March 17, 2022
As an S-Corporation owner, there are several different retirement account options available including the traditional IRA, ROTH IRA, SEP-IRA, SIMPLE IRA, and the Solo 401(k). Each type of account has various tax implications and specific contribution limitations and requirements. Your customer success team at Formations can go over all the options with you and help you choose the account structure that will allow you to maximize your retirement savings.
We can show you the overall benefits of contributing before the April 15th tax filing deadline to maximize contributions while also reducing your tax liability.
The Traditional IRA
The traditional IRA (Individual Retirement Account) is one that any individual with earned income can open and contribute to. For 2021 the contribution is limited to the lower of $6,000 or the total earned income for the year. If you are over the age of 50 you can contribute an additional $1,000 in catch-up contributions. Traditional IRAs receive a tax benefit when you put funds in by allowing a deduction from your taxable income. Because you receive a tax benefit when you contribute, you will pay taxes on the funds when you withdraw them. Effective with the passing of the Secure Act of 2019, there is no age limit for being able to contribute to a traditional IRA. If you are covered by a retirement plan through your employer, then contributions to a traditional IRA may be limited or completely phased out based on your modified adjusted gross income. If you withdraw funds from your traditional IRA before the age of 59 & ½ you may pay a 10% early withdrawal penalty. Traditional IRAs also require minimum distributions starting at the age of 72. Fees for opening and maintaining a traditional IRA are minimal and no additional fiduciary insurance is required for the plan administrator or employer.
The ROTH IRA
The ROTH IRA limits the amount an individual can contribute based on filing status and total modified adjusted gross income (MAGI). For 2021, a single individual with MAGI greater than $140,000, is ineligible to contribute to a ROTH. The MAGI limit for a married couple filing jointly is $208,000, and any MAGI over $10,000 for those married couples who file separately. As with the traditional, you must have earned income to contribute to a ROTH and the total contribution limits are also the same as with the traditional. You cannot deduct your ROTH contributions on your taxes, but you are able to withdrawal your contributions tax-free and penalty-free. There are also no required minimum distributions (RMDs) during the lifetime of the original owner. Fees for opening and maintaining a ROTH IRA are minimal and no additional fiduciary insurance is required for the plan administrator or employer.
The SEP-IRA (Simplified Employee Pension Individual Retirement Account)
The SEP-IRA is different from other IRAs because it is not the individual employee contributing funds out of their wages, but the employer making the contributions to the employee’s account. The employer can contribute up to 25% of the employee’s annual wages, up to a maximum of $58,000 for 2021. Since you are the employer and the employee, you can effectively boost your annual salary by the amount contributed to the SEP-IRA while minimizing your self-employment taxes. For example, you can pay yourself a salary of $50,000 and contribute 25%, or $12,500, to your SEP IRA. You have now effectively paid yourself $62,500, but only paid self-employment taxes on $50,000. SEP contributions are deductible on the business tax return, thereby reducing overall profits and potential federal taxes on the amounts that flow through to the shareholder(s). Because the tax benefit is given in the year of contribution, withdrawals from a SEP IRA are taxable. SEP IRAs require minimum distributions starting at the age of 70 & ½. Fiduciary insurance is not required and there are minimal maintenance fees if any. It should also be noted that you can contribute to the SEP-IRA as the employer and still also contribute the annual limits to a traditional or ROTH IRA as an employee.
The SIMPLE IRA
The SIMPLE IRA is more like a 401(k) than the other IRAs. The employee makes pre-tax contributions of up to $13,500 (for 2020 and 2021), with a catch-up contribution of an additional $3,000 if over the age of 50. The employer then matches the employee’s contribution dollar for dollar, for up to 3% of the employee’s wages. Because you, as an S-Corp owner receiving a salary, are both the employer and the employee, you will gain the benefit of the pre-tax contributions on the employee side and the deduction for the employer’s contributions on the business side. There are no additional costs for the plan after the matching contribution, such as administrative fees or insurance, for the employer. The employee controls and owns the account. There are early withdrawal penalties for taking money out before the age of 59 & ½. The penalty is 25% if funds are withdrawn in the first two years, and then 10% after that. The SIMPLE IRA has required minimum distributions when you reach the age of 72.
The Solo 401(k)
The Solo 401(k), also referred to as the Individual 401(k) or the Self-Employed 401(k), works like a regular 401(k). There are two types of contributions. The employee makes an elective deferral, also known as an employee contribution, and the employer makes a profit-sharing, or employer, contribution. For 2021, the employee contribution is limited to the lesser of $19,500 or total compensation. A catch-up contribution of $6,500 is permitted if age 50 or older. The employer contribution cannot exceed $58,000 for 2021. For corporations, the profit-sharing contribution is limited to 25% of gross income or the annual limit. For California sole proprietors and partnerships, the maximum contribution is limited to 20% of net income or the annual allowed limit.
