Don't Cut Corners with Your Retirement Savings

This has been a tough year for many small business owners, and many are looking for corners to cut to conserve cash.  One corner that you should not cut unless you are desperate is contributing to your retirement plan.  Not only do these contributions help you fund your future retirement, but they can also provide you with a current tax deduction when you contribute to a self-employed retirement plan or to most traditional IRAs.

The benefit derived from the deductions for pension contributions is based upon your tax bracket.  The higher your tax bracket is, the larger the tax savings; thus, higher-income taxpayers benefit the most.  For example, John and George both wish to contribute $5,000 to their retirement plans.  John is in the 15% tax bracket, and George is in the 35% bracket.  Assuming both contribute to a deductible plan, George will save $1,750 on his tax bill by making the contribution while John only saves $750.

Here is where some tax-planning strategies come into play.  Distributions from deductible plans are taxable when withdrawn at retirement, while distributions from Roth IRA accounts are tax-free at retirement (provided a five-year holding period is met and withdrawals are made after age 59½).  Thus, John may find it more beneficial to make a Roth contribution and forego a current tax deduction while having tax-free retirement income.  George, on the other hand, would benefit from a nice deduction now but still may wish to consider the Roth options.  However, he will be barred from making Roth IRA contributions because his income exceeds the AGI phase-out limitations.  Instead, George might consider making a nondeductible traditional IRA contribution and then converting it to a Roth IRA in 2010 when the Roth IRA AGI limitations for conversions are removed.

There are a number of retirement account options available to a self-employed individual.  The 2009 limits for the most commonly encountered plans are:

• Traditional IRA - Contributions are limited to $5,000 ($6,000 if age 50 or over) and are deductible, but the taxpayer can elect to treat the contribution as nondeductible.  If the taxpayer participates in another pension plan, the deductibility may be limited depending on income.

• Roth IRA - Contributions are limited to $5,000 ($6,000 if age 50 or over), and the contributions are nondeductible.  Contributions are limited for higher-income taxpayers.  The yearly contribution limit for traditional and Roth IRAs is a combined limit.

• Self-Employed Retirement Plan (SEP) – The contribution limit is 25% of the net profits from self-employment (20% of the net profits before deducting the contribution itself) but not more than $49,000.  If you have employees, you generally must contribute the same percentage amount of their wages for the year to their SEP accounts (but not more than $49,000).

• Spousal IRA – Frequently overlooked is the fact that the spouse of a self-employed individual may also be able to make a contribution to either a traditional or Roth IRA based on the self-employed spouse’s self-employment income.

There are additional requirements that must be met for these plans as well as other options.  Please call this office for further details and/or assistance with selecting the pension option that best suits your current situation and your long-term needs.

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