By Jason Watson, CPA
Posted Monday, December 30, 2024

There are also several options and combination of options, and we can work with you to settle into the best plans. Here are some jumping off points-

One Person Show or Husband/Wife Team

Solo 401k plan with Roth Option is the best bet. Very low cost, efficient contributions, and has a good mix of pre-tax and after-tax contributions to hedge against future income tax rate risk.

Second best option is SEP IRA which allows conversion to Roth IRA each year. But this is usually after the fact, or when you are in crisis management mode and want to save taxes.

Multi Owner Partnership or MMLLC

Owners-Only 401k plan.

Multiple Employees

Company-sponsored 401k plan with Roth and Safe Harbor provisions is the best bet. Similar benefits to Solo 401ks. However, Safe Harbor provisions forces the business to make contributions to avoid highly compensated employee (HCE) testing.

Piggyback the profit sharing plan and cash balance plan to the 401k plan to super-size your contributions while retaining over 90% of the plan assets for the owners.

SIMPLE 401ks are not as attractive. While the non-elective business contributions are slightly lower than 401ks, the contribution limits are low in comparison. At $60,000 in salary, a 401k allows for a total plan injection of $38,500 ($23,500 + 25% of $60,000) whereas the SIMPLE 401k is only $17,300 for the 2025 tax year.

Multiple Entities

Company-sponsored 401k plan implemented at the multi-member LLC level and adopted at the subsidiary S Corp entity level. This would be an Affiliated Service Group and be subjected to controlled group testing.

Piggyback the profit sharing plan and cash balance plan to the 401k plan to super-size your contributions while retaining over 90% of the plan assets for the owners.

SIMPLE 401ks are not as attractive. While the non-elective business contributions are slightly lower than 401ks, the contribution limits are low in comparison. At $60,000 in salary, a 401k allows for a total plan injection of $38,000 ($23,000 + 25% of $60,000) whereas the SIMPLE 401k is only $17,300 for the 2024 tax year.

Multiple Entities

Company-sponsored 401k plan implemented at the multi-member LLC level and adopted at the subsidiary S Corp entity level. This would be an Affiliated Service Group and be subjected to controlled group testing.

By Jason Watson, CPA
Posted Monday, December 30, 2024

For our small business owners or contractors working overseas, there is a consideration when it comes to tax deferred retirement planning. Currently the amount of foreign earned income that can be excluded from ordinary income tax is $130,000 (for the 2025 tax year). Therefore, if you qualify as an expat and your income is less than $130,000 all your income is excluded.

Fast forward, if you elect to defer some of your earnings into a tax deferred retirement account you might be creating a tax liability unnecessarily. In other words, if your income was already being excluded from income tax, why put money into a tax deferred retirement account just to pay tax on the money later when that money was never supposed to be taxed in the first place. Huh? Stay with us.

You make $130,000. You pay $0 in taxes. You put $7,000 in a normal trading account. This $7,000 was never taxed and never will be. You make $10,000 on it because you’re smart. You sell the investments and recognize a $10,000 taxable gain all at capital gains rates.

Same situation, but with an IRA-

You make $130,000. You pay $0 in taxes. You put $7,000 (for the 2025 tax year) in an IRA. This $7,000 is not taxed. You make $10,000 on it because you’re smart. You sell the investments, withdraw the money and recognized a $17,000 taxable gain, all at ordinary income tax rates.

There are more devils in the details of course, but you get the general idea. To put money away in a tax deferred retirement account when that income was already going to be excluded generally does not make sense. A Roth IRA in this situation would be more ideal.

Implementing a 401k plan doesn’t solve any problems either. According to the IRS and specifically IRC Sections 1402(a)(11), 3401(a)(8) and 911, and Revenue Ruling 70-491, if all your income is excluded using the foreign earned income exclusion, then you cannot contribute to a 401k plan.

Revenue Ruling 70-491 sums it up from 1970 (when the foreign earned income exclusion was $25,000). An attorney established a profit-sharing plan and earned $40,000. The ruling stated only $15,000 was considered earned income for the purposes of Section 401 (which is where we get 401k plan stuff).

By Jason Watson, CPA
Posted Monday, December 30, 2024

Two arguments abound when considering a pre-tax 401k contribution. The argument goes like this- your retirement tax rate will be lower than your wage-earning tax rate. For those in the 32%, 35% or 37% marginal tax brackets, this is likely true. However, those earning big bucks probably continue to earn big bucks during retirement from investments, real estate, consulting, etc.

The other argument is about the free loan from the IRS. If you contribute $31,000 ($23,500 + $7,500 catchup for the 2025 tax year) to your pre-tax 401k and you are in the 32% marginal tax bracket, you just put $9,920 in your pocket ($31,000 x 32%). Another way to look at this is that $31,000 only took $21,080 in cash.

Sure, at some point the IRS wants it back when you withdraw it during retirement and will tax the original contribution plus whatever you earned on it. But this might fall into the let’s worry about next time, next time category.

As such, the second argument is about using the IRS’s money to build additional wealth. You take your $9,920 and do something good with it. Yeah, this argument sort of works. $9,920 annually might not move the needles much on your wealth building strategies. You would need $9,920 x 10 years at 6% rate of return just to afford a down payment on an average rental property.

Rather, most wealth is built with after-tax dollars. The leveraging of the IRS free loan concept sounds great on paper until you gain perspective on the size of the lever.

Another side argument is completely avoiding state income taxes by reducing your state income and therefore income tax with 401k contributions during your wage-earning years, and then establish residency in a tax-free or a tax-friendly state during retirement.

The theories above make sense; however, we ask a basic question- is it easier to pay taxes during your wage-earning years or during retirement? Sure, it depends how much you withdraw during retirement. Please consider that to spend $150,000 during retirement, you might have to withdraw upwards of $180,000 to account for the income taxes.

During your wage-earning years you might have the ability to work a little harder to pay for taxes now. Pick up an extra shift. Close an extra deal. Get a few more tax returns out of the door if you are a tax accountant. Whatever it takes, right? During your retirement years, especially mid-70s or older, you pay taxes with retirement savings (or at least it feels like you do depending on your cash sources).

Also, keep in mind that your primary objective in life is to build wealth. Your second objective is to save taxes, and what a lot of people forget about is saving taxes is not done in a vacuum or just one year; it is done over your entire lifetime.

Finally, consider that the law of 72 suggests that your investments will double every 8 years. Huh? The average rate of return for the S&P 500 is 9.2% since inception. If you take 72 and divide it by 9 (the rate of return) this equals 8, and suggests that your investment will double in 8 years. Where are we going with this? If you have 2 or 3 “doubles” coming up, to have that growth be tax-free upon retirement might be nice.

As mentioned elsewhere, WCG CPAs & Advisors recommends financial planning by a qualified planner to determine your objectives and model your particular scenario.

By Jason Watson, CPA
Posted Monday, December 30, 2024

What if the structure did not have any employees and only had owners? This changes the rules a bit since now discrimination, or specifically, exclusions are allowed within 401k plan documents.

Let’s also go back to our example and say that Fred and Shaggy all had created solo 401k plans for each respective S Corp. This works, but only if there are no other employees other than owner-employees.

Here is how it looks-This would allow Fred and Shaggy’s S corporations to pay W-2 shareholder wages and make employer 401k contributions at the S Corp level. Beauty! Why should Fred and Shaggy have to plan for retirement in concert with each other, or worse be limited by Velma’s three ex-husbands who are bleeding her dry? You didn’t know that about Velma, did you? Messy.

In other words, Fred could put away $70,000 (for the 2025 tax year) into his 401k plan while Shaggy only contributes $15,000 into his 401k plan. These plans are independent and are not cross-tested, and as such each owner can do his or her own thing.

As you can see Affiliated Service Groups and 401k plans don’t defeat the beauty of the MMLLC – S Corp schematic, it just makes it a bit more complicated. There are more rules about FSOs, ASGs, A-Orgs and B-Orgs… nauseating. Just remember the possible issues and do the homework. WCG works with a handful of Third-Party Administrators (TPAs) who can give you deeper advice and defend the 401k and profit-sharing plans.

Here is a link to our referrals document-

wcginc.com/9500

401k plans are about $1,000 to $1,500 annually yet piggybacking a profit-sharing plan will add additional fees. You can custody the plan assets with any custodian who accepts outside retirement plans and TPA services.

By Jason Watson, CPA
Posted Monday, December 30, 2024

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

A quick recap of the limitations of a garden variety Roth IRA- a Roth IRA is only available to those who earn less than $246,000 per year for married filing joint taxpayers ($165,000 for single taxpayers) for the 2025 tax year, and a Roth IRA has very low contribution limits of $7,000. What can be done? Two things- a Roth 401k, which grows tax free, can accept business profit sharing and has a much higher contribution limits of $23,500 (for the 2025 tax year) or $31,000 with catch-up as we’ve already discussed. That is option #1.

Another Roth like option involves two steps. You create a SEP IRA in 2024 and take your deduction on your 2024 tax return. You convert the SEP IRA into a Roth IRA in 2025, and this in turn creates a taxable event for 2025 but no penalty. You then create another SEP IRA in the same year to counter the tax consequence of the conversion. Imagine putting $70,000 (for the 2025 tax year) 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. However, SEP IRAs can be viewed as the middleman, and we always want to cut out an unnecessary stop. Implementing a 401k plan circumvents this.

If you have a traditional IRA you can do the same thing. Be careful about shooting your income into the stratosphere in terms of marginal tax brackets. Too many financial advisors and taxpayers mess this up. Let us help. Let us model this taxable event.