As an S-Corp owner maintaining the role of both the employee and the employer, if you maximize the employee contribution of $19,500 the most you can then contribute as the employer would be $38,500 (for 2021) and then the allowed catch-up contribution of $6,500 if age 50 or older. One advantage of the Solo 401(k) is that the plan also allows you to make post-tax ROTH contributions. Contribution deadlines for the Solo 401(k) are the same as your tax filing deadline, so an LLC being taxed as an S-Corp would have to make the contributions by March 15th to apply to the prior tax year or September 15th with a properly filed extension. Minimum distributions are required at the age of 72.
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Now that you have a better understanding of the various retirement accounts available to you as an S-Corp owner, let’s talk about funding the account and maximizing tax savings.
S-Corp Owners Wages vs. Distributions
It is important to understand that the earned income required to fund a retirement account is based on the W-2 wages that you pay yourself as an S-Corporation shareholder-employee. Distributions that you receive from the S-Corporation are not considered earned income for retirement plan purposes. And you need to find the balance between maximizing retirement savings, reducing the overall profits of the company through payroll and retirement contributions, and minimizing self-employment taxes. It would not make sense to increase your salary and pay more in self-employment taxes to maximize the allowed contributions for retirement. Your success team at Formations can calculate various scenarios to help you find the right balance.
Deadlines to Open and Fund Accounts
Traditional IRAs can be opened at any time and can be funded up until the date of filing your tax return for the prior year. So, you could essentially open one of these accounts and fund it by April 15th of 2021 to get the tax benefit on your 2020 tax return. The ROTH IRA can also be opened at any time, but there is no current tax benefit to be gained by funding this type of account. A SEP IRA must be established by the tax filing deadline of the business to contribute for that year and deduct the contributions on the business tax return. The SIMPLE IRA can be opened between January 1st and October 1st if you did not previously have a SIMPLE IRA plan. If you have previously had a SIMPLE IRA, then you must set up a new account effective January 1st. If you are a new business that came into existence after October 1st, you can establish a SIMPLE IRA as soon as administratively feasible. The Solo 401(k) must be established by December 31st. The employer profit-sharing contribution for the Solo 401(k) can be made up until the filing deadline for the business tax return.
Deadlines to Fund Accounts for Prior Year Tax Benefits
Of the five types of retirement accounts listed, only the ROTH IRA does not provide an immediate tax benefit for funding. The other four accounts provide a tax benefit on either the business tax return, as a decrease in profits which flows through to the shareholder(s), or on the individual tax return, or both. The deadline for funding any of these four types of accounts is the same as the tax filing deadline. So, you can fund your traditional IRA until April 15th, 2021, or October 15th if you filed an extension, and take the deduction for the contribution amount on your 2020 tax return. The SEP-IRA deadline for making contributions is also April 15th, or October 15th if an extension was filed. The employee contributions to a SIMPLE IRA must be made by April 15th and the IRS does not extend the contribution deadline to coincide with extensions, so, even if you filed an extension for October 15th, you must still make the employee contributions for a SIMPLE IRA by April 15th. The employer matching contribution must be made by the due date of the business tax return, so March 15th for an S-Corporation, or September 15th if an extension was filed. For the Solo 401(k), the employee must elect to make a deferred contribution by December 31st but has until the tax filing deadline to make the contribution. The employer profit-sharing contribution for the Solo 401(k) is also due by the tax filing deadline. For S-Corporations the deadline is March 15th, or September 15th if an extension has been filed.
SEP IRA vs. the SOLO 401(k)
As a business owner and a self-employed individual, there are several options available for funding your retirement. The SEP-IRA and the Solo 401(k) are both great options and while the benefits are similar there are certain differences that may make one a better option for you. Both are widely available through most major brokerage firms and are simple to set up. There are minimal overhead costs, if any, associated with managing these accounts.
The SEP-IRA is ideal for companies with one or more employees and any business with one or more employees is eligible to open a SEP. A Solo 401(k) is only available for self-employed individuals and, potentially, a spouse if the spouse works at least part-time. Having even just one employee, other than the owner and the spouse, means you are no longer eligible to use a Solo 401(k) to save for retirement. And, switching from a Solo 401(k) to a SEP IRA in the future if you add employees can be complicated.
One difference between the SEP IRA and the Solo 401(k) is that only the employer can make contributions to the SEP account. Employees are not permitted to make contributions. Another difference between these two accounts is that the SEP-IRA does not allow a catch-up contribution but the Solo 401(k) does. Individuals over the age of 50 can contribute an additional $6500 a year to the Solo 401(k).
At the end of the day, the goal is to put aside money for your retirement and to have that money grow. Each retirement account listed here will serve that function, but one may be better suited to your specific situation.
Curious about what plan is best for you? Meet with one of our Business Consultants today.
