Author Topic: maximizing pre-tax savings  (Read 2285 times)

jdchmiel

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maximizing pre-tax savings
« on: January 14, 2013, 08:09:15 AM »
Does anyone run their own business and have the retirement aspect figured out?
My scenario is I hope / expect to earn a large sum but for a relatively short period of time, and I want to avoid high taxes right now in preference for lower taxes when the withdraw is spread out over many years.
I am only in the research stage right now, but have come up with a few unknowns...

If I have a day job with a maxxed out 401k, can I set up my own 401k with my side job business and max that out too?  The yearly employee contribution limit does not state if that is total for an individual or if that individual could have multiple jobs with each one having the 17,500 ( in 2013) limit.

If I cannot set up a second maxxed out 401k, could I reduce my dayjob deferrals in favor of the sidejob 401k, and do a 5 to 1 employer match to reach the employer and employee contribution limits, and then if anything is still left over, set up a SEP and contribute up to ~50k or 25% of salary ( which will be set to 100% deferred to 401k).

Does this make sense / is it legal?  Is there a better or easier way to get 100k-300k / year into pretax accounts?

RadicalPersonalFinance

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Re: maximizing pre-tax savings
« Reply #1 on: January 14, 2013, 02:17:07 PM »
Max the 401(k) at your corporate job and set up a separate deferred comp plan at your side business.

The answer to what type of plan to set up in the side business is a bit complicated.  It depends on what your business status is (sole proprietorship / S-corp / C-corp), how many employees you have, the age and diversity of your employees, how steady and how much your cash flow is, whether you're willing to set aside for employees vs. for yourself, and other factors as well.

The problem is that all defined contribution plans are capped at about $50k annual contributions.

If you truly want to get $100k to $300k into pretax accounts, the only way to do it is to organize as a C-Corp so you can do a defined benefit plan.    With a defined benefit plan your contribution amount is calculated based on the level of pension income you will receive.  There is no arbitrary amount (like $17,500 for a 401k).  You decide the income level at retirement and work backwards to figure out how much funding you need to do.  (by the way, you'll hear this called a 412(i) or a 412(e) plan) 

These plans really are incredible when they're set up right.  They are extremely specialized, however, and you have to do them exactly right and have your plan documents lined up properly.  Consult a qualified planner.  This would generally not be something you try to set up yourself on the cheap.

bigchrisb

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Re: maximizing pre-tax savings
« Reply #2 on: January 14, 2013, 03:35:23 PM »
I've got an approach that works in the Australian tax system.  It relies on dividend imputation which we have, but I don't think the US has - but might be worth a look?  Dividend imputation is where dividends are taxed at your normal tax rate, but you get a tax credit for any tax already paid by the company.

I have shares of a profitable business (that I work for) in a family trust.  I pay part of my income as dividends, with the associated imputation credits.  These go to the trust.  The trust distributes these to an investment company that I own.  The investment company invests the money, and I can draw it down at a future time of my choosing.  The neat thing is that the income tax paid on the company's income is equal to the imputation credit, so no out of pocket cost.  And this shows up as tax that the company has paid, so can be passed on with future dividends.

For an example, and choosing nice round numbers of $1000 in additional income, a 5 year period to I stop working and draw down, and a 10% pre-tax rate of investment return (5% capital gain, 5% dividends).  Marginal tax rate in earning year = 46.5%, company tax rate = 30% and marginal tax rate in consumption year = 21.5% (or may be 34.5% depending on how much income I want).  Dividends are taxed in the year paid, capital gains are taxed in the year liquidated, Australian capital gains tax is based on 50% of your marginal rate.

Scenario 1: receive income directly, invest in own name.
$1000 of income would be taxed at 46.5%.  I would receive $535 to invest.  Any earnings on this would be taxed at 46.5%.  After 5 years, I would have $774, and a CGT bill of $9 or $14 depending on my retirement income level.  i.e., at 21.5% level (up to $37k/year), I would have $765 to consume.  At 34.5% level (up to 80k/year) I would have $760

Scenario 2: receive income through company, invest in company, pay to self after retirement
$1000 of income would be taxed at 30%.  The company would have $700 to invest, and $300 of imputation credits.  Any earnings are taxed at 30%, with the tax paid added to the imputation credits.  After 5 years, this would be $1009 plus $405 in imputation credits.  i.e. gross income of $1414.  I'd then pay individual income tax on this, leaving either $1110 or $926 depending on the retirement income level (and tax payable) that I want.  i.e. if I keep my retirement needs below $37k/year, I'm 45% better off, while if I my retirement income is up to $80k/year, I'm still 22% better off.

Of course, its not as tax attractive as the Australian superannuation system, (15% tax, tax free in retirement), but I want to be able to access it at 35, not past 60.