Another option along the IRA lines is to make a non-deductible traditional IRA contribution and then convert that into a Roth IRA the following year. This has zero tax consequence since it was never deducted in the first place. Therefore, if you make too much money for a Roth IRA contribution you can contribute to a non-deductible traditional IRA and later convert it.

You are limited to one rollover or conversion per year per account (there is mild controversy within the IRS publications and industry practices on the number of allowed rollovers).

By Jason Watson, CPA
Posted Monday, December 30, 2024

Simplified Employee Pension Individual Retirement Arrangement. Yes, the A in IRA does not stand for Account, it technically is Arrangement but if you say Account, it’s okay. We know what you mean. But if you call your IRA a 401k, our OCD does not allow us to let that one go. IRAs are not 401ks and 401ks are not IRAs. From what we understand, we can no longer say “our OCD.” Our apologies. So many words and phrases we used to say… it’s probably better that we don’t anymore. We digress…

How about this? Our super highly stressful and highly technical profession coupled with the desire to be hyper accurate cannot let you call your 401k plan and IRA and vise versa. Bagels and donuts are both breakfast foods, but that is where it ends. Hopefully that explanation is better than the OCD reference.

Back to business. As an employee, you do not make contributions to a SEP IRA, the business does so on your behalf. Yes, it is a tax deduction to the business which is essentially a tax deduction to you. The business can contribute 20% of business income (for sole proprietors, single-member LLCs and partnerships) or 25% of your salary (for corporations such as S Corps). There are no catch-up provisions since the business is making the contribution.

All eligible employees must have a pro-rata employer contribution. So, if you make $100,000 and your assistant makes $30,000, if the business contributes 10% on your behalf it must do the same for your assistant.

Four reasons why these are fading (but there is a silver lining below)-

• SEP IRAs require much higher salaries to reach the $70,000 maximum retirement savings for the 2025 tax year,

• Pro-rata contributions strictly based on salaries is no more beneficial or less restrictive than a 401k with Safe Harbor, and

• The administrative costs of 401k plans have been reduced to that of a SEP IRA.

• Another consideration is that the SEP IRA does not allow for plan loans whereas 401k plans do (up to $50,000 for the 2024 tax year).

SEP IRA contributions are due with the associated tax return including extensions (similar to employer contributions in 401k plans). An interesting yet allowed tactic is to always file an extension for your tax returns. This allows you to file your tax returns any time up to the extension deadline, but not make the employer contribution until the extension deadline. Huh? Hang in there on this one. Here is another way of saying it-

You could file an extension on February 1. File your Form 1040 on March 1. And make the contribution on October 15. However, if you skipped the extension filing and simply filed your Form 1040 on March 1, your SEP IRA contribution is due April 15. Weird. Then again, we don’t make the rules, we just tell you about them.

SEP IRAs are old school in favor of the 401k plan. Prior to the SECURE Act, 401k plans must be implemented before the calendar year is over, SEP IRAs can be used for crisis management after the fact. As such, December 31st can come and go blowing up your desire to have a self-employed 401k plan, but a SEP IRA can be created after January 1 and allow for previous year contributions and tax deductions.

However, with the SECURE Act, you can open a 401k plan in 2025, and make employer contributions in 2025 but have them earmarked for the 2024 tax year. Employee deferrals are not available in this fashion. So, your 401k plan is not “retro’d” back to the previous year, but the SECURE Act provisions allows for prior year contributions. Subtle difference. You can think of this similar to a SEP IRA which can be opened in 2025, contributed in 2025, but applied to 2024.

By Jason Watson, CPA
Posted Monday, December 30, 2024

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

• A matching contribution up to 3% of each employee’s pay up to $350,000 (for the 2025 tax year), or

• A non-elective contribution of 2% of each eligible employee’s pay (non-elective means that the business must do it without fail to maintain the plan’s integrity)

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 (HCEs) unlike traditional 401k plans.

Contributions are $16,500 for the 2025 tax year plus $3,500 for catch-up.

SIMPLEs have fallen out of favor recently since the only real benefits were no testing and low costs- that has changed a lot lately since the landscape of 401k plan providers is much more competitive (low cost) and lawmakers have given us 401k with safe harbor provisions so therefore no highly compensation employee (HCE) testing.

We haven’t seen these plans get deployed with any kind of regularity since Bush was president. As in the first one.

By Jason Watson, CPA
Posted Monday, December 30, 2024

Oftentimes business owners want to put away a ton of money in a small business 401k plan, but cannot due to inherit limitations within the plan. Or business owners want to keep most of the plan money for themselves, which is shocking yet natural. For example, to have the business make a 10% profit sharing contribution, every eligible employee will also receive a 10% contribution which is usually undesirable. You only thought having a staff was a pain because of drama and turnover. Add this dilemma to the list.

You work hard to make money, and you shouldn’t have to work too hard to keep most of it. There are turbocharger kits you can add to your normally aspirated 401k plan. These usually work best with an underlying safe harbor 401k plan. Here we go-

• Age-Weighted / New Comparability Profit Sharing Plan, and

• Defined Benefits Pension / Cash Balance Plan

Age-Weighted

A profit sharing plan based on age allows older employees to receive more of the profits than younger employees (hence the tricky name of age-weighted). Another way to look at this is to consider those closer to retirement possibly needing the most assistance in saving for retirement. This also makes sense since older employees are usually more valuable, and therefore profit sharing plans can be used to discriminate in their favor.

Age-weighted profit-sharing plans are designed to be top heavy, and two people earning the same salary can have very different profit sharing contributions simply based on age which is perfectly acceptable. No, there is a not a weight-weighted formula where older employees are usually heavier and therefore get more of the profit sharing. That would be fun though. Brings a whole new meaning to a top heavy plan. There are probably some more jokes in there, yet we digress.

How the formula works is beyond this book, but an age-weighted profit sharing plan allows a business to contribute more to those employees who are older including owners.

New Comparability

The new comparability profit sharing formulas take age-weighted formulas one step further by grouping certain employees together such as officers, executives, clerical, etc. Officers are given a higher portion of the profit sharing, and within the officer group the older employees are given a higher portion. A double shot. For example, a crusty officer will have a much larger contribution than a new administrative assistant.

The new comparability method is also referred to as cross-tested, and will normally have underlying actuary consultants defending the plan’s provisions and discrimination. Remember, discrimination is not bad as long as it can be justified and supported. Yes, this adds to the cost. But let’s look at a real life example that WCG worked on to see how this works first.

The following is a husband and wife business with over $600,000 in net profits from 2016. Yeah, it is a bit old but the illustration remains meaningful.

Employee	Age	Salary	Deferral	NEC	Profit Sharing	Total
Mike	43	265,000	18,000	7,950	27,050	53,000
Susie	43	212,000	18,000	6,360	28,640	53,000
Linda	35	62,155	2,486	1,865	876	5,227
Aaron	29	39,868	1,595	1,196	562	3,353
Timothy	32	24,611	0	738	347	1,085
Blake	25	33,452	0	1,004	472	1,475
Jacqueline	31	34,411	1,376	1,032	485	2,894
Denise	23	27,529	0	826	388	1,214
Nate	32	22,104	0	663	312	975
Tony	26	22,086	0	663	311	974

Tilt. Analysis on the next page.

Here are some observations and clarifications-

• NEC refers to non-elective contributions, and in this example these are the contributions required under the safe harbor 401k plan provisions.

• Profit sharing is based on salary and age. Note the subtle differences for everyone except Mike and Susie.

• $53,000 was the maximum allowed under a 401k plan with tiered profit sharing for 2016.

• In this real case, the owners kept 75% of all monies put into the plan. Not shabby.

• The annual cost in 2016 to administer this plan was $2,500.

• The tax deferral savings was over $53,000 for these business owners including state income taxes too (based on 39.6% federal rate and 11% state rate). This was California, and the couple plan to retire in Nevada- instant 11% tax savings.

• Yes, those salaries for Mike and Susie are ridiculously high. Therefore, the increase in payroll taxes must be weighed against the savings and benefits. After $176,100 (for the 2025 tax year) only Medicare taxes are being “unnecessarily” paid at 2.9% plus the surtax of 0.9%. The benefits could outweigh this 3.8%.

Defined Benefits Pension / Cash Balance Plan

If the age-weighted or new comparability profit sharing plans supercharge a 401k plan, the defined benefits pension and cash balance plan turbocharges it. We can hear gear heads moaning all over the country above turbo and super charging your engine. Regardless, the defined benefits pension and cash balance plan adds a ton of meat to your 401k platter. Here we go.

A defined benefit is in contrast to a 401k plan since a 401k plan is a defined contribution. A defined contribution plan specifies the amount going into the plan and has nothing to do with how much will be available when you start taking withdrawals. It could be $0 or millions. A defined benefit is a calculus where some future benefit is defined and is usually a stream of payments similar to an annuity.

A cash balance plan is a form of a defined benefits pension, with one major difference. The participant can see his or her account balance grow over time similarly to an IRA or 401k plan. A cash balance plan can be considered a hybrid since it does not rely on formulas and salary histories although it falls under a defined benefits umbrella by definition.

This is important. Since it is a defined benefit, the business has an obligation to fund the plan. Unlike a defined contribution, defined benefit is a 3-to-4-year commitment and a business cannot adjust contributions into the plan based on performance or cash flow needs. There are provisions allowing a business to pause the plan, but that gets tricky really fast. We have heard of cases where the IRS has seized a business owner’s house and assets until the pension was correctly funded. Ouch.

