It’s mid-April, you’re a business owner, you haven’t filed your taxes yet, and you are freaking out a little bit thinking about paying your 2020 taxes. In a “normal” year you would have filed your taxes or extension already, but 2021 continues to be “not normal” just like 2020 was (though thankfully we’re seeing the light at the end of the tunnel now). Since we have one more month before the filing deadline of May 17, 2021, let’s talk about some last-minute ways that you can defer income and lower your taxes for 2020! **Caveat that always applies when a non-CPA talks about taxes** Always talk to your CPA or tax preparer to make sure you are eligible for any tax strategies you read or hear about from outside sources.
With that out of the way, let’s talk! First, we’ll go through a few options you have for deferring income right now, and then we’ll talk about options that you can set up now so you have more options to defer income in 2021.
Traditional IRA –
- If you are single and do not participate in an employer-sponsored retirement plan (401(k), 403(b), SIMPLE or SEP IRA, etc.), you may be able to make a $6,000 contribution to a Traditional IRA for 2020 ($7,000 if you're age 50 or older) regardless of how much earned income you have. Sole-proprietors and small firm owners may be in this position. If you are married and neither of you is covered by an employer plan, you can each make Traditional IRA contributions to lower that taxable income further.
- If you are married and you don't have an employer-sponsored plan, but your spouse does and they are covered by it, then you can only make a full contribution if your adjusted gross income is $196,000 or less. Deductibility phases out from $196,000 to $206,000, and over $206,000 means you cannot make a deductible contribution. If your income is under the $196,000 threshold, you can consider making contributions for yourself and your spouse.
- If you have both W2 income and Schedule C income (either of your own or between you and a spouse) you may be able to make both Traditional IRA and SEP IRA contributions...we'll talk about that in a minute.
SEP IRA –
- There is no income limit for eligibility for SEP IRAs, or differences between single and married tax filers. SEP IRAs are best suited, however, to sole-proprietors. If you have employees, you must contribute the same percentage of eligible income to everyone's SEP IRA, and only employers contribute to SEP IRAs (not employees) so they are typically used by sole-proprietors or married couples who own a business together.
- Technically, the limit for SEP IRA contributions for 2020 is 25% of eligible income or $57,000, whichever is less. For sole-proprietors, the formula reduces your eligible income by 50% of your self-employment tax (7.65%) and by the SEP contribution itself, so the short-hand assumption is that your SEP contribution can be roughly 20% of your Schedule C income. **Your CPA will calculate this for you, don't do it yourself (unless you're a CPA and this is your job)**
- Example 1: You are a sole-prop, don't have employees, and you have $200,000 of net profit on your Schedule C after all your deductions are factored in. Your max SEP IRA contribution is right around $37,757 for 2020. Example 2: Same info as before, but you have $400,000 of net profit on your Schedule C. Your max SEP IRA contribution is $57,000 because 25% of your eligible compensation (or roughly 20% of your net schedule C profit) is around $80,000...over the $57,000 SEP IRA max contribution limit.
I mentioned above that there’s a way to contribute to both a Traditional IRA and a SEP IRA. Ready for the magic?
Traditional IRA and SEP IRA together –
- Two scenarios work really well here. Example 1: You are a sole-prop just like above, under 50 years old, you have $180,000 of net Schedule C profit, you're married and your spouse has $15,000 of W2 income and is covered by a retirement plan at work. You can make a $33,810 SEP IRA contribution from your business earnings, and since you're under the $196,000 income threshold for Traditional IRA contribution (the limit applies because your spouse is covered be a retirement plan at work), you can each make $6,000 Traditional IRA contributions as well. Total deferral is $33,810 + $6,000 + $6,000 = $45,810 that you don't pay taxes on for 2020. If you're both over 50, you can bump the Traditional IRA contributions up to $7,000. Bonus points if your spouse can also defer some of their income and get an employer matching contribution!
- Example 2: You are a single tax filer and a sole-prop with Schedule C income, but you also have W2 income from another job (I know realtors for whom this strategy applies, but it could be a lot of different job combinations). Your net Schedule C profit is $180,000 and your W2 income is $15,000 and you are not covered by a retirement plan at that W2 job (again, there's no income limit for contributions when you're not covered by a retirement plan at work). You can make a $33,810 SEP IRA contribution from your Schedule C income, and if you're under 50 years old you can make a $6,000 Traditional IRA contribution from your W2 income ($7,000 if you're age 50 or older). Total deferral is $33,810 + $6,000 = $39,810 that you don't have to pay taxes on in 2020.
There are other scenarios that will work as well, but every situation is unique and you should consult your financial advisor and your CPA to make sure you’re following all IRS guidelines properly.
Phew! 2020 is taken care of. Now, what can you do for 2021 to make sure you don’t wait until the last minute?
If you now have a Traditional IRA and a SEP IRA in place, these are both good accounts to have for tax-deferral purposes but they aren’t your only options. It’s worth it to research other account types depending on your typical annual income and on how much you want to save for the future. You might prefer to use a SIMPLE IRA over a SEP IRA, especially if you plan to hire employees, or you might prefer to use a 401(k) (a Solo(k) if you are a sole-prop or a regular 401(k) if you have employees). You could also consider a Defined Benefit plan if you have significant income and want to defer larger portions each year.
SIMPLE IRAs and regular 401(k) have to be established before October 1 in order to be used for the current tax year, and Defined Benefit plans and Solo 401(k)s have to be established by December 31. The moral of the story here is that you can take a breather from tax and retirement planning for a minute, but you do need to make decisions in August or September in order to take whatever next steps are needed before October 1 if you go the SIMPLE IRA or regular 401(k) route.
Last but certainly not least, if you would like to make charitable contributions to both benefit causes that matter to you and reduce your taxable income, you need to get those contributions done before December 31 each year. Charitable contribution rules are complicated and require more than a quick paragraph, but again, just as a reminder, you do need to make any charitable contributions before year-end. Keeping your financial advisor and CPA in the loop as you’re considering options will help both of them give you the best advice possible for your situation and help you avoid taxes (legally and ethically) in lots of ways.
One final time, always talk to your CPA or tax preparer about your specific situation, as not all strategies are appropriate for or available to all people. And make sure you get your 2020 taxes (or extensions) filed before May 17, 2021!