Business Owner's Guide: Cut Taxes and Supercharge Your Retirement Savings

Let’s be honest, nobody actually likes paying taxes. Well, actually, I’ve met one person over the last decade who told me he didn’t mind paying extra taxes because of how much he loves this country. I love this country too, but I don’t want to pay taxes beyond what my minimum legal requirement is, and I believe the vast majority of people reading this article feel the same way. My goal is to introduce strategies for business owners to reduce their tax liability while also putting additional money away for retirement. Over the years, I’ve advised countless business owners on how to minimize taxes and maximize retirement savings by utilizing retirement plans. I hope this article provides you with value, and if you would like to discuss these topics further, feel free to contact me.

Author: Zak Gardezy, CFP® | Founder, Wealthstone Private Wealth Management

Email: zak@wealthstonepwm.com

What Is a Retirement Plan?

A retirement plan is a financial strategy or program designed to help individuals save and invest their money over time to provide income one day in retirement. For example, a 401(k) plan is a type of retirement plan. Specifically, a 401(k) is an employer-sponsored retirement plan, whereas an IRA is an individual retirement plan. These investment vehicles were created to encourage employees to save for retirement, and people are incentivized to use these plans by getting certain tax breaks for contributing.

For example, a 401(k) allows you to contribute your income directly prior to getting taxed—we call that pre-tax. Depending on your income tax rate, this could save you considerable money annually, as the portion of your income that goes into your 401(k) doesn’t get taxed today. However, upon retirement, when you’re hopefully in a lower tax bracket, you’ll be able to withdraw money from your 401(k) and you’ll pay income taxes at that time.

In addition, 401(k) plans typically include matching contributions, and there are other strategies within them, such as Roth 401(k)s and after-tax contributions, which can all be utilized in different ways to accomplish your goals. However, I wanted to provide you with a simple definition of a retirement plan; we’ll get into specific plans and details later on.

What Is Not a Retirement Plan?

Taxable brokerage accounts are not retirement plans. Additionally, life insurance and annuity products are also not retirement plans. There are advisors out there that try to portray annuities and life insurance products as suitable retirement vehicles, and in most cases, they’re not appropriate for retirement savings purposes. Financial advisors that lead with annuities or life insurance products typically do so because the commissions paid to the advisor for selling those products to you are, well, quite lucrative. I’ve seen commissions as high as 6–8% upfront, so if you invest $1 million into one of those products, your advisor could have earned $60,000 to $80,000 in commissions.

Although taxable brokerage accounts are important and can help supplement your income in retirement, they are not designed to be retirement accounts. They don’t get the benefit of tax deferral; therefore, any capital gains (realized), dividends, interest, etc., that are generated each year are taxable, whereas in a 401(k) or IRA they are not.

Can a Business Owner Establish a Retirement Plan?

Yes. Even if you’re running a solo operation, you can establish a retirement plan. In some cases, being solo could create the best outcomes for creating a retirement plan strategy that allows you to maximize contributions and reduce taxes. Business owners can establish a 401(k) plan, SEP-IRA, defined benefit plan, and more.

Which Retirement Plan Should I Go With?

This depends on a lot of factors and is something that I help clients figure out. Some of the questions that I ask are:

  • How much income do you make from your business?

  • How many employees do you have?

  • What is your age?

  • What are their ages and compensation?

  • What industry are you in?

  • How consistent is your income?

  • When do you plan on retiring?

  • How’s your personal and business cash flow?

I meet a mix of business owners who either don’t have a retirement plan at all and just put money in their savings or brokerage account, or I meet business owners who are utilizing the wrong type of retirement plan and not maximizing their potential tax savings. I’ll briefly explain the most common retirement plan types for business owners and my thoughts on them.

SEP-IRA

The SEP-IRA is a popular choice for business owners because it’s simple to establish, has minimal upkeep costs, and has a decently high contribution limit. For 2024, contributions are capped at the lesser of 25% of compensation or $69,000. If you have employees, this could be the wrong choice because you’re required to also contribute into SEP-IRA accounts for your employees at the same percentage rate that you contribute for yourself.