A cash balance plan is usually piggybacked onto a safe harbor 401k plan, and it truly is a separate plan (the latter is a defined contribution, and the former is a defined benefit). So why would a small business want a cash balance plan in addition to a 401k plan? The usual reason- put more money into a self-employed retirement plan for the owners’ personal retirement and defer taxes.

Similar to age-weighted and new comparability profit sharing plans, cash balance plans use a person’s age to determine the amount that can be contributed and use actuary consultation to defend the plan’s discrimination.

Here is a quick list of the 2024 amounts that can be contributed into a cash balance plan based on age-

Age	401(k) only	401(k) with Profit Sharing	Cash Balance	Total	Tax Savings
66-70	30,500	76,500	376,000	452,500	181,000
60-65	30,500	76,500	336,000	412,500	165,000
55-59	30,500	76,500	274,000	350,500	140,200
50-54	30,500	76,500	214,000	290,500	116,200
45-49	23,000	69,000	167,000	236,500	94,600
40-44	23,000	69,000	130,000	199,500	79,800
35-39	23,000	69,000	101,000	170,500	68,200
30-34	23,000	69,000	79,000	148,500	59,400

Before you lose your mind on the tax savings (which is assumed to be at 40% total between federal and state), you need the cash to do so. To save $116,200 at age 50 you need to part ways with $290,500 in cash. Also, if your spouse is on the payroll, you can double it.

Here is a link to FuturePlan by Ascensus who provides a full table-

wcginc.com/6104

Here is another real life example that we consulted on in 2016 (outdated, but very illustrative and current in concept)-

Employee	Age	Salary	401k Deferral	Profit Sharing	Cash Balance	Total Contribution
Betty	45	265,000	18,000	35,000	75,000	128,000
Fred	47	115,385	18,000	35,000	0	53,000
Subtotals		380,385	36,000	70,000	75,000	181,000
Wilma	43	70,181	9,825	4,562	500	14,887
Dino	25	23,109	693	1,502	500	2,695
Pebbles	29	22,892	687	1,488	500	2,675
Barney	23	13,908	417	904	500	1,821
Mr. Slate	23	13,444	403	874	500	1,777
Arnold	26	11,670	350	0	0	350
Tex	51	7,088	213	0	0	213
Daisy	18	713	0	0	0	0
Subtotals		163,005	12,589	9,330	2,500	24,419
Totals		543,390	48,589	79,330	77,500	205,419

It is a lot to absorb, and we could have cut off the example after Pebbles but we wanted to give you a real case. More notes and clarifications-

• Betty and Fred are the owners, and were able to keep 92.5% of the money contributed to the 401k and cash balance plans. That is ridiculously good!

• Profit sharing can be on a gradual vesting schedule over 6 years (same holds true for standalone profit sharing plans without the cash balance piggyback).

• Cash balance contributions can have a cliff vesting over 3 years (remember the 3 to 4 year commitment previously mentioned).

• Total tax savings was 51% since this case was also in California, or about $92,000 combined for just the owners’ portion.

• The annual cost to administer this in 2016 was $1,750 for the 401k plan portion and $4,300 for the cash balance plan. Cash balance plans are pricey since actuary consultants are used to defend the plan’s discrimination. Worth every penny.

Ok, so we’ve covered the basics of how to turbocharge your 401k plan to allow for more contributions and tax savings. What are some of the downsides?

The plan costs are not low. Sure, the tax savings is much higher than the costs, but those tax savings are actually tax deferrals. And in most cases tax deferrals become tax savings, but you must be disciplined on using those savings to grow your business or invest wisely (which might be the same thing).

Asset management fees range from 1.5% to 3% for Vanguard, American Funds, Nationwide, etc. 401k plans and defined benefits pension plans have two cost elements- the direct plan cost including a per participant charge, plus the asset management fees. Granted asset management fees are everywhere you turn- but small 401k plans usually have the highest. Having said that, small 401k plans are also nimble and completely customizable so your investment options are vast.

The commitment on a defined benefits pension and cash balance can be huge. And there are some devils in details such as minimum interest rate credits and other things that can be challenging. This is not your problem- the people you retain to manage your defined benefits pension and cash balance plan take on this responsibility.

If a handful of employees are older than the owners, this will adversely affect how much the owners can contribute into the plan for themselves. As mentioned, profit sharing and cash balance plans are age-based. Ideally the owners are 8-10 years older than the rank and file for this to work well.

Total holdings in the defined benefits pension plan are limited to about $3.5 million (for the 2024 tax year), enough to cover the maximum allowed payment in retirement of $350,000 a year (for the 2025 tax year). The IRS also has strict required minimum contribution rules and a steady source of income is fairly important. Therefore, you cannot be a contingency based attorney with a huge stockpile of cash today without being able to demonstrate the ability to support the plan next year and the following years.

By Jason Watson, CPA
Posted Monday, December 30, 2024

Another twist. Let’s say you have a side business and a regular W-2 job where you max out your deferrals into the 401k plan. You cannot make employee deferrals to your side business solo 401k plan since you are collectively limited to $23,500 (for the 2025 tax year) or $31,000 with catch-up, but your business can make a discretionary non-elective contribution up to $70,000 or $77,500 with catch-up (for the 2025 tax year).

Here is the word for word example from the IRS using 2016 limits of $18,000 as an example (occasionally they illustrate things 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 2016, $18,000. 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, $18,000.

He has enough earned income from his business to contribute the overall maximum for the year, $53,000. Greg can make a non-elective contribution of $53,000 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. From the employer or business perspective, a discretionary non-elective contribution is in contrast to a matching contribution. This means that a contribution can be without the employee making a deferral. This is key since in the tidy IRS example above, Greg has max’d out his deferrals at his regular job, so he cannot make additional deferrals with his side business. However, the business can make a non-elective contribution.

A non-elective contribution means that the business’s contribution is not dependent on the employee’s deferral. Seems counter-intuitive. In other words, you do not put anything into the 401k plan, but your business can contribute up to 20% of your income from the business as a garden variety LLC (or 25% of your W-2 from your business if electing S Corporation status). These are also referred to as discretionary contributions.

Sidebar: The phrase profit-sharing contributions is sometimes used as well. However, this is like interchanging 401k and IRA. Technically, a profit-sharing plan is different than a 401k plan, and it can either be standalone or deployed in combination with a 401k plan.

Therefore, if a company has excess profits (cash) and wants to make a contribution to the 401k plan, these are considered discretionary non-elective contributions and not profit-sharing contributions. This is because a 401k plan is being used and not a profit-sharing plan. Our apologies for splitting hairs and getting all nerdy on the nomenclature.

In summary, the $23,500 (for the 2025 tax year) limit is your limit as a person. But each 401k plan has a limit of $70,000 (see the last line of the IRS example on the previous page using 2016’s limits) which can add a lot of muscle to your self-employed retirement plan.

No, you cannot add your W-2s together (main job and side job) and use that for the basis of your side job / business employer contribution. That would be nice though.

Warning! Each year a handful of small business owners neglect to let us know they picked up W-2 income on the side, and they also forget to inform us that they contributed to their “side W-2 gig’s” 401k plan. Yes, we ask. We ask often. Therefore, keep in mind that the $23,500 deferral limit into a 401k plan (for the 2025 tax year) is for all plans, combined.

By Jason Watson, CPA
Posted Monday, December 30, 2024

If you want your retirement savings to grow tax free, you need a Roth IRA or Roth 401k. But don’t get too hung up on the phrase tax free growth. Roth IRAs and Roth 401k’s are not for everyone, and tax deferral today (non-Roth investments) might be the better answer as alluded to earlier (see Tax Savings and Tax Deferrals). Let’s back up the truck a bit and chat about the Roth tag on an IRA or 401k. Yes, a Roth IRA is different than a Roth 401k. The words have dramatically different meanings.

The 401k and traditional IRA came about because it was theorized that you had a much higher marginal tax rate during your wage-earning years than you would during retirement. For example, you could easily be in the 22% marginal bracket when you are 55, but be in the 12% bracket when you are 70. So, you would save taxes at 22% and pay them back at 12%. Not bad. This theory still holds true for hundreds of thousands of Americans but there have been some recent hiccups.

The data were shifting and suggested that the delta between wage earning marginal tax rate and retirement marginal tax rate was waning. So, some smart people got together and passed laws allowing the Roth IRA. Specifically, it was Senator William Roth from Delaware in 1997 who passed the legislation. Thankfully not much was going on in Delaware in the 90s and Senator Roth was able to create this excellent legislation. As you might be aware, the Roth IRA allows you to take after-tax dollars and invest it, and when you take the money out all of it is tax-free. Beauty!

So, the Roth IRA is not a tax deferral system like a traditional IRA. It is a pay tax now and avoid paying tax later system. But all that glitters is not gold as Robert Plant would say. A Roth IRA is only available to those who earn less than $246,000 per year for married filing joint taxpayers ($165,000 for single taxpayers) for the 2025 tax year, and a Roth IRA has very low contribution limits of $7,000 (for the 2025 tax year). Yuck. Now what?

Enter the Roth 401k which is a hybrid of a 401k and a Roth IRA, and can be a great selection among the small business retirement options. All the taste of a Roth IRA without the calories. Starting January 2006, many businesses amended their 401k plans and started introducing Roth options. So, even if your small business doesn’t adopt a 401k plan, your spouse’s job or your main job might benefit from the Roth 401k. Ask your benefits administrator to see if your other job or your spouse’s other job offers the Roth 401k option.

