharing contribution can be reduced.
- A well designed and funded profit sharing plan can help attract great employees.
- Administration and costs are negligible.
There are several different types of profit sharing plans. The one I see the most is called a “New Comparability Plan.” A new comparability plan is a profit sharing plan that divides employees into groups. A simple division between groups might be an owner group and a non-owner group. Each group receives a profit sharing contribution match based on a percentage of compensation. However, the match percentage for each group does not have to be the same. As such, profit sharing contributions can be allocated significantly in favor of the small business owner.
As an example, the non-owner group might receive a contribution based on 3.0% of their salary and the owner group might receive a contribution based on 9.0% of their salary. If there is one employee in the non-owner group and their compensation is $40,000, the company will make a profit sharing contribution of $1,200 to the non-owner. If the owner’s compensation is $200,000, the company makes a profit sharing contribution of $18,000. So for a total cost of $19,200,which is fully tax deductible, the owner will receive $18,000 into her account. The goal for a small business owner might be to reach the annual tax deferral limit of $51,000 in a given year. Deferring this amount of income annually will save significant tax dollars and should create significant long term wealth for the small business owners.
There are some restrictions, including discrimination testing. However, most of these restrictions can be overcome by contributing 5% to the employees’ accounts, then the small business owner should be able to defer the full $51,000 for herself. Additionally, you will need to engage someone experienced in creating these types of plans, which has an administration cost. However, for many small business owners, the tax benefits can be substantial.
If you have any questions in regard to this article, please contact Jamie Downey at 800-849-6022 or jmdowney@downeycocpa.com.