Also, there are no catch-up contributions; therefore, unlike other plans, when you reach age 50, you don’t get an extra “boost” in how much you can contribute to this type of account. Additionally, if you have employees, they cannot elect to contribute their income into this type of plan; only the employer (you) can make contributions. Therefore, if one of your employees wants to contribute to a retirement account, they would need to look at individual plans with much lower limits than a 401(k), for example.

There’s also no Roth option with a SEP-IRA. A Roth 401(k) or Roth IRA is a type of account that allows you to put money in after-tax, but the investments grow tax-deferred, and you can withdraw the funds later tax-free, which protects you from future tax rate increases. I won’t spend too much time discussing Roths in this article because I want to focus on strategies that reduce your taxable income today, whereas a Roth does not do that.

In closing, if you’re running a solo operation and would like to contribute more per year than a traditional IRA, then a SEP-IRA could be ideal. You can always start with a SEP-IRA and change to utilizing a 401(k) or other account type later.

401(k)

A 401(k) is probably the most well-known type of retirement account; however, it’s also one of the most misunderstood. I typically recommend this account to my business owner clients because of the high contribution limits and its flexibility.

Additionally, if a client’s business has employees, a 401(k) plan can be a great way to attract and retain employees because your employees can contribute their income to their 401(k) plan, and you as the employer can provide them with a tax-deductible matching contribution. You get a tax deduction for giving them a match, and the employee gets a bit extra per year added to their 401(k) balance. Employees often view the match as a form of additional income because it’s “free money” from the company.

Now, as a business owner, in 2024, you can contribute up to $69,000 (under age 50) or $76,500 (age 50+) to your 401(k) plan. That income goes into your retirement account pre-tax, which means if you put in $76,500 of your income into the account, you don’t pay tax on that portion of income until many years in the future when you are ready to retire and begin using your retirement accounts as your income source. Therefore, during your peak earning years, when you’re most likely in the highest tax bracket, you’ll be saving a considerable amount on taxes each year, and you can strategically start pulling money out in retirement when you’re expected to be in a lower income tax bracket.

Also, your 401(k) plan can be designed to allow Roth or after-tax contributions, I typically break the 401(K) down into three buckets,

  1.    Traditional (Pre-Tax)

  2.    Roth (After-Tax, tax-free withdrawals)

  3. After-Tax (Contributions come out tax free, growth portion is taxable.)

Roth and after-tax contributions don’t provide you with tax savings today, but they’re designed to provide future tax benefits. The after-tax bucket in a 401(k) plan allows you to contribute money after-tax, and most people who utilize this part of their 401(k) account do so when they want to do a mega-backdoor Roth.

To understand a backdoor Roth, I need to explain why it exists in the first place. If your tax filing status is single and your modified adjusted gross income (MAGI) is $161,000 or more in 2024, then you’re not allowed to contribute to a Roth IRA. At this income level and higher, savers look for “backdoor” ways to contribute to a Roth. This is where the backdoor Roth came to life. A traditional backdoor Roth works like this:

  1. You contribute to a traditional IRA but choose not to claim a tax deduction for your contribution, making it effectively an “after-tax IRA.”

  2. You process a “Roth conversion” from your after-tax IRA to a Roth IRA.

  3. Since you already paid taxes in the “after-tax” IRA, the Roth conversion from step 2 isn’t a taxable event (unless you invested the money you put in the after-tax IRA and it grew—but don’t do that if your goal is to do a backdoor Roth; it creates complexity for no reason).

End Result: You were able to “contribute” money to your Roth IRA, even though you’re technically not allowed to do so directly because you make “too much.” Since the funds got into the Roth via a “conversion” and not a “contribution,” there’s no problem. Congress has discussed patching this loophole for years, but it never really goes anywhere.

Now, a mega-backdoor Roth is essentially the same thing, but the after-tax bucket of your 401(k) lets you contribute a lot more per year than an IRA account would, so the “conversion” in step 2 would be a lot bigger, hence the name “mega-backdoor Roth.”

