Last minute Tax Deduction for Business Owners 1/28/07
Stewart H. Welch III, CFP, AEP
Founder, The Welch Group, LLC
Last minute Tax Deduction for Business Owners
“Last Minute Tax Deduction for Business Owners”
While December 31st has come and gone, there are still options available to lower your tax liability for last year.
As you may know, the IRS allows you to make contributions to your IRA for the 2006 tax year as late as April 15, 2007. There are several different types of IRAs that can be utilized. The key is to determine which online calendar will best suit your needs, whether it is an immediate tax deduction or a way to save more money for retirement.
This article will examine the benefits and drawbacks of one particular type of IRA plan known as a SEP-IRA (Simplified Employee Pension). A SEP-IRA is a retirement plan typically established to help fund the retirement needs for owners of small businesses and their employees. Any employer can establish a SEP-IRA including sole proprietorships, partnerships, S Corps, C Corps, even not for profit organizations. A SEP-IRA differs from traditional IRAs in several ways. The two most notable differences are that the amount that may be contributed for each participant is much higher and the employer usually makes all of the contributions to the SEP-IRA. Note: there is an option available that also allows the employee to contribute to a plan as well as the employer.
A SEP-IRA can be very beneficial to small business owners who have few employees. Employers can contribute up to 25% of each employee’s annual compensation on the first $220,000 of earnings (not to exceed a total of $44,000 in contributions). This limit is much higher than the $4,000 ($5,000 including the catch up provision for individuals over the age of 50) allowed for traditional and Roth IRAs. Contributions to a SEP-IRA are made on a discretionary basis, meaning the employer decides each year whether to make contributions to the plan. This is beneficial to employers whose income fluctuates greatly from year to year. In addition, the contribution does not have to be made until the tax filing deadline of the company, including extensions. SEP-IRA contributions are deductible and earnings are tax deferred until distributions are taken by the employee. Finally, unlike many qualified plans, SEP-IRAs are easy to set up and administer and inexpensive to maintain.
Contributions to the plan must be allocated in one of three ways: 1) a set percentage of each employee’s annual compensation; 2) a flat dollar amount, for example $3,000 to each eligible participant, or; 3) Social Security integration where employees with higher wages, typically the business owners and top executives, will receive more benefit based on a special allocation formula provided by the IRS.
Contributing up to 25% of eligible employee’s compensation can quickly become expensive, so employers should work closely with their tax advisor to determine if a SEP-IRA is appropriate. This is why a SEP-IRA works best for employers with a relatively small number of employees. However, current rules do allow you to postpone making contributions for new employees for their first three years of employment after which time all contributions are fully vested. This allows you to avoid contributions for short-term employees.
My thanks to my associate, Michael Wagner, CPA, for his assistance with this article.