Best tax deferral options for business with employees

[miranda622]

Hi all!

First post here but have been reading and absorbing all the incredibly useful info on the forum and blog, and it's really motivated my husband and I to take our savings and investments to the next level. I'm hoping there might be any fellow business owners here (or savvy CPAs) who can weigh in on our plans...

So here's the deal: The two of us are joint owners in a small marketing agency that's been doing pretty well lately. We began hiring employees a little over a year ago, and grew revenues to slightly over $300K, with about $90K of that as profit on top of what we pay ourselves in salary ($59K each). After various personal deductions (including maxing out SEP IRAs at $13,000 each, based on % of salary), our accountant got our taxable income for last year down to $144K, which left us owing $15K in federal tax and $10K state.

This year, it's looking like we may do even better (fingers crossed), but we're hoping to minimize our taxes even more -- one option we're looking at is moving to an income tax-free state, given that our work is all remote (which isn't doable this year, but we're seriously considering for the future - we would still owe employees' payroll tax in this state, but could take total business income out of the equation). In advance of that, though, what we're aiming to do is:

-   Switch to an index fund-based 401k (Guideline's looks pretty good and has low fees, though am curious if anyone has experience with Vanguard directly?)
-   If possible, max out full $53,000 each in deductions there ($18,000 as employee, the rest as employer - we only have 1 full-time employee and she has not been with us a full year yet, so don't believe she is eligible at this point - but in future, will we need to match her at same rate as ourselves?)
-   Invest max $6,750 contribution to our HSA

Any other tips or tricks we might be missing?

Obviously business deductions come into play as well and we will see if we can combine personal travel with business travel to get some tax advantages there too - but as far as the retirement plan goes, it seems like we are in a grace period with employee eligibility so would like to set aside maximum savings while we can, though will likely move to 3 or 5% match once staff become eligible. We do have 2 kids (1 in full time daycare) so have reasonable living expenses, and will need to keep at least $20K in business account as a safety net there, but whatever we can do to minimize tax implications beyond that is fantastic.

Thanks for any feedback or advice!

[miranda622]

I forgot to mention, we are structured as an LLC filing as an S Corp, if that makes a difference... Also open to restructuring if there is a way to shield more income and keep it within the business itself, at the moment the income all passes through to personal returns. Thanks!

[Vilgan]

Not sure about the employer matching stuff - there might be some issues with trying to crank in employer matching and then turn it down before the employee is eligible. Another option to consider is aftertax contributions for a mega backdoor roth. It won't be tax deferred but once you get it into your Roth IRA it will be tax free after that.

[seattlecyclone]

Any chance your employees are Mustachian enough to agree to a cut in base salary in exchange for a corresponding increase in tax-deferred employer contributions to their 401(k) account?

[dandarc]

Any chance your employees are Mustachian enough to agree to a cut in base salary in exchange for a corresponding increase in tax-deferred employer contributions to their 401(k) account?

I like this idea - if your employees are willing, cut pay some, then give everyone 25% of salary as an employer-contribution.  Should work out for everyone, unless someone "needs" that take-home-pay to make ends meet.

[miranda622]

Thanks all!

I don't think our employees would be super-thrilled to have money taken away, only added... So, been doing a bit more research and talking with our accountant, and here's what we decided in case it's helpful to anyone else:

- Open a 401(k) with a Safe Harbor 4% employee match, which enables us to contribute the max $18,000 plus 4% of our $59,000 payroll-taxable salaries, and requires us to cover up to 4% of employee salaries, based on what they put in.
- Also keep a SEP IRA, where we can contribute up to 25% of our salaries, minus the 4% we're doing through the 401k. Other employees are not eligible to contribute to this plan for 3 years, at which point we'll deactivate it and probably roll it over to the 401k.

So doing things this way, we'll be eligible to contribute up to $65,500 total, or more if we decide to give ourselves an end of year bonus, depending how things go the rest of this year. It turns out we aren't able to put in the full $106,000 unless we were to raise our salaries accordingly (which adds to payroll tax costs). Once we kill the SEP, we can only put in a total of $40,720 based on the salaries we've set, so we'd like to frontload as much savings as we can if it's a good year.

Also, recommendation for Guideline (guideline.com) for anyone looking for a small-biz 401k... All Vanguard funds and just a 0.03% custodial cost plus $8/employee/month. It was the lowest cost of any we found by a long shot.

[SeattleCPA]

Your easiest two options are to implement a SEP and cover only the shareholder-employees by writing the participation rules in a restrictive manner. E.g., your firm's SEP covers full-time, older than age 21 employees with at least three years of service and only shareholder-employees pass these three tests.... or you can use a SIMPLE-IRA which requires a 3% match to employees if they contribute 3% or more.

BTW, 401(k)s allow for way bigger elective deferrals but to get good investment options, you're often looking at around $4K a year in fees. (That's what ADP charges, for example.)

Also, note that your own pension amounts will be based on your W-2 amounts and not your K-1 amounts. E.g., if shareholder-employee makes $40K a year and gets another $80K on K-1, only that $40K factors into the pension calcs.

[miranda622]

Thanks for the additional feedback -- not sure if we'll end up at that level (yet), but may start looking into defined benefit, thanks for the suggestion Dillydally - may be in touch!

[Axecleaver]

The 401k and SEP-IRA may not be compatible. Depends on the actual plan documents you used. The IRS model doc for SEP-IRA, for example, does not permit contributions to both in the same year. Check this thread for details: https://www.bogleheads.org/forum/viewtopic.php?t=102421.

SEP-IRAs are structured as total profit sharing plans, while the 401k is a profit sharing and employee contribution plan. If you have an employee, you need to structure the plans so that you're grandfathered in, but the employee doesn't qualify. Otherwise whatever you give yourselves from the company as employer contributions, the employee qualifies for it, too. The risk if you don't make those contributions, is that the plan is found invalid and ALL tax deferrals are taxable. That's where all those "how to fix compliance problems in your plan" docs on the IRS site come from.

Curious how you ultimately resolve this as I have a similar situation. I'd resigned myself to just using the 401k this year, but would love to be shown a path that allows me to take advantage of the SEP-IRA as well. My plan docs are based on the IRS model document, so I don't think it's possible in my case.

[miranda622]

Hey Axecleaver,

Thanks for the head's up, it does look like you're right in fact -- under the standard IRS form (which we used too), we can't technically contribute to a SEP and a 401k in the same year. I'd been hoping we could keep the SEP as a money-dump for overage after we have a good amount of operating margins for the business (assuming it's a good year), but looks like that's not an option after all.

My partner and I will each max out our "employee" share and the 4% match that we've offered to our employees as well. Currently, we each pay ourselves salaries of $59K, so that'll bring our total to $40,720. Assuming the business does as well or better than it did last year, though, that will still leave us with a fair amount of profits taxed at full rates... So we're looking at exploring the "profit sharing" option that our 401k plan also offers, ideally making employees eligible only after 2 years if that's allowed, so my partner and I can max out with a 25% contribution in the first two years before anyone else joins and then bring it back to a 5ish% ratio. The other option is to raise our "salaries" as employees (LLC filing as S corp), which means our 4% match would grow, but we would also owe FICA taxes on the additional salary in that case so it would be pretty close to even. Anyway, must look into it more - thanks for the warning, my accountant didn't catch it, but it does look like you're right.