A Roth 401k has no income limitations and employees (you) can defer up to $23,500 (for the 2025 tax year) or $31,000 with catch-up. But business contributions cannot be designated as Roth. Since the business (employer) matching or profit-sharing is a deduction to the business, these funds are considered pre-tax and will not enjoy tax free growth. In other words, your contributions as an employee may be designated as after-tax or Roth type contributions, and the business’s contribution will be automatically designated as pre-tax or traditional type contributions.

Note: The SECURE Act of 2022 allowed for employer contributions to be post-tax (Roth). Many 401k plans are outdated and don’t allow for this, and need to be restated.

In essence, the Roth 401k has two accounts which can be managed separately within the 401k plan; one after-tax and another pre-tax.

Since the biggest challenge in deciding on using a Roth IRA or Roth 401k pivots on your marginal tax rate during retirement, and crystal balls don’t have the accuracy they used to, a good plan is to hedge against both. A Roth 401k has this feature built-in. Your deferrals as an employee can be Roth (post-tax) which hedge against retirement tax rates being similar to wage earning tax rates. Conversely, business funds are traditional (pre-tax) and hedge against retirement tax rates being lower than wage earning tax rates. Got it? How about this-

Employee deferral into 401k	Pre-Tax (deduction to you)
Employee deferral into Roth 401k	Post-Tax
Business contributions into 401k	Pre-Tax (deduction to you vis a vis the business)
Business contributions into Roth 401k	Allowed since SECURE Act of 2022

The mix between the two is the challenging part. 80% Roth and 20% pre-tax? 60-40%? Truly depends on your vision of retirement and your income sources. Bunch of rental income and residual earned income? Rich parents leaving you with thousands of dollars in dividend income? Gotta coin to flip? Two out of three? As mentioned earlier, financial planning and tax projections are the starting point for an answer that will unfortunately take a lifetime to validate. We can see your headstone now- “Her tax projections hit a 95% confidence interval. Kids are proud.” Small font or big stone. You decide.

Therefore, be careful of anyone telling you to always max out your Roth contributions without at least asking questions. Yes, there are zillions of calculators available on the internet- simply search for “ira versus roth ira calculator” and the inundation will be overwhelming. Or perhaps underwhelming.

Historically Roth options on a 401k plan used to be costly, but thanks to Adam Smith and his concept of economics, fierce competition has driven the pricing down. Many of WCG CPAs & Advisors small business owners leverage eTrade for their 401k plan.

By Jason Watson, CPA
Posted Monday, December 30, 2024

Solo 401k plans do not need a safe harbor provision- this is reserved for company-sponsored 401k plans. Regardless, we believe you should understand the rules.

Congress and the IRS want to ensure that self-employed 401k plans do not favor highly compensated employees (HCEs). To be a highly compensated employee you must

• either own more than 5% of the business or

• earn more than $160,000 in salary (for the 2025 tax year) and was in the company’s top 20% in terms of pay.

Therefore, nearly all small business owners are HCEs from an ownership perspective regardless of salary. There are three tests-

• You cannot defer more than 2% above the average deferral of non-HCEs. Take a standard deviation curve, go out 2%, and draw a line in the sand. This is the ADP test (Actual Deferral Percentage).

• Another test looks at matching contributions from the employer (your business). This is the ACP test (Actual Contribution Percentage).

• 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 and more likely all three. A common example is where you have several plan participants, but only your HCEs are deferring close to the maximum. This creates a top-heaviness to your small business 401k plan, and the tax code will fail your plan by suggesting it discriminates in favor of a few highly compensated employees. Not your fault of course since you cannot force your staff to make deferrals into the 401k plan, but if the cookie crumbles that way the plan fails.

If your 401k fails the ADP or ACP testing, there are two methods to bring the 401k plan back into compliance. One method is to make an employer contribution for all non-HCEs. The second method is more individualized where each HCE is refunded a portion of their contributions and those amounts are also contributed by the employer to all non-HCEs. Messy and complicated. Read IRS Revenue Procedure 2013-12 for more information.

But isn’t that the point? Isn’t the point of a self-employed retirement plan to give the people who are worth the most, the most of the business’s benefits and resources (i.e., the owners)? Of course, it is. At the same time, we must play by the rules. So, help is on the way through the Safe Harbor provision. You can defer the maximum, and also have the business match it, without the HCE testing. What’s the catch? There’s always a catch in the “harbor.”

A Safe Harbor plan must satisfy four requirements, with required contributions being the main one. This entails using one of the following formulas-

• Basic- Match 100% of the first 3% of compensation, plus 50% of the next 2% of compensation, or

• Enhanced- Match 100% on the first 4% of the compensation, or

• Non-Elective- Contribute 3% of compensation to all eligible employees

The first two options appear to be more in favor with small business owners than the third since you can take the chance that not all employees will contribute. In addition, the safe harbor 401k plan must have-

• 100% vesting for the required contributions,

• provide an annual notice to all participants, and

• contain withdrawal restrictions (no hardship withdrawals, for example).

However, if the business contributes more than the safe harbor amount, that portion may follow a vesting schedule.

Therefore, don’t run out and make your 401k a 401k plan with safe harbor provisioning just because you think you need it. If you do not see a problem passing the discrimination tests, then skip it. For example, you have a small business, the disparity of salaries is low, everyone is participating well and you as the owner are not overloading the plan. Your 401k plan might pass testing as is without having to add the safe harbor provision. Remember, under the safe harbor provision, the employer is required to make contributions according to one of the options above. So, there’s your catch.

One planning strategy is that if you require a 401k with safe harbor, you could use the required contribution to defer an annual raise. In other words, you could attempt to pass on an employee raise by contributing the obligatory 3% (for example) employer portion of a safe harbor 401k plan. Probably only one time though, unless you enjoy posting jobs and conducting interviews. Even the first attempt might be a bust.

As a side note, those employee groups that have a collective bargaining agreement can have a separate 401k plan. For example, airlines have pilots who are a large employee group and who have the most discretionary income among the other groups. Therefore, if the airline had one single 401k plan, it would probably fail ADP or ACP testing. Instead of electing safe harbor provisioning, the pilot group is allowed to have its own 401k plan under a collective bargaining agreement which isolates the plan from flight attendants, customer service, mechanics, etc. Who knew? I’ll take 401k plans for $600, Ken.

By Jason Watson, CPA
Posted Monday, December 30, 2024

The i401k, solo 401k, solo k, uni k, or owners-only 401k (or whatever marketing name a bank or securities firm is selling) is a great small business retirement plan for-

• a one-person show,

• a one-person show with a spouse who also works for the business, or,

• a group of members in a multi-member LLC that does not have any employees. The Economic Growth and Tax Relief Reconciliation Act of 2001 modified the contribution limits and rules, and allowed for an emergence of the owners-only 401k plan.

Due to special tax rules, you can contribute more to this type of plan than other comparable retirement plans. The previous table in the beginning of this chapter illustrated this point with real life numbers. Under the usual rules for defined contribution plans such as SEP IRAs and profit-sharing plans, the deductible contribution is capped at-

• 25% of your salary or 20% of your earned income (as adjusted), or

• $70,000 for the 2025 tax year (plus $7,500 for catch-up) whichever is more restrictive.

But your deferrals as an employee into your solo 401k plan do not count towards the 20% and 25% caps, and this rule extends to your spouse. This is why the owner-only or solo 401k plan allows for the largest contribution because you have three sources of funding-

• You at $23,500 (for the 2025 tax year) plus $7,500 for catch-up (employee deferral), and

• Ditto for your spouse, and

• The business contribution up to 25% of your W-2 compensation or 20% of your self-employed earnings, and

• The funding is independent of each other (deferrals are deferrals, and contributions are contributions).

Read that again. Let’s say you have a $60,000 salary, $39,000 to invest into retirement savings and you are married. If only one person draws a salary, he or she can only defer a maximum of $23,500. But if a married couple pays a $30,000 salary to each person, then the total retirement deferral can be $47,000 without having to increase salaries to allow for a larger business contribution.

With a SEP IRA, in contrast, you would need a 4 x $47,000 or $188,000 salary to make the same retirement contribution (alternative math is $47,000 from the example above divided by 25%). The increase in payroll costs would wipe out your returns for at least two years. Not good. We’ll talk more about why a SEP IRA is used for crisis management and not for self-employed retirement plans (although the recent passage of the SECURE Act makes this moot, but we’ll explain anyway).

Here is an illustrative table showing this concept in a different way from Chapter 10 (Adding Your Spouse to Payroll, page 269) where we show Susan earning $100,000 versus Susan earning $65,000 and Mark earning $35,000.

	Option A		Option B
	Susan		Susan	Mark
Salary	110,000		70,000	40,000
401k Deferral	31,00		31,000	31,000
Business Contribution	27,500		17,500	10,000
Total 401k	58,500		89,500

Deferrals and contributions are discretionary, so you can cut back as cash flow and objectives change. The deadline for funding the business (employer) matching or non-elective contribution to your solo 401k plan is the tax filing deadline for your business including extensions. So, if you are an S Corp, the business tax return (Form 1120S) is due March 15. But with a tax return extension you could delay the funding until September 15. However, sole proprietors have until April 15 (the tax return filing deadline) or October 15 (if you file an extension) to make his or her deposits.

Employee deferrals for corporations (such as an S Corp) must be deposited by the 15th of the following month. So, a March 27 paycheck for Q1 would require you to deposit employee funds by April 15, which is typically a slow day around the WCG office (kidding, we’re celebrating at the local taco bar).