If you’re reading this article, you’re most likely looking for ways to reduce your taxable income, and a Roth, backdoor Roth, or other variety won’t accomplish that. But if you’re someone who believes that you’ll be in a much higher tax bracket in the future (rapidly growing wealth and income), or you believe the government will increase income tax rates in the future, then you may bite the bullet and pay higher taxes today to hedge against the risk of paying higher tax rates in the future. Remember, in the non-Roth or “traditional” 401(k)/IRA, you get a tax break today but have to pay taxes in the future when you pull money out. Normally, business owners are in higher tax brackets during their working years and in lower brackets during retirement, but this isn’t the case for everyone, which is why it’s important to spend some time with your financial planner to determine which type of account is best for you.

Defined Benefit Plan

A defined benefit plan is probably the least known type of retirement plan among financial advisors, tax advisors, and other professionals as well. However, it’s arguably the most powerful retirement planning vehicle in existence.

A defined benefit plan is essentially a pension plan. Decades ago, many employers primarily offered pensions, where the arrangement was simple: you worked for a certain number of years, the company made contributions on your behalf, and you would receive a guaranteed paycheck for life upon retirement. However, over time, as pension plans experienced funding challenges due to market downturns, economic recessions, and increased longevity of retirees, employers recognized the financial and legal risks of maintaining these long-term commitments in an unpredictable market. As a result, most employers gradually shifted away from pensions in favor of defined contribution plans, like the 401(k), which put more responsibility on employees to save for retirement. Today, defined contribution plans have largely replaced pensions as the standard retirement offering for most employers

However, as a business owner, you can establish your own defined benefit plan. Defined benefit plans have a minimum contribution that you must make each year to avoid penalties from the IRS, which is a big difference compared to a 401(k) or IRA, where contributions are optional. Therefore, for business owners in cyclical industries or those who generate highly variable income, a defined benefit plan is typically not ideal.

But if you’re someone in an industry or business model with a consistent income stream, you’re a high-income individual with either no employees or a small team, this can be an immensely powerful tool.

So, with a defined benefit plan, you’re essentially setting a future target income stream that your plan will be able to provide you with for the rest of your life; this is called a target annual benefit. The maximum annual benefit that you can target in 2024 is $305,000 or 100% of the participant’s average compensation for their highest three consecutive calendar years (whichever is lesser).

Now, the closer you are to retirement (the older you are), the more you can typically contribute to your defined benefit plan per year. Because picture this: if you’re 60 years old and you’re planning to retire at age 65, then you have 5 years to get your defined benefit plan account balance to a level where it can generate $305,000 of annual income consistently for the rest of your life. The actual calculation to find this “target plan balance” is extremely complicated and contains many variables. Therefore, to prevent this article from becoming a book, I’ll just use a number—let’s say $2.5 million.

So, if you’re 60 years of age, you need to get your defined benefit plan account balance to $2.5 million by age 65 so that your plan can meet its target, which means that you could contribute $500,000 a year, pre-tax, into this account annually. If you’re in the highest marginal tax bracket, which is 37% at the federal level, and I’m assuming you live in Arizona, which has a 2.5% flat income tax rate, then a $500,000 pre-tax contribution would save you about $197,500 in income taxes. Additionally, because defined benefit plan contributions come from the business, your $500,000 contribution is also not subject to self-employment taxes (15.3%), saving you another $76,500. In total, you'd save approximately $274,000 in annual taxes.

My calculations above were extremely simplified and for illustrative purposes only. However, I have had clients put $400,000+ per year in their defined benefit plans and have seen firsthand the immense tax benefit these strategies provide.

As I mentioned earlier, there are risks involved with defined benefit (DB) plans. For example, if you can’t make the minimum required contribution, you could be subject to IRS penalties. I say could because there are mechanisms that allow for temporarily freezing or reducing contributions, though you would eventually need to achieve the target funding level to remain compliant. Additionally, there are variations of DB plans, such as cash balance plans, which offer more flexibility. These plans allow for amendments and adjustments to funding targets, making them more adaptable to changes in business performance.

