The tax year is drawing to a close, which means it’s time for proactive business owners to think about moving liquid assets to tax-favored applications. What does that have to do with retirement? Funding retirement plans in 2021 may lower the amount of tax you will have to pay on April 15, 2022, but there are some rules you must be familiar with:
Traditional IRAs
- Taxpayers can take a tax deduction for contributions to an IRA provided their income falls below certain limits and they meet the other eligibility requirements. For 2021, traditional IRA contributions are capped at $6,000 a year, with the option of an additional $1,000 catch-up contribution if you’re 50 or older, for a total of $7,000.
- Contributions can be made at any time during the calendar year and up to tax day of the following calendar year (usually April 15).
- Withdrawals from an IRA are taxed as ordinary income.
- At age 72, taxpayers must begin to withdraw funds from their IRA. The minimum amount of this withdrawal, known as the required minimum distribution, is calculated using an age-based formula.
- With certain exceptions (e.g., to pay your medical insurance premium after a job loss), early withdrawal from an IRA (i.e., withdrawal prior to age 59 1/2) is subject to being included in gross income plus a 10% additional tax penalty.
- Funds from a 401(k) can be rolled into a traditional IRA upon retirement or a change of employer.
Roth IRAs
- Roth IRAs are subject to the same contribution limits as traditional IRAs, including catch-up contributions ($6,000 plus $1,000 for taxpayers over age 50 for 2021).
- To be eligible for a Roth IRA, taxpayers must meet certain income limits.
- For 2021, married filers who submit a joint tax return and have a modified adjusted gross income of no more than $198,000 can contribute to a Roth IRA. The contribution amount is reduced for those who make more than $198,000 and is completely phased out for taxpayers who earn $208,000 or more.
- For 2021, the limit for single filers is $125,000, and contributions are completely phased out at $140,000.
- Contributions are not tax deductible. However, withdrawals from a Roth IRA are not taxed as long as five years have passed since the tax year the taxpayer made his or her Roth IRA contribution.
- Roth IRAs are not subject to the RMD rules.
SEP IRAs
- SEP IRAs are available to employers as well as self-employed taxpayers. Many small-business owners fit into both categories.
- Taxpayers may be able to contribute to both a SEP IRA and a traditional IRA.
- Plans must be established by the business’s tax-filing deadline, including extensions. The deadline is the same for making annual contributions.
- The employer gets a tax deduction for contributions.
- Contributions grow tax deferred until they are withdrawn.
- Withdrawals are taxed at the individual tax rate.
- With some exceptions, the RMD rules apply.
- For 2021, taxpayers can contribute up to 25% of their compensation, up to $58,000.
Solo 401(k) and Roth 401(k) plans
These types of retirement savings plans allow the highest contribution amounts:
- For 2021, the contribution limit to a solo 401(k) is $19,500 plus a $6,500 catch-up contribution for taxpayers who are 50 or older. The business may also make a profit-sharing contribution of up to 25% of payroll. That means a grand total of $58,000 (or $64,500 for those over 50) could be saved provided the individual contributes the maximum amount allowed by the IRS ($19,500 for 2021) and the business contributed the maximum allowable amount for payroll.
- For 2021, the contribution limit to a Roth 401(k) is $19,500 plus a $6,500 catch-up contribution for business owners over the age of 50.
Defined-benefit pension plan
- Businesses that want to put even more away for the future should consider setting up a defined benefit plan. Contribution limits vary according to age and income, but contributions can add up to about $150,000.
- However, these plans are not for everyone because they are complicated and time consuming to set up.