These deadlines are true for all 401k plans (solo, company-sponsored, Roth option, Safe Harbor provision, etc.). However, there is more wiggle room and less scrutiny for when employee deferrals are deposited since discovery is a challenge (in other words, you won’t rat on yourself). To keep things simple and elegant, we recommend following the same schedule as “big person” 401k plans.

As a side note, there is nothing saying you cannot wait until Q4 to make all your deferrals into your 401k plan, or any other quarter where perhaps a little bit of market timing or dollar cost averaging might be beneficial. Being the boss gives you flexibility with your small business retirement options.

Side Note: There is nothing saying you cannot wait until the last few months to make all your deferrals into your 401k plan, or any other quarter where perhaps a little bit of market timing or dollar cost averaging might be beneficial. Being the boss gives you flexibility with your small business retirement options.

Sidebar to the Side Note: Be careful about running out of room on your last few paychecks of the year. If you are paying yourself $60,000 a year or $5,000 a month, your November and December paychecks will be $10,000 and will not have enough room for a one and done $23,500 (for the 2025 tax year) employee 401k deferral. Then again, nothing that a bunch of payroll amendments can’t solve. Yeah, that sounds cheap and easy.

Unlike company-sponsored 401k plans, the individual or solo 401k plan does not need to perform discrimination testing of highly compensated employees (HCEs). More on that in a bit.

Solo 401k plans are also very economical to administer, allow for attractive retirement savings for you and your spouse, and remain simple enough to avoid all the hassles of a full company-sponsored plan. A company-sponsored plan (in contrast to a solo 401k plan) will cost about $1,000 to $1,500 per year (as of December 2024, WCG CPAs & Advisors has 80 team members and our 401k plan with Sure401k, a sister company to SurePayroll, was about $1,700 annually).

However, most solo 401k plans only charge for the commission or sales charge of the investments. For example, if you invest in A share mutual funds, there is a one-time sales load or commission of 5.75% (which might vary a bit between funds and fund classes). On that particular investment there are not any additional commissions, and the account fees are very small or non-existent. A shares (as opposed to C shares) are desirable for long-term investing since the commission paid is a one and done, and this cost is essentially amortized over several years.

The only downside is you cannot have a solo 401k or an owners-only 401k if you have employees. Even one part-time admin might blow this up depending on their hours and years of service (see below).

By Jason Watson, CPA
Posted Monday, December 30, 2024

Many taxpayers walk into our offices at WCG CPAs & Advisors and tell us they want to pay fewer taxes. Who doesn’t? We usually chuckle, and tell the client that he or she is the only one and it is sooooo refreshing to hear someone want to pay fewer taxes. Sorry for being snarky, but taxes are a way of life. Yes, our job is to have you pay the least amount of taxes permitted by law and not a dollar more, but that isn’t the only objective.

Tax savings comes in four variants- you can lie, cheat and steal, or you can understand the allowances, deductions and credits alongside the wiggle room afforded by the IRS code. We prefer the latter of course although the audit rate risk of 0.4% for S Corps and partnerships makes it all too tempting. Darn laws and ethics!

However, notice how 401k plans, IRAs, and other tax-deferred vehicles are not listed as one of the four ways to save taxes within self-employed retirement plans. A tax deferral is not automatically a tax-savings technique- it might be. It might not be. In true accountant fashion, it depends.

This is a real-life case- we have two Boeing engineers who saved about $1 million in the company 401k plan. The employee deferrals were all pre-tax, so they avoided about $250,000 in taxes since they were in the 25% marginal tax rate. Not bad.

However, they currently have four children, a house mortgage, and the usual tax deductions of a household of this size and age. When this couple retires in 2025, their marginal tax rate will increase to 32% due to their pension income and other income sources, and the dramatic reduction in tax deductions and credits.

So, they saved at 25% and they will pay it back at 32%. Bummer. But wait! There is more to the story. Just like Paul Harvey, there is a page 2, or in the case of this book, on the next page. Yes, we are dating ourselves by referring to Paul Harvey but when that is all your parents listened to in the car, it is hard to forget.

What about all tax deferrals? Where does that money go? Usually to buy stuff like cars, vacations, food, and other consumables which don’t offer a return on investment. But what if this same couple invested the current tax deferrals into a conservative portfolio which yields a nice 5% rate of return (after tax consequence)? Things tilt in their favor- so we are back to having a tax benefit from tax deferrals. Huh?

The following is a ridiculously overly simplified table to demonstrate what we are talking about. Here are the assumptions-

• Defer $23,500 (for the 2025 tax year) per year for 10 years.

• Marginal tax rate is 22% during wage earning years.

• Rate of return on investing tax deferral savings is 5% net of taxes.

Year	Defer		Tax Savings @ 22%		Growth at 5%
1	23,500		5,170		5,480
2	23,500		5,170		11,289
3	23,500		5,170		17,447
4	23,500		5,170		23,974
5	23,500		5,170		30,892
6	23,500		5,170		38,226
7	23,500		5,170		46,000
8	23,500		5,170		54,240
9	23,500		5,170		62,975
10	23,500		5,170		72,233
Total	235,000		51,700		72,233

A quick recap- you deferred $235,000 and deferred $51,700 in taxes. That deferral grew to $72,233 because you invested it in a safe 5% investment portfolio. Great. What does this do?

Here is the realized savings for a 22% marginal tax rate during retirement-

Withdrawals Taxed at 22%	51,700
Growth on Tax Savings	72,233
Realized Savings (difference)	20,533

If your marginal tax rate remains the same at 22% you still see a savings of $20,533 as shown above. Again, this is predicated on you taking the tax you normally would have paid and investing it wisely. Not all of us are this disciplined.

But if your marginal tax rate increases from 22% to 35%, your savings is zero. Granted, to jump 13% in marginal tax rate between wage earning years and retirement years seems rare, but you get the point.

The moral of the story is this. Yes, tax deferrals can lead to tax savings, but you must work the system and be disciplined. Not just today, but for several years, and you need a jump in marginal tax rate that is 9% or less (in general). Assuming you have an increase at all. See below-

Withdrawals Taxed at 32%	75,200
Growth on Tax Savings	72,233
Realized Loss (difference)	-2,967

The bummer of this table is the leap from 22% to 32% marginal tax rate. Recall that you deferred tax at the 22% marginal tax rate. If you pay it back at 22%, then you are golden. You pay it back at 32% (the next marginal tax rate), then you lose money.

What should you do? Financial planning and review with your financial advisor is a must. Generally, we see people in the 10 and 12% marginal taxes doing post-tax (Roth). We see people in the 32, 35 and 37% marginal tax rates doing pre-tax. Then, we see people in the 22 and 24% marginal tax rates doing a mixture of post-tax and pre-tax retirement contributions.

We’ll talk about the hedge with the employer (your business) contributions being made with pre-tax dollars. In other words, your 401k deferrals are Roth (post-tax) and your employer contributions are pre-tax. This combination is a great hedge.

Note: The SECURE Act of 2022 allowed for employer contributions to be post-tax (Roth). Many 401k plans are outdated and don’t allow for this, and need to be restated.

There is also the RMD angle. RMD is a common TLA (three letter acronym) tossed around at bingo parlors and country clubs, and stands for required minimum distributions. In a nutshell, the IRS forces you to take out a portion of your pre-tax retirement savings every year so they can collect on the IOU you gave them several years ago.

RMD calculations are simple. You take your age, find your life expectancy factor and divide that into your aggregate pre-tax account balance. Do you remember science class and discussing a molecule’s half-life? RMDs are very similar- over the course of retirement, you must withdraw pre-tax retirement dollars, but the calculus doesn’t force you to take it all out over your lifetime. It always has some factor of your age, and depending on your frugality you might die with a pile of money since the minimum leaves behind a lot.

The IRS released updated life expectancy tables and distribution periods in November 2020. The last time this was done was nearly 20 years ago! Here is snippet of the IRS RMD table which can be found in the appendix of IRS Publication 590-B (the most recent is for the 2022 tax year)-

Age	Factor
72	27.4
75	24.6
80	20.2
85	16.0
90	12.2

So, if you are 75 years old and had $1M in pre-tax money, your RMD would be $40,650 ($1,000,000 divided by 24.6).

What does this have to do with tax deferrals becoming tax savings? At some point you die, and if you only take out the minimum amount from your accounts, you will die with money in the bank. And this now-inherited IRA, for example, is taxed at your heirs’ rate. Under the new SECURE Act from December 2019, distributions from inherited IRAs to individuals other than spouses must be fully distributed in 10 years. There are some exceptions and other issues such as disabled individuals and minors, but that is the general gist.

The IRS wants to collect your previous IOU to them, like a Vegas bookie, and they don’t want to watch you keep kicking the can down the road.

So, for you there is tax savings built into the RMD system since not all the money is taken out and taxed. If you add in your heirs’ marginal tax rates, perhaps this changes from a “family unit” perspective. Heck, you’re the dead person- let your kids worry about your taxes by assuming them as their own. It takes a while to payback for all those sleepless nights and stinky diapers, but eventually it happens.

All kidding aside, here is something to consider- with life expectancy well into the 90s, your children might be retired too when you pass. Crazy but realistic, especially if you had kids before you had a career.

By Jason Watson, CPA
Posted Monday, December 30, 2024

Most people have a pretty good handle on personal finance and basic retirement savings, and while the principles are generally the same in the small business world, a lot of business owners have a deer caught in your headlights at 2:00AM look when it comes to leveraging their business for retirement. And there is good reason- retirement planning within your small business carries a bunch more options and potential pitfalls (sounds like life in general, doesn’t it?).

