As a small business owner, you’re constantly thinking about how to reinvest in your business to make it more successful, create stability, and keep employees happy and engaged.
One way to do this is to focus on their financial well-being and invest in their retirement. You can do this by creating a 401(k) and profit sharing plan that will invest in your own future to save up to $67,500 per year for your own retirement, which can save you up to 24 $975 in federal taxes and helping your future employees retire.
A 401(k) combination and incentive plan
A 401(k) plan and a profit sharing plan are two separate plans that can be combined to increase the contribution amounts established by ERISA (The Employee Retirement Income Security Act of 1974).
This federal law provides rules for how companies establish contributions and sets minimum standards for participation, vesting and funding of retirement benefits for themselves and their employees.
401(k) and incentive plans can be complex and governed by many rules. It is therefore important to have the right financial team in place to help you make good financial decisions. This team should involve your CPA, your financial advisor, your third party administrator (TPA) and your accountant. There is a long list of services each service provider can offer your business, but here is a short list.
- Your CPA helps you better understand the tax benefits of setting up and funding a 401(k) plan and helps you create a budget for the total amount of your contribution based on your net income.
- A financial advisor typically helps select options for the TPA and accountant based on 401(k) plan size, contribution amounts, and technology requirements and helps provide investment product recommendations.
- The TPA helps the owner review plan design, contribution and matching formula options and fulfills annual compliance and filing requirements.
- The Recorder is the company that receives the dues and shows all participants their balances.
401(k) contribution limits
The optional employee contribution limit under the 401(k) plan for each employee is $20,500 in 2022, plus a catch-up contribution of $6,500 for participants age 50 or older.
The company may also make contributions for each participant, including owners, which are considered “profit participation contributions”. ERISA provides total contribution limits each year, and in 2022, the total contribution limit for participants under age 50 is $61,000 (this includes the employee contribution of $20,500 and the contribution of the employer for profit sharing of $40,500). For participants, including business owners aged 50 and over, the total contribution limit is $67,500 (including their employee contribution of $20,500 plus the catch-up contribution of $6,500 and profit sharing contribution of $40,500).
I like to think of retirement plans as a way to reduce their best taxable income, especially when they are able to make significant contributions. For example, suppose a business owner, who reports being single, earns a combination of salary and net income from his business of $575,000. If they were to settle and pay the full $67,500 contribution in 2022, they would reduce their taxable income by $575,000 to $507,500. Taxable income of $575,000 would put them in the 37% federal tax bracket, but paying the full $67,500 contribution would drop their income to $507,500 of taxable income and they would be in the bracket. 35% taxable income. The contribution would save $24,975 ($67,500 x 37%) in federal taxes. You can also perform a similar calculation for your respective state income taxes to perform a full tax benefit calculation.
For a married couple who own a business and are 50 or older, they can contribute a maximum of $67,500 each for a total contribution of $135,000 for 2022. Assuming they are also in the bracket federal tax rate of 37%, they would save $49,950 in combined federal taxes by making the 401(k) contribution and profit sharing.
Cost-benefit analysis of owner contributions versus participant contributions
Business owners will need to work with their TPA to determine how much they wish to contribute for their own retirement plan and then the minimum requirement they will need to contribute for their employees. The business owner will want to calculate the tax savings from their pension contributions and compare with employee contributions plus plan costs to calculate the cost-benefit analysis. The cost-benefit amount does not have to be positive in favor of the business owner, but it is important to understand the benefit formula and the net costs of the plan.
Establishing a 401(k) and incentive plan can be a powerful tool to help you save for retirement, reduce your taxes, attract and retain top talent, and help your employees save for retirement. 401(k) plans are complicated, so it’s important to have the right finance team in place that provides suggestions based on your personal contribution goals, company contribution cash budget, and contribution goals employees.
Halbert Hargrove Global Advisors, LLC is an SEC-registered investment adviser located in Long Beach, California.