How Business Owners Can Lower Their Tax Bills Via Retirement Planning

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Are you a small business owner, a contractor or a freelancer—and in a high tax bracket? Well, why stay there? You can use retirement planning to lower your tax liability.

The idea is to plug in a lot of money to retirement funds, allowing you to build your post-work future and also to whittle down your net income, and thus minimize what you owe the Internal Revenue Service. Not a lot of people know about this. More should.

Let’s show this by way of an illustration. Say you own a small chain of car washes. You earn $500,000 annually. True, not everybody makes this kind of scratch, but the retirement strategy works for other income levels, and this one has big, bald numbers to drive home the point.

Here, you’re married and your kids are grown and are no longer at home. With your income, you are in the 35% federal tax bracket. In other words, the IRS will dine out well on you, claiming more than a third of what you make (and that’s even before FICA, the withdrawals for Social Security and Medicare).

The core strategy of lowering your tax bracket is making a large contribution toward retirement. Say your goal is to get into the 24% bracket. Money you stash away in your retirement accounts is subtracted from taxable income, to enable you to do that.

While old-school defined benefit (DB) pension plans are thought to be the exclusive domain of big companies, the truth is that many of the big guys are shedding them and the smaller businesses actually have a fair share of them, which they aren’t getting rid of.

If that’s the case for you, here is another way to decrease taxable income. With a DB plan, retirees receive a fixed pension amount. The beauty of a DB plan is that the ceiling on how much you can contribute to it is very high, giving you great flexibility. And in all likelihood, you also have a defined contribution (DC) plan like a 401(k). That’s where you put away a set sum to be invested in mutual funds.

In 2019, the upper limit on contributions to a DB plan is $225,000, and $56,000 as the employer contribution for a DC plan. Totaled, that’s $281,000.

Now, you don’t have to salt away the maximums to get into the 24% bracket. All you need to do is be sure you are below $321,450 in taxable income if you’re married filing jointly and $160,725 for a single.

And should your business be a partnership, a sole proprietorship or an S corporation, you are eligible for another tax break.

Then, your business is what’s called a pass-through entity, meaning that its income is not taxed at the corporate level, but goes directly to you, the owner.

To get this additional tax break, your taxable income must not go over $315,000 for a married couple ($157,500 for a single). This provision is called a 199A deduction. It permits you to deduct 20% from taxable income. That maths out to $63,000, which is 20% of that $315,000.

As a denizen of the 24% bracket, your tax liability becomes a lot less onerous than it otherwise would be.

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