Reasons for Small Business Financial Planning

There are three major wealth considerations for small business owners (or anyone for that matter)-

• Accumulation (fun and exciting part)

• Preservation (the tricky part)

• Transfer (the necessary evil part)

Each of these major wealth considerations are interwoven, needs comprehensive focus to ensure the necessary dots are connected, and should have no gaps or holes exist during transitions. That is where financial planning comes into play.

Accumulation is easy. Most people think if they toss some money at a mutual fund they are planning for retirement. Nope.

Preservation gets tricky since we need to have our money outlast our lives. And with people living well into their 90s, this can be tough. Let’s put it another way- if you work for 40 years, from age 25 to 65, you need to save enough to live for another 25-30 years. That is incredible. If you are spending $100,000 at age 55, you better be making $180,000 and putting the $80,000 into a moderate growth retirement vehicle.

Preservation also includes proper insurance, asset protection through trusts, pro-active maneuvering and other tools in the toolbox.

Transfer of wealth is automatic. We have yet to see a hearse with a trailer hitch. Or, said in a completely starker way, every life comes with a death sentence. How it is executed is partially up to you. Did we just ruin your appetite? Sorry.

Transfer of wealth can also be tricky. The current federal estate tax exemption is $13.99 million (for the 2025 tax year) per person, and a passed spouse can posthumously port his or her exemption to the surviving spouse. Not bad. And most people don’t have over $26 million in estate value. Rich people problems (now referred to as high net worth… the most over-used and water-downed phrase today).

Sidebar: According to a November 2019 Forbes article, over $30 trillion in wealth will be transferred by baby boomers. Furthermore, according to a 2018 study from Bankrate.com, millennials are less inclined to invest in the stock market. So, where this wealth goes is certainly unclear.

These federal exemption amounts are indexed each year, and while Congress can always vote to repeal, this estate tax exemption was written in stone with passing of the American Taxpayer Relief Act of 2012. However, various states have much lower exemptions. For the 2022 tax year, Connecticut was $9.1 million, Hawaii was $5.5 million, among other examples.

Nebraska does not have an estate tax, but they do have an inheritance tax (the recipient pays depending on relationship and could be as high as 13%). California, the class favorite, is one of 33 states that do not impose an inheritance tax. Apparently, you’ve been taxed to death and there is nothing left to tax when you die in California.

Therefore, just because you are out of woods federally, doesn’t mean the transfer your wealth is free of taxation. Get a plan.

What about your business? Does it have an exit strategy or wealth transfer strategy? Businesses are like marriages; easy to get into, hard to get out. Add this to the plan.

The reasons for financial planning are-

Goals and Objectives

Define your goals and objectives, determine your current position and discover unmanaged risks. This sounds simple and makes sense, but defining goals and objectives is a fluid concept. They change. And as they change, the plan needs to be malleable enough to adapt. Financial plans are modified annually or whenever a major life change as occurred, whichever is more frequent. This is important.

The Plan

Financial plans also create a blueprint and chart a course on how to reach goals and objectives while managing risk. Again, this sounds simple. But even the most basic house needs a blueprint for framers, plumbers, electricians and even inspectors to review and implement. And in the case of a financial plan, these same players are your financial advisors, tax professionals, attorneys and insurance specialists.

Accountability

Financial plans also provide confidence, measure success and hold everyone accountable. If everyone agrees that your financial plan will ensure financial security in your life, then it becomes a measuring stick for determining success along the way. Anyone can throw some money at an investment, but what does it mean? And does it fit the plan? And is the selection of that investment meeting the plan’s objectives.

WCG CPAs & Advisors can always assist you with retirement and financial planning as it relates to your small business and taxation. If you need a referral for a financial advisor, we might be able to help with that too. However, we have fallen out of favor with a lot of the assets under management fee schedules, so we have trouble endorsing an advisor since most charge a percentage based on your asset values. We are not quite sure how the size of your portfolio translates into time and expertise, and in turn the value for services provided, but we digress.

Small Business Retirement Plans Comparison

We are going to put the carriage in front of the horse, and show you a comparison of basic small business retirement plans before explaining each plan. We cheated, and used Pacific Life’s online calculator to demonstrate these differences. Why re-invent the wheel? And frankly, they do a fantastic job at this type of stuff. Here is their link-

wcginc.com/6103

We took a handful of salaries (for corporations including S corporations) and net incomes (for sole proprietors and partners in partnerships) and plugged them into Pacific Life’s calculator, and came up with the following table based on the 2025 tax year limits-

Salary/Income	Entity	Max 401k	Max SEP IRA	Max SIMPLE
60,000	Sole Prop / Partner	34,662	11,152	18,162
60,000	Corporation	38,500	15,000	18,300
125,000	Sole Prop / Partner	46,734	23,234	19,963
125,000	Corporation	54,750	31,250	20,250
150,000	Sole Prop / Partner	51,381	27,881	20,656
150,000	Corporation	61,000	37,500	21,000
186,000	Sole Prop / Partner	58,111	34,611	21,653
186,000	Corporation	70,000	46,500	22,080
246,000	Sole Prop / Partner	70,000	46,451	23,315
246,000	Corporation	70,000	61,500	23,880
280,000	Sole Prop / Partner	70,000	53,159	24,257
280,000	Corporation	70,000	70,000	24,900
365,000	Sole Prop / Partner	70,000	70,000	25,086
365,000	Corporation	70,000	70,000	27,450

 

Note the bolded $70,000 number. This is the maximum defined contribution amount permitted in 2025 per plan (and Yes, you can have two plans- we’ll talk about Greg and his two plans in an example later).

Crazy! The following are some quick observations-

• In 2025, the maximum you can contribute to a qualified retirement plan is $70,000 ($69,000 for the 2024 tax year). You can go above this with a defined benefits pension (cash balance)- more on that later.

• Partnerships (those required to file Form 1065) follow the same limits as Sole Prop above.

• $186,000 in W-2 salary from your C Corp or S Corp is the magic number for maximizing your 401k. After that, any increase in salary does not help. Your fastest way to reach your contribution limit is through a 401k plan.

• $280,000 in W-2 income from your S Corp is the minimum salary for a max SEP IRA contribution.

• $365,000 from your small business or K-1 partnership income from your Schedule E as reported on your individual tax return is the magic number for maximizing your SEP IRA contribution. SEPs are old school and used for crisis management rather than planning (more on that too).

• Earned income from a sole proprietor is net profit minus 50% of your self-employment (SE) tax minus your contribution. Since the contribution actually adjusts the maximum contribution, this can be a circular reference. And No, 401k or SEP contributions do not reduce SE tax.

• 401k max is computed by taking $23,500 employee (you) contribution, plus 25% of your W-2 or earned income (as adjusted). This is for the 2025 tax year.

• SEP IRA max is computed by taking 25% of your W-2 or earned income (as adjusted).

• Max SIMPLE 401k is basically $16,500 plus 3% of your W-2 or earned income (as adjusted). Don’t spend too much time thinking about SIMPLE 401k plans.

• You can add $7,500 for catch-up contributions if you are 50 years old or older.

Note: With the SECURE 2.0 Act, those aged 60-63 can do “super catch-up” allowing $11,250 versus $7,500 catch-up contributions into a 401k plan for the 2025 tax year. The $11,250 number is 150% of the regular catch-up limit, and in the case of a 401k plan, that is $7,500. If this should change, the super catch-up automatically adjusts.

Let’s talk about each of these qualified plans in turn, starting with the 401k. Out of the box, or non-traditional retirement plans will follow (profit sharing plans, defined benefits pensions, cash balance plans, Section 79 plans, etc.). Exciting!

By Jason Watson, CPA
Posted Saturday, November 5, 2023

Spouses generally have attribution to the other spouse by virtue of marriage. For example, a 5% shareholder cannot receive educational benefits from a corporation and by virtue of marriage neither can your spouse.

However, spouses may have separate businesses with separate 401k plans without violating controlled group rules. This also allows each plan to be tested separately. For example, one spouse could have a business with employees and offer a 401k plan with safe harbor provisioning. The other spouse could also have a solo 401k plan for his one-person S Corporation.

Here is the snippet from 26 CFR 1.414(c)-4-

(5)Spouse –

(i)General rule. Except as provided in paragraph (b)(5)(ii) of this section, an individual shall be considered to own an interest owned, directly or indirectly, by or for his or her spouse, other than a spouse who is legally separated from the individual under a decree of divorce, whether interlocutory or final, or a decree of separate maintenance.

(ii)Exception. An individual shall not be considered to own an interest in an organization owned, directly or indirectly, by or for his or her spouse on any day of a taxable year of such organization, provided that each of the following conditions are satisfied with respect to such taxable year:

(A) Such individual does not, at any time during such taxable year, own directly any interest in such organization;

(B) Such individual is not a member of the board of directors, a fiduciary, or an employee of such organization and does not participate in the management of such organization at any time during such taxable year;

(C) Not more than 50 percent of such organization’s gross income for such taxable year was derived from royalties, rents, dividends, interest, and annuities; and

(D) Such interest in such organization is not, at any time during such taxable year, subject to conditions which substantially restrict or limit the spouse’s right to dispose of such interest and which run in favor of the individual or the individual’s children who have not attained the age of 21 years. The principles of § 1.414(c)-3(d)(6)(i) shall apply in determining whether a condition is a condition described in the preceding sentence.

Drool. Let’s cook the previous legalize down to two major bullets-

• Spouses don’t have direct ownership in each other’s business (mine is mine, yours is yours), and

• Spouses don’t meddle in each other’s business affairs.

