Maximizing Small Business Retirement Plan Deductions

Most small business owners have been at a party, on a golf course or just talking with a friend who boasts “I don’t worry about taxes much, I deduct most of my income.” What are they talking about? Are they serious? Is that legal?

Much of the early part of my career was spent working with large institutions designing and planning 401(k) and other retirement benefits. Most all of us have some sort of experience with a 401(k) or 403(b) plan…these standard retirement plans are pretty straight forward. In many jobs you are allowed to take a portion of your income pretax and deposit it in an account which grows tax deferred. Many companies also match a portion of these deposits.

Owners of small companies are surprised to find that 401(k) and pension plans can be used to defer income in much larger sums. Let’s take a look at your business to see if a pension and 401(k) solution may work for you.

For small business retirement plans, your company is normally going to fall into two different groups:

Bottom Heavy: You or a few partners own the business, but most of the employees are paid employees and work full time.

Top Heavy: Your business up primarily of high-income earners with very few other full-time employees. This could also be an “owner only” business where you or your partners are the only employees. Many doctors, lawyers, plumbers, consultants, real estate investors, independent contractors or board directors operate as sole proprietorships. Pass through businesses very often fall in this category.

Companies that are more “bottom heavy” have many traditional options. Simplified Employee Pension (SEP) plans as well 401(k) plans are often used. It is important to note, that both a 401(k) and a SEP must be designed in a way that benefits employees as well as employers. For instance, a SEP plan must compensate all employees equally based on percentage of compensation with a max deduction for 2022 of $61,000 or 25% of compensation…which ever less.

There is a lot of information available concerning contribution limits on the IRS website:
https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-contributions

Top Heavy companies tend to have much more flexibility in terms of plan design. The owners of these companies tend to be the ones boasting about how much they can deduct. Let’s take a look at the basics concerning how and when company owners should look at different options.

One of the first questions that most top-heavy small business owners should ask themselves is, how much can I put away per year? Top heavy small business owners can, and probably should, look at opening a SEP if the max contribution they intend to make is less than $61,000 per year (2022 maximum.) Solo 401(k) plans have similar limits.

If a business owner wants to defer tax on larger amounts of profit, there is a more complex solution which is a combination “defined benefit & defined contribution” retirement plan. Many different legal structures exist for this option depending on your company’s legal structure. The most common is probably “Cash Balance Pension & 401(k).”

There is some complicated math that goes into determining how much a business owner can contribute to a pension plan. I will not bother you with all the details but for 2022 the maximum retirement benefit allowed from a pension plan increased to $245,000 annually. You would need to contribute annually enough to reach whatever goal you set. On top pension contribution companies can add a 401(k) plan. You can start to see how some business owners may be deferring 60% or more of their income.

So, what is the catch? If business owners can defer 60% or more of their income, why isn’t everyone doing it? It’s simple…administering pension and 401(k) plans…is expensive and more complicated than the other options. First, you will need to hire and actuary. Actuaries are fancy accountant/mathematicians. Most also perform some legal services since you will need a “plan document” drawn up.

If your top-heavy company has enough profit to annually put away $90,000 or more consistently, a cash balance pension and 401(k) might be the most efficient option. This number needs to be large enough to justify the initial legal fees and ongoing actuarial fees that accompany these more complicated plans.