A side business provides a great opportunity to save for retirement. In fact, a business owner may be able to save and deduct most or all side business income using a Defined Benefit Plan.
SEP and 401(k) Plans significantly limit retirement contributions. Defined Benefit Plans, on the other hand, are not subject to the same limits. As a result, Defined Benefit Plans may allow for much higher deductible contributions than other retirement vehicles. What’s more, a business owner can adopt both a Defined Benefit and 401(k) Plan to further increase the available deduction.
A side business Defined Benefit Plan works well when a person:
Retirement plans such as SEPs, 401(k) Plans, and Defined Benefit Plans provide favorable tax treatment of retirement contributions. For example, retirement contributions generally are tax-deductible, grow tax-deferred, and the participant can rollover retirement assets to an IRA to continue tax deferral.
Because these vehicles are tax-advantaged, the IRS limits the annual amount that can be contributed. SEPs and 401(k) Plans are Defined Contribution Plans and for those over 30 years old generally have lower limits than Defined Benefit Plans.
When a business owner wants to save and deduct most of their side business income, SEP and 401(k) limits are generally insufficient. That’s because the IRS limits employer contributions from SEP and 401(k) Profit Sharing Plans to 25% of earned income. And while a 401(k) Plan allows the owner to defer as much as an additional $30,000, this only is possible if they have not “used up” their deferral in another 401(k) Plan. Thus, if the objective is to save most or all of the side business income, SEP and 401(k) limits generally will be insufficient.
On the other hand, Defined Benefit Plans are not subject to the 25% of earned income limit. As a result, contribution limits to Defined Benefit Plans may be significantly higher than SEPs or 401(k) Plans. What’s more, the business owner can have both a Defined Benefit and a 401(k) Plan to save a large portion of their side business income.
Situation: Mr. and Mrs. Adams are both 35 years old. Mr. Adams is a full-time employee and Mrs. Adams runs a part-time business with no employees. Her side business is taxed as an S-Corporation and earns $40,000 per year, all of which is paid to Mrs. Adams as a W-2 wage. Mr. and Mrs. Adams live off Mr. Adam’s full-time income and would like to contribute and deduct all or most of Mrs. Adam’s business income to a retirement plan.
401(k) Solution: Using a 401(k) Plan, Mrs. Adams can defer $22,500 in 2023. Additionally, her business can provide her a Profit Sharing allocation of 25% of earned income, or, in this case, $10,000. In total, Mrs. Adams can save and deduct $32,500, nearly all of her business income.
Situation: Mrs. Baker is 55 years old. Her full-time employment provides her with sufficient income. In addition, Mrs. Baker has a side business, which she has set up as an LLC taxable as an S-Corporation. The business has no employees and has a net income of $45,000 per year. Mrs. Baker does not need this income and would like to deduct and save as much of it as possible in a retirement vehicle. She already is maxing out her 401(k) as a full-time employee.
401(k) Doesn’t Work: Because Mrs. Baker is already maxing out employee deferrals as a full-time employee, she cannot defer anything else in her side business. However, her business can provide her a Profit Sharing allocation of 25% of earned income or $11,250, which is significantly less than the $45,000 she wanted to save.
Defined Benefit Solution: Based on her age and income level, Mrs. Baker is able to deduct $45,000 per year in a Defined Benefit Plan. This is because the IRS does not limit Defined Benefit Plans to 25% of earned income like SEPs and 401(k) Plans. What’s more, in some years, Mrs. Baker may be able to deduct more than $45,000, creating a business loss to offset other income she receives. Mrs. Baker decides to consult with her tax advisor to see if deducting more than $45,000 will benefit her tax situation.
Situation: Mr. Chen is 45 years old. He is a 10% owner and physician in a doctor’s group where he has a Defined Benefit Plan. The Plan is making large contributions to the owner physicians to ensure a maximum payout. In addition, Mr. Chen has an unrelated side business with a net income of approximately $100,000, paying him a wage of $40,000. Mr. Chen has sufficient income in his “main” business and would like to defer as much of the side income business as possible.
401(k) Doesn’t Work: In a 401(k) Plan, Mr. Chen is able to defer $22,500 in wages. Additionally, his side business can pay a Profit Sharing allocation of $10,000 or 25% of employer wages. In total, he only can save $32,500 in a 401(K) Profit Sharing Plan, far below the $100,000 he wanted to save.
Defined Benefit Solution: Depending on when his business started, Mr. Chen may be able save and deduct $100,000 or more using a Defined Benefit Plan. To the extent a large retirement deduction creates a business loss, Mr. Chen may be able to offset other income that he receives. However, he should discuss this with his tax accountant.
In general, Defined Benefit Plans require annual contributions. SEP and 401(k) Plans, on the other hand, have discretionary contributions.
Although the annual range of allowable contributions in a Defined Benefit Plan can be wide, a side business with an annual income that varies significantly and unpredictably likely will create issues for the business owner. In this case, a 401(k) or SEP may be a better option even though the maximum deductible contribution may be substantially lower.
On the other hand, if side business income varies each year, but the owner can reasonably predict the income, a Defined Benefit Plan may be possible. This may be the case, for example, if the owner expects an income spike in the current or in a future year.
In some cases, a person’s businesses may need to be aggregated for retirement Plan purposes. That could mean employees in one business need to be covered even though the retirement Plan is in the other business. Additionally, retirement contributions in all businesses may need to be aggregated and compared to deductible limits. In summary, aggregation for retirement Plan purposes could result in higher employee benefit costs and a lower deductible limit.
Aggregation is required when businesses are considered a controlled group or affiliated service group. These rules are complex, so we will not explain them here. However, in complex situations, a pension attorney can provide advice on whether you need to aggregate your businesses for retirement Plan purposes.
If you have a Defined Benefit Plan with your full-time employer, the side business Defined Benefit Plan limit is independent of your other Defined Benefit Plan. Put another way, you potentially could “max out” two Defined Benefit Plans.
Side business Defined Benefit Plans are a powerful strategy when you have sufficient income from one source and want to defer most of your side business income. In many cases, a SEP or 401(k) is insufficient, but Defined Benefit limits often are significantly higher, allowing a side business owner to save and deduct most of his or her business income.
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