Don’t get too wrapped up in controlled groups or affiliated service groups- just understand the basic premise of what you offer in one must be offered in others if a controlled group exists. We can help identify the problem and then steer you to people smarter than us on this extremely narrow topic.

By Jason Watson, CPA

Posted Saturday, November 5, 2023

If you have a staff, but you do not want to deploy a company-sponsored 401k plan, you can still maintain an owners-only self-employed 401k plan by excluding employees.

• Your plan can exclude any employee who has not reached the age of 21.

• If the employee is 21 years old, and during a calendar year, the plan year (which is usually the calendar year) or any rolling 12-month period does not work at least 1,000 hours, he or she may also be excluded.

If one of these conditions is true, then you can maintain your solo 401k plan.

Don’t go out and try to make your admin an independent contractor. In most states, to maintain independent contractor status, the person must hold themselves out to the public as a contractor in that trade or profession. We don’t see too many full-time, dedicated, one-client admins running around with business cards and websites advertising admin services.

There is wiggle room. First, there are PEO (professional employee organizations) which allows you to hire the leased employees, but the PEO runs payroll and handles all the human resource functions. There is some mounting pressure on PEOs since they help small business owners avoid or reduce a lot of things such as unemployment compensation insurance, workers compensation premiums, fringe benefits, health care, and in some cases, retirement plans.

You can also have everyone in your office be licensed. For example, insurance agents, financial advisors or real estate agents might work together as a team, but with revenue sharing capabilities an independent contractor status can be maintained while effecting certain “control.” This gets tricky and is a narrow example.

By Jason Watson, CPA
Posted Saturday, November 5, 2023

We don’t want to go too far down this road, but you should be aware of this option. It is usually reserved for highly compensated employees such as executives who can set aside more money, and it might allow a non-qualified deferral to help a qualified plan, such as a 401k plan, to conform to plan testing. 401k plans with profit sharing and defined benefits pension piggybacks usually eliminate the need for this.

Exotic Stuff

There are all kinds of exotic stuff out there. Be careful. If it sounds too good to be true, check it out. Do your research. Talk to us. Yes, there are several legitimate yet exotic plans out there. A lot of them use life insurance as the vehicle. Life insurance has many unknowns and can prove difficult to tease out the problems or issues. With life insurance there must be an insurable interest by the policy owner, and some of the life insurance-based plans cannot be used in a pass-through entity such as S corporations and disregarded entities such as single-member LLCs.

Here are some things that might be a good fit for you and your business-

Self-Directed 401k Plans

Self-directed 401k plans allow you to invest into non-traditional investments such as rentals, other businesses, etc. This is very similar to self-directed IRAs. However, similarly to self-directed IRAs, self-directed 401k plans have several pitfalls such as unrelated business taxable income (UBTI) and unrelated debt financed income (UDFI).

Please visit our website for more information-

wcginc.com/sdira

You can also review our previous chapters. Be careful with self-directed IRAs and 401k plans. Not always a bad thing, but being unaware can leave you with expensive lessons.

Employee Stock Ownership Plans

You can also set up an employee stock ownership plan (ESOP) where employees can purchase business stock over time, and the stock is held in trust. A cool feature is the tax deferral of this system- the employee-owned portion of the business profit’s is added to the ESOP’s overall asset balance, and is only taxed when the employee makes withdrawals similar to an IRA. Check out the National Center of Employee Ownership here-

wcginc.com/6110

Section 79

Internal Revenue Code Section 79 offers huge deductions of policy premiums and instant tax savings. A Section 79 plan is where life insurance is offered as a group policy, but employees are able to obtain more benefits that are taxable as income. However, there is cash value to the policies that allow for borrowing in the future. There is one inherent problem- when a life insurance policy for a business under ten employees is underwritten, no medical exam is necessary which means the policy has high risk. And to balance that, the policy will have poor cash accumulation. Short-term gains, potentially long-term failures. Are all Section 79 plans bad? No. Just do your homework and ask those pointed questions.

Captive Insurance Company

If you have high property and casualty insurance needs, you can create another corporation that is essentially in the insurance business by collecting premiums from your primary business and investing those premiums into quality investments. The primary business gets a massive tax deduction since insurance premiums are an expense, and if the premiums are less than $1.2 million per year, the captive insurance company only has to pay taxes on the investment income.

Read that again. The captive insurance company does not pick up any taxable income directly from the premiums paid. Eventually the money is returned to you at dividend tax rates.

Tax savings is difference between ordinary income tax rates and capital gains tax rates.

The use of a captive insurance company is disclosed on your tax returns as well. At present, WCG has about 30 clients who leverage this arrangement, and with recent tax court and federal court decisions, captive insurance is under severe scrutiny and is being lumped with other abusive tax shelters.

Controlled Executive Benefits and Endorsement Split-Dollar

These programs are similar in the sense that life insurance is used to retain key employees by controlling the access to the cash value. The tax deferral or tax savings might not be available with type of arrangement, and depending on how it is setup, the payout to the beneficiary might be taxable as well. This is very complicated, and your garden variety financial planner might not be comfortable with these. Your best bet is to speak directly to an advisor who works for a life insurance business such as Transamerica, Northwestern Mutual, New York Life, etc. Or at the very least get a second opinion.

Again, do your homework and ask around before jumping into a life insurance-based product. They have their place, and they can provide huge tax savings especially during high marginal rate tax years. But not all products and plans are the same.

By Jason Watson, CPA
Posted Saturday, November 5, 2023

We don’t want to go too far down this road, but you should be aware of this option. It is usually reserved for highly compensated employees such as executives who can set aside more money, and it might allow a non-qualified deferral to help a qualified plan, such as a 401k plan, to conform to plan testing. 401k plans with profit sharing and defined benefits pension piggybacks usually eliminate the need for this.

By Jason Watson, CPA
Posted Saturday, November 5, 2023

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 business must offer the same retirement programs for both businesses.

Two general types of controlled groups might exist- a parent-child and brother-sister. The parent-child is where one business owns another. That’s simple. It gets a bit more complicated with brother-sister where various individuals own multiple businesses. 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.

For example, you are smart and you connect with two other smart people to form a multi-member LLC. Since you have a revenue splitting scheme that varies from year to year, you use the multi-member LLC as a funnel and feed income to the underlying S corporations. Therefore, each person owns an S Corp that owns an equal interest in the multi-member LLC. Simple enough.

In this example, a 401k plan would be better implemented at the multi-member LLC level. Let’s dive into the details shall we?

Affiliated Service Group Rules

Let’s say a law firm is structured as a partnership similar to the schematic above. There are three partners. Each partner is separately incorporated as a professional corporation and taxed as an S Corp. Each corporation has a one-third partnership interest in the law firm (MMLLC). The sole employee and sole shareholder of each professional corporation is an attorney who would otherwise be an individual partner of the law firm if he or she were not incorporated. Easy so far.

All billings for legal services are done by the law firm and partnership income is distributed among the corporate partners according to the Operating Agreement. The law firm is the First Service Organization (FSO) and each of the three S corporations is an A-Organization (A-Org) with respect to that FSO. The four organizations constitute an Affiliated Service Group (ASG). This is the “classic example” of an ASG and can create all kinds of problems with retirement plans.

How did we go from easy to yuck in just a few sentences? A business is automatically a First Service Organization (FSO) if it engages in one of the following fields-

• Accounting

• Actuarial Science

• Consulting

• Engineering / Architecture

• Health / Medicine

• Insurance

• Law

• Performing Arts

This list should look a little familiar; it was the basis for the specified service trade or business (SSTB) designations for Section 199A. While you do not see certain professions called out, such as Financial Advisors, the IRS and ERISA are more concerned with function over form. Accounting + Consulting + Insurance might equal Financial Advisor. So be careful on trying to consider this list to be strict from a definitions perspective.

If you are an ASG, then the employees of all of the ASG businesses are deemed to be employed by a single employer for purposes of meeting the retirement plan provisions outlined below-

• Non-discrimination rules, IRC Section 401(a)(4)

• ADP/ACP testing for 401k plans, IRC Sections 401(k) and 401(m)

• Compensation limits, IRC Section 401(a)(17)

• Participation and coverage rules, IRC Sections 401(a)(3), 401(a)(26) and 410

• Vesting rules, IRC Sections 401(a)(7), and 411

• Limits on contributions and benefits, IRC Sections 401(a)(16) and 415

• Top-heavy rules, IRC Section 416

• SEP and SIMPLE rules, IRC Sections 408(k) and 408(p)

How do the IRS and ERISA find out? Challenging for sure! We’ve seen businesses run around with an ASG for a decade without a problem. But let’s say the IRS develops an app that allows them to peer over your shoulder. Aside from them telling you to floss more, they also notice your 401k plan.

By Jason Watson, CPA
Posted Saturday, November 5, 2023

401k plans may have loan provisions. This means you can borrow up to 50% of the account balance with a 2024 tax year hard ceiling of $50,000 (or 50% of $100,000+). This limit has not changed for several years. You are basically paying yourself interest on the loan.

401k plans can also buy life insurance, which is a neat way of deducting your life insurance premiums since the money going into the 401k plan may be pre-tax. There are all sorts of rules and limitations, but you should be aware of this option.

By Jason Watson, CPA
Posted Saturday, November 5, 2023

Let’s lay some groundwork first. On your individual tax return, you have three basic IRA options-

• Traditional IRA, deductible

• Traditional IRA, non-deductible

• Roth IRA, not deducted

You probably knew this already, however, we want to focus on the traditional IRA that is non-deductible due to income limits. At some point in household income, a Roth IRA is unavailable. Bummer. Yet at another point, a deductible traditional IRA is unavailable leaving the non-deductible IRA contribution. Super bummer.

