Per the latest tax rates available on the IRS website, the self employed tax rate for 2017 will be as follows:
Social Security: 12.4% on your first $127,200 of earnings
Medicare: 2.9% on all of your earnings.
Total FICA: 15.3% maximum
If you are self-employed, you pay the entire tax and can deduct half of this on your tax returns as an adjustment.
But what about the rest of your income? How much of that can you deduct?
Do you know that one of the largest deductions available to a self employed individual is that of a retirement plan!
Many people think only of a 401(k) plan when it comes to retirement planning, but there are many better options for self employed individuals.
Let’s walk through some of them very quickly:
Self employed with high cash flow: With a high cash flow, you should adopt a single life Defined Benefit Plan. A defined benefit plan is capable of generating a deduction of up to $200,000 and higher in some scenarios, making it an ideal choice for a self employed individual looking for a large tax deduction.
Use our defined benefit calculator on this page to find out how much you can contribute to a defined benefit plan based on your age and income.
Self employed with medium cash flow: A profit sharing plan is a good plan for a business with medium cash flow or inconsistent cash flow. It allows you to contribute up to $54,000 annually and provides flexibility in choosing the amount of contributions in any given year. This plan can be beneficial if the company employs the spouse as well and contributions can be made for the spouse, thereby increasing the total amount of contributions.
How can we help you here?
One of the reasons why defined benefit plans or profit sharing plans are not popular is the complexity of the plans. Defined benefit plans require the certification of an enrolled actuary in addition to drafting a plan document and filing annual returns for the pension plan. Similar is the story for profit sharing plans.
This is where we come in to mask the complexity for you and provide services for drafting plan document, actuary certification, annual administration and IRS filings. Our clients benefit each year by claiming thousands of dollars in deductions and getting ahead in the retirement game. We guide you every step of the way with delicate hand holding so that you enjoy this process.
How to set up a pension plan or a defined benefit plan?
Setting up a defined benefit plan requires a certain amount of ground work that needs to be put in before you can actually start contributing to the plan.
Step 1: At first a calculation needs to be performed about how much you can actually contribute to a defined benefit plan. Unlike 401(k) and profit sharing plans, contributions to a defined benefit plan vary from person to person. They are typically based on the age of the individual and the compensation history. You can calculate an estimate using our defined benefit calculator. A final calculation needs to be performed by an actuary though.
A contribution to the profit sharing plan can be any amount up to $54,000 or 25% of your gross compensation, whichever is lower.
Step 2: Every pension plan requires a plan document which will list all assumptions of the pension plan and ensure compliance with all IRS rules and regulations. This document has to be drafted by an actuary before you can set up the investment accounts for the plan. A new TIN also needs to be registered for the pension plan as it is a distinct legal entity. The actuary will customize a plan document based on the contributions you need. Make sure your actuary provides you a plan document that is pre-approved by the IRS so you don’t need to go through the hassle yourself. You can read more about a pension plan document here.
Documents for a profit sharing plan need to be compliant with the Pension Protection Act (PPA) of 2006. Documents for a defined benefit plan need to be compliant with Economic Growth Tax Relief Reconciliation Act of 2001 (EGTRRA)
Step 3: After the plan document has been drafted, you are all set to open the investment account for the plan. You should reach out to your financial advisor or a broker to set up the accounts. Make sure you tell them to open a ‘qualified account’ so that the investment gains are not taxed at source. We can help you set up investment accounts and fill up all relevant forms with any investment company that you prefer.
Step 4: You can start making contributions to the plan as and when free cash flow is available once the investment accounts are open. For the first year, the contribution will be what was decided between you and the actuary if you adopt a defined benefit plan. The actuary will calculate a range for each subsequent year along with a recommended contribution amount. You are required to contribute within the range to avoid over funding or under funding the plan. The deposits can be made until you file the tax returns for your business.
Step 5: All qualified plans are required to file annual returns with the IRS. Note that these returns are different from the company tax returns and your personal tax returns. If you have a defined benefit plan, note that the CPA or financial advisor cannot file these returns since these are required to be certified by an actuary.
The actuary will fill up a form called the Form 5500SF and certify another form called the Schedule SB. You will need to sign the form as the plan sponsor and the actuary will file it electronically. The penalties for not filing these forms run in to hundreds of dollars and the pension plan could end up getting disqualified.
Each of these steps can be confusing and troublesome without proper guidance. If you are a self employed individual and interested in exploring the idea of a defined benefit plan for yourself feel free to give us a call. We specialize in this area and can provide you with valuable advice and services that could end up saving thousands of dollars and getting a boost to your retirement planning.
If you still have questions specific to your individual circumstance, feel free to email us at firstname.lastname@example.org. We will get back to you in less than 24 hours.