Additionally, the design and annual management of a defined benefit plan is more complex than any of the other accounts mentioned earlier in this article; therefore, the annual costs to maintain this plan are higher. However, the upkeep costs are minuscule compared to the potential tax savings—I’ve never had a client say no to a defined benefit plan because of the fees. Clients who decline to establish a DB plan do so because they recognize that their cash flow is inconsistent and setting this up could add unnecessary stress, which is a smart decision.

Examples of Ideal Candidates for a Defined Benefit Plan

Highly Compensated Solo Professionals

These individuals generally work independently or with minimal support staff and often seek ways to maximize their own retirement contributions:

  1. Medical Professionals Independent Physicians (e.g., specialists, surgeons), Anesthesiologists in solo practice, Dentists and Orthodontists with solo practices, Psychiatrists,, Psychologists, or Therapists with private practices.

  2. Legal Professionals Solo Attorneys (e.g., estate attorneys, tax lawyers, trial lawyers) Independent Mediators or Arbitrators.

  3. Financial Advisors Independent Registered Investment Advisors (RIAs), Solo Financial Planners or Consultants Independent CPAs or solo tax advisors.

  4. Consultants Management Consultants, IT Consultants, Cybersecurity Experts, Healthcare Consultants (e.g., billing, regulatory compliance), Independent Business Strategists.

  5. Real Estate Professionals Independent Real Estate Agents or Brokers, Real Estate Developers managing their own projects.

  6. Engineers and Architects Independent Structural or Civil Engineers, Solo Architects with boutique practices.

  7. Creative Professionals Freelance Graphic Designers or Brand Consultants, Independent Writers or Authors with substantial royalties, Professional Photographers.

  8. Tech Entrepreneurs and Freelancers Freelance Software Developers, or Data Scientists, IT Specialists providing high-demand tech services.

  9. Healthcare Specialists Independent Chiropractors, Solo Physical Therapists, Naturopaths or other wellness practitioners.

Highly Compensated Professionals with Employees

These professionals run businesses with teams of employees and are often focused on both personal retirement savings and providing employee benefits:

  1. Medical and Healthcare Practices Physicians with Medical Practices (e.g., family medicine, pediatrics), Dentists and Orthodontists with multiple hygienists and support staff, Veterinarians with animal clinics employing vet techs and support staff, Optometrists with practices employing opticians and office staff, Chiropractors or Physical Therapists with clinics that include therapists and administrative staff.

  2. Law Firms Attorneys with small to mid-sized firms (e.g., family law, corporate law), Estate Planning or Tax Attorneys with a team of paralegals and junior lawyers.

  3. Financial and Accounting Firms Wealth Managers or RIAs with teams of advisors and client service representatives, CPA Firms employing junior accountants, bookkeepers, and tax preparers.

  4. Consulting Firms Management Consultants with teams of analysts and support staff, IT Consulting Firms with junior IT specialists and project managers, Healthcare Consulting Firms with additional consultants or regulatory experts.

  5. Real Estate and Construction Firms Real Estate Brokers with a team of agents and marketing specialists, Real Estate Developers with project managers, construction staff, and admin support Construction Company Owners with site managers, laborers, and administrative staff.

  6. Engineering and Architectural Firms Civil or Structural Engineers with teams of junior engineers and draftsmen Architects with firms employing junior architects, designers, and project managers.

  7. Franchise and Small Business Owners Restaurant Owners or Franchise Operators with managers and staff, Gym or Fitness Studio Owners with trainers, instructors, and front desk staff Daycare Owners with multiple caregivers and administrative staff.

  8. Healthcare Specialists Group Therapists or Psychiatrists employing other therapists or counselors, Naturopaths or Wellness Clinic Owners with multiple providers and staff.

  9. Entrepreneurs and Tech Startups Founders of small tech startups employing software developers, or IT staff Online Business Owners with virtual assistants, marketing staff, and developers.

Combining 401(k) + Defined Benefit Plan for Maximum Benefits

Another reason why I like 401(k) plans more than SEP-IRAs is because you can pair a 401(k) plan with a defined benefit plan for maximum tax savings.