No biggie, right? You simply do a Roth conversion of the non-deductible traditional IRA. Not so fast. There is a little-known problem called aggregation where you must ratably convert both the deducted and non-deducted IRA pools simultaneously should you do any conversion.

For example, you have $90,000 in deducted IRA funds and $10,000 in non-deducted IRA funds for a total of $100,000. If you want to convert $10,000 into a Roth IRA, you will be converting $9,000 from the deducted IRA pool and $1,000 from the non-deducted IRA pool. The $9,000 will be a taxable event.

The solution is to roll your deducted traditional IRA funds into your 401k plan leaving your non-deducted IRA funds naked. Then in turn you convert these remaining funds into a Roth IRA.

By Jason Watson, CPA
Posted Saturday, November 5, 2023

Other benefits of having a 401k within your business include being able to consolidate other plan assets such as profit sharing, money-purchase plans, traditional IRAs and SEP IRAs into your 401k plan. You can gain some elegance with this- for example, often times your IRA will have both deductible and non-deductible contributions. You could roll the deductible contributions into your solo 401k plan and roll the non-deductible contributions into a Roth IRA or Roth 401k (a Roth conversion). No, Roth IRAs cannot be rolled into your 401k unless the 401k has a Roth option.

Another benefit comes from backdoor Roth conversions. When converting a non-deductible IRA contribution to a Roth IRA, all your IRAs are considered even the pre-tax (deductible) ones. Your conversion is subject to “pro-rata” rules which is summarized by SmartAsset.com as “if your traditional IRA contains both pre-tax (deductible) and after-tax (non-deductible) contributions, the Pro-Rata rule dictates that your Roth conversion will be taxed proportionate to your pre- and post-tax percentages.”

Therefore, a solution is to take all your pre-tax IRA contributions and roll them into your solo 401k plan. This leaves only the after-tax contributions behind which can then be converted to Roth without tax consequences.

Some words of caution. Rolling old IRAs and such into your shiny new self-employed 401k plan might not be the best idea. In some cases, the rollovers will be captive or trapped in the 401k plan. For example, let’s say you have a $50,000 IRA and you move it into your 401k. Two years later you have a crisis and need to access the $50,000. Your 401k plan might not allow you to withdraw this money without a hardship provision, have an in-service rollover or allow loans against the plan assets. These features, or some would say are poorly documented limitations, vary among plan providers.

Another concern is the filing of a 5500-EZ tax form. This is not a massive problem, but once your 401k plan reaches $250,000 in plan assets, you must file a 5500-EZ each year.

Also, 401k plans (beyond the solo 401k plans) might have higher fees and fewer options. In our observation, many 401k plans have an annual asset management fee of 1.5% to 3.0% of assets, whereas most IRAs (and solo 401k plans) operate for less than 1.5% annually. There are kickbacks from the asset managers to the 401k plan administrators which is why you see some administrators like Wells Fargo offering free 401k plans.

By Jason Watson, CPA
Posted Saturday, November 5, 2023

Typically, an employee must be allowed to participate in the 401k after obtaining 21 years of age and one year of service. One year of service is defined as 1,000 hours in any calendar year, plan year or rolling 12-month period.

Plans can be modified to have less restrictive eligibility requirements, and the recent SECURE Act has allowed part-time employees to enroll into a 401k plan without being counted towards plan testing.

401k plans cost around $1,000 to $1,500 annually for the plan administration from a TPA (third party administrator) and there are asset management fees of 0.5% (index funds) to 1.5% (managed mutual funds) as well.

Therefore, you will have two vendors with a traditional or company-sponsored 401k plan. You will have a 401k plan administrator and you will have a custodian / asset manager. These are oftentimes handled together but have several clients who custody the assets with Vanguard, for example, yet maintain the plan administration, like filing Form 5500, themselves. Seems like a lot of work.

Be very leery of ADP, Paychex and Wells Fargo. These are the top 401k plans that are lost to competitors who offer better customer service, better choices and overall better plans for you and your employees. Wells Fargo is notorious for offering “free” 401k plans, and once you are committed, you discover that the plan is very limiting and underperforms. Free? Really? When was the last time you received something for free that was worth keeping (besides an office doughnut)?

You don’t work for free, so be careful of those who claim to.

By Jason Watson, CPA
Posted Saturday, November 5, 2023

There are 401k plans that allow you to invest in non-traditional investments such as real estate or buying a business. A common phrase you hear in a ROBS 401k which stands for Rollover for Business Start Ups. It is beyond the scope of this chapter, and frankly it can be a very bad idea although it sounds hip at your next cocktail party. Rob is certainly the operative word since we see a lot of these ideas rob people of their retirement money.

A self-directed IRA is easier to set up and maintain, while a self-directed 401k plan is much more challenging. While these two self-directed vehicles share similar problems and gotchas. Here is a recent post on the pitfalls of self-directed IRAs and 401k plans-

wcginc.com/6133

If you want more information, we have worked with Equity Trust and New Direction IRA who can create and help maintain these accounts and plans.

By Jason Watson, CPA
Posted Saturday, November 5, 2023

A 401k plan is a defined contribution plan. Specifically, the name 401k refers to the section in the IRS code that allows for retirement plan contributions to give you an instant tax savings. Technically it is Title 26, Chapter 1, Subchapter D, Part I, Subpart A, Section 401, Subsection K.

Subchapter D deals with deferred compensation. Part I deals with pensions, profit sharing, etc. Subpart A deals with the general rule. Section 401 deals with qualified pensions, profit sharing, etc. And Subsection K deals with deferred arrangements. Who knew?

But from there, the 401k plan has several variants and options. We’ll be exploring-

• i401k, Solo 401k, Solo K, Uni K, Owners Only 401k (and all the marketing terms)

• Company-Sponsored 401k (when you have a staff)

• Safe Harbor Provisions for 401k Plan Testing

• Roth Options with a 401k Plan

• Two Plans, Rolling Old Plans

• 401k Plans and Roth IRA Conversions

• Loans and Life Insurance

• Age Based or Tiered Profit-Sharing Add-On to a 401k Plan

• Defined Benefits Pension / Cash Balance Add-On to a 401k Plan

• SIMPLE 401k (not the same as SIMPLE IRA)

By Jason Watson, CPA
Posted Saturday, November 5, 2023

If financial planning is being skipped, then you need to boil things down a bit. There are three very simple questions that need to be asked and, in most cases, the last question is the most important.

Retirement Goals and Objectives

When do you want to retire? Will it be transition-style or cliff-style? Is it better to burn out than to fade away (Rock of Ages anyone?)? And then all the issues of how much and for how long.

What type of legacy do you want to leave behind for your heirs? Do you want the check to the mortician to bounce?

Investment Risk

The quintessential question for all financial planning is investment risk so retirement plans and products can be matched with the investor’s level of risk tolerance.

Show Me the Money

How much money can you give up temporarily? This is the most important question. This will single handedly dictate 401k versus SEP IRA versus IRA versus defined benefits pension versus whatever. Perhaps not single-handedly, but the amount of cash you can stomach separating from as a small business owner will be a compelling factor in your decision making.

For example, if only have $7,000 to spend, an IRA is all you might need assuming 2024 IRA contribution limits. Having said that, a solo 401k plan which also has a Roth option to it, might be better even if you only put in $7,000. More on that in a bit.

And as any small business owner will explain, most extra dollars are invested back into the business. This is a simple math equation- many small business owners believe in and perhaps even realize a larger return on investment with a dollar invested back into the business versus the stock market or real estate.

In many cases, a small business will be a huge source of retirement income either through residual income (such as an insurance agent or a financial advisor), shareholder or partnership income such as guaranteed payments, or from the sale of the business.

This might not be as true for the one-person consultant of course, but you get the idea of pressure between growth and retirement.

By Jason Watson, CPA
Posted Saturday, November 5, 2023

There are two plan basics, either a defined contribution plan or a defined benefits plan.

A defined benefit plan is a benefit that is payable to you upon retirement. It is usually based on formulas to compute the periodic payments made to you during retirement. These are sometimes referred to as a pension or annuity since a benefit is defined, and the paid to you. For example, military personnel who meet certain obligations are paid a recurring benefit for the rest of their lives. It might be indexed each year for cost-of-living increases and it might have survivor benefits. Either way it is a guaranteed payment based on a formula. If you live to 100, you might “beat the system.” If you die at 55, the pension payment ends, and the money set aside for you is lost.

In contrast, a defined contribution plan specifies how much money will be contributed to a retirement plan today. This is precisely how 401k plans work. It removes a lot of the guesswork and risk from guaranteeing a certain defined benefit to you upon retirement. Rather, the risk is all yours- the amount you invest, how long you invest and how you invest it will dictate the retirement benefit. This benefit might be projected with planning software, but it is not technically defined or guaranteed.

Because of guaranteed payments and life expectancy issues, employers have scaled back on defined benefit plans. The cool thing is this- as a small business owner you are the employer and defined benefit plans might have a real place in your retirement planning. One of the examples is a cash balance account which is technically a defined benefits plan, but you can see the account balance like a defined contribution plan. More on that later.

Some terminology clarification. We use the word deferral when referencing employees and contributions when referencing businesses. When an employee is putting money into a retirement plan, he or she is deferring a portion of compensation hence our use of deferral. This has nothing to do with deferring taxes since deferrals into Roth 401k plans do not reduce taxes.

As a side bar deferred compensation plans include pension plans, retirement plans and employee stock option plans. For now, let’s go back to the defined contribution plan and run through some of the basics.