By combining a 401(k) plan with a defined benefit plan, you’re getting the best of both worlds. Using the 39.5% federal and state income tax rate used in the example earlier and 15.3% self-employment tax rate; by pairing a 401(k) with a defined benefit plan, this hypothetical person would be contributing $576,500 towards their retirement annually and saving approximately $311,000 in taxes.

Another potential benefit of making large 401(k) and defined benefit plan contributions is that the contributions reduce your modified adjusted gross income (MAGI). Remember earlier when I mentioned that after you earn a certain income you can’t contribute to a Roth IRA? Well, if your 401(k) and defined benefit plan contributions reduced your MAGI down to where you’re once again allowed to contribute to a Roth. If your tax status is single and your MAGI falls below $146,000 in 2024, you would be able to max out a Roth IRA, and if it falls between $146,000 - $161,000, you would still be able to contribute to a Roth but your contribution would be partial/phased out. After $161,000, you would be ineligible to make a Roth contribution.

If you’re married filing jointly (MFJ), your Roth income limits are much higher. For example, someone MFJ with a combined AGI below $230,000 would be able to max out a Roth, and between $230,000 - $240,000 you would be able to make partial/phased-out contributions. Beyond $240,000, you would be ineligible to make Roth contributions.

If you wish to further reduce your taxable income and you’re healthy, you could also consider contributing to a Health Savings Account (HSA), which you can contribute for you, your spouse, and family. You receive a tax deduction for making a contribution to an HSA. This account type has restrictions. Funds can be used tax-free for qualified medical expenses; otherwise, withdrawals would be taxed as income and penalized at 20%! However, once you reach age 65, HSA funds can be withdrawn for any purpose and used like your other retirement account assets—but will still be taxed like income since you got tax deductions for making contributions in the first place. This dynamic of the HSA is why many call it a “Stealth IRA.” If you expect high medical expenses, then an HSA may not be appropriate for you because you would need to have a high deductible health plan to utilize an HSA.

Health Insurance Expenses

Besides taxes, one of the other leading personal expenses my self-employed clients deal with is health insurance premiums. Many don’t know that the Affordable Care Act (ACA) health insurance plans don’t care about how much assets you have. You could have $10 million in your savings account; it doesn’t matter. Qualification for subsidies (which reduce your insurance premiums) is purely based on your household income. The larger your household (spouse, kids), the more you’ll save. Additionally, other common insurance factors affect your premiums, such as age, geographical location, tobacco use, etc.

Prior to getting on ACA, many of my business owner clients were paying thousands per month to provide health insurance for their family. For example, a husband and wife, aged 55, with kids that are 15–20 years of age, are going to pay $1,500–$2,000+ a month for decent, non-ACA health insurance.

By making significant contributions to retirement accounts, you will reduce your MAGI, which is what is used to qualify you for ACA subsidies. Depending on how low your MAGI gets, you could potentially end up qualifying for ACA and dramatically reduce your health care expenses, saving your family tens of thousands per year on health insurance premiums.

Summary

Let's face it: paying taxes isn't exactly anyone's idea of a good time. But here's the good news—you have options to legally reduce your tax bill while beefing up your retirement savings. From SEP-IRAs to 401(k)s and the powerhouse defined benefit plans, there are strategies tailor-made for business owners like you. Whether you're running a one-person show or leading a team, the right retirement plan can make a world of difference in your financial future—and your peace of mind.

Of course, there's no magic bullet; the best plan for you depends on your specific circumstances. That's where I come in. If you're ready to stop giving Uncle Sam more than his fair share and start investing in your own future, feel free to reach out. Let's work together to find the retirement strategy that fits like a glove and helps you keep more of what you earn.

This content is for educational purposes only, and is not personalized financial, legal or tax advice. I encourage you to speak with a financial, legal or tax advisor prior to making any financial decisions. For personalized financial advice, you can contact the author directly to request a consultation.

Email: Zak@wealthstonepwm.com

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