Investing

Choosing the Right Retirement Plan to Maximize Benefits…

September 28, 2023 by BGMF CPAs

With the various restrictions and limitations on retirement plan contributions and benefits, small business owners and professionals may wonder whether it is possible to fund adequate retirement benefits for themselves using a tax-qualified plan. In many cases, it is — if the most appropriate plan design is chosen.

Why So Many Restrictions?

Many of the restrictions and limitations added to the federal tax code in the pension area have been aimed at making plans nondiscriminatory — i.e., making sure that the plan does not discriminate in favor of a firm’s highly paid employees. In some cases, the perhaps unintended effect of the restrictions has been to dampen enthusiasm for retirement plans because business owners question whether the benefits they will receive justify the expense of maintaining a plan.

What plans should a business owner who is concerned about funding his or her own retirement consider? Several possibilities are discussed below.

Age-Based Profit Sharing Plan

One type of plan that may be appropriate for many small business owners and professionals is the age-based profit sharing plan. The plan combines the traditional benefits of a profit sharing plan with the ability to allocate employer contributions to participant accounts using factors that consider both compensation and age. In contrast, traditional profit sharing plans allocate contributions based only on compensation, with each participant receiving a flat percentage of pay.

If employee demographics favor the age-based approach, more of the annual profit sharing plan contribution is shifted to the accounts of the older owner(s) and key employees participating in the plan. In some instances, the total plan contribution can be lowered while allocations to the owner and the key employees remain at the same levels — or even increase.

Target Benefit Plan

This type of plan is a cross between a defined benefit pension plan and a money purchase plan. It uses actuarial assumptions — including assumptions about remaining years to retirement — in determining the amount to be contributed for each participant. As with an age-based plan, no more than $66,000 a year (in 2023) can be added to each employee’s account, regardless of compensation or age. However, the plan is not as flexible as an age-based plan in that an annual employer contribution is generally required.

Defined Benefit Pension Plan

If the per-employee cap on additions to a plan account is a source of concern, a traditional defined benefit pension plan can often provide more lucrative benefits. With this type of plan, the closer a participant is to retirement age and the larger the promised retirement benefit, the higher the plan contribution, all else being equal.

Other Considerations?

Before deciding to implement any of these plans, the effect of the tax law’s top-heavy rules should be analyzed. These rules generally are triggered when key employees hold more than 60% of the account balances or accrued benefits in all plans sponsored by the employer. When a plan is top heavy, every active participant must receive a minimum contribution or benefit (3% of pay for a defined contribution plan).

There are both retirement and tax strategies to maximize contributions for the company’s employees and owners. This can be discussed in planning sessions we hold with clients on a regular basis.

Contact our team today to begin the process of reviewing or adding a retirement plan to your business.

Understanding Pre-Tax and After-Tax 401k Plans

September 10, 2020 by BGMF CPAs

retirement savings plans A recent study showed that when 401(k) plans are offered, about 90 percent of all employees who have the option to contribute do so. There is, however, an important difference between pre-tax and after-tax contributions.

Most people think about saving for retirement. If your employer offers a 401(k) plan, which about half of all companies currently do, taking advantage of that plan is an attractive option.

In fact, a 2018 report by the Stanford Center on Longevity study found that most employees of all ages participated: 91 percent of those 25–34 to years old, 91 percent of those 35–44 to years old, 92 percent of those 45–54 to years old and 89 percent of those 55–64 to years old.

Pre-Tax 401(k) Plans

Pre-tax 401(k) plans are popular for the following reasons:

Contributions are tax-deferred, which means your money isn’t taxed until it is withdrawn, when it is likely you will be in a lower tax bracket.
Companies often match part or all of your contribution.
You don’t have to think about it once you choose to participate because deductions are automatic.
Because the amount you contribute is a pre-tax deductions from your take-home pay, your taxable income is reduced so you may pay lower income tax.

The amount you can contribute to a traditional 401(k) is limited. For 2019, the maximum limit is $19,000 (pre-tax and Roth). Amounts matched by your employer are not included in this limit. Participants age 50 and older are allowed to contribute an additional $6,000 “catch-up” contribution, bringing the total allowable contribution to $25,000.

After-Tax 401(k) Plans

That already sounds attractive, but some taxpayers are eligible to supersize their contributions and save even more – if their employers allow after-tax contributions to their 401(k). These plans allow you to contribute up to $37,000 more than the $19,000 limit. This means you can potentially save $56,000 annually in an after-tax 401(k) (that’s up to $62,000 if you are 50 or older).

Note the following tax considerations:

Your maximum contribution is reduced by any matching contributions.
Plan limits apply.
The plan is subject to nondiscrimination testing for highly compensated employees.
Your contributions are taxed in the year they are made, so your taxable income is not reduced by the amount of your contribution.
Because you’ve already been taxed on your contributions, any interest or dividends you earn grow tax-free rather than tax-deferred.

In-Plan Roth Rollover

Some employers allow participants to their traditional 401(k) plan to convert their plan to a Roth 401(k) while they are still employed at the company. Although this option is not widely available, it can be beneficial.

And Then What?

Certain tax events are triggered once you leave a company or retire:

If you have a traditional 401(k), your pre-tax contributions generally are rolled over into a traditional IRA. Any withdrawals are taxed as ordinary income.
If you have an after-tax 401(k), your contributions can be rolled over into a Roth IRA.You do not have to pay any taxes when you make withdrawals, because your contributions already have been taxed.

There is a lot to consider as you decide how to fund your retirement. This article doesn’t even touch other retirement vehicles such as other IRA’s, backdoor Roth contributions, defined benefit plans, or others. To ensure that you get the results you want, it is important to align your full financial situation with your financial goals and to speak with a professional.

Five Strategies for Tax-Efficient Investing

June 26, 2020 by BGMF CPAs

tax and investment strategies As just about every investor knows, it’s not what your investments earn, but what they earn after taxes that counts.

After factoring in federal income and capital gains taxes, the alternative minimum tax, and any applicable state and local taxes, your investments’ returns in any given year may be reduced by 40% or more.

For example, if you earned an average 6% rate of return annually on an investment taxed at 24%, your after-tax rate of return would be 4.56%. A $50,000 investment earning 8% annually would be worth $89,542 after 10 years; at 4.56%, it would be worth only $78,095. Reducing your tax liability is key to building the value of your assets, especially if you are in one of the higher income tax brackets. Here are five ways to potentially help lower your tax bill.

Invest in Tax-Deferred and Tax-Free Accounts

Tax-deferred accounts include company-sponsored retirement savings accounts such as traditional 401(k) and 403(b) plans, traditional individual retirement accounts (IRAs), and annuities. Contributions to these accounts may be made on a pretax basis (i.e., the contributions may be tax deductible) or on an after-tax basis (i.e., the contributions are not tax deductible). More important, investment earnings compound tax deferred until withdrawal, typically in retirement, when you may be in a lower tax bracket. Contributions to non-qualified annuities, Roth IRAs, and Roth-style employer-sponsored savings plans are not tax deductible. Earnings that accumulate in Roth accounts can be withdrawn tax free if you have held the account for at least five years and meet the requirements for a qualified distribution.

Pitfalls to avoid: Withdrawals prior to age 59½ from a qualified retirement plan, IRA, Roth IRA, or annuity may be subject not only to ordinary income tax but also to an additional 10% federal tax. In addition, early withdrawals from annuities may be subject to additional penalties charged by the issuing insurance company. Also, if you have significant investments, in addition to money you contribute to your retirement plans, consider your overall portfolio when deciding which investments to select for your tax-deferred accounts. If your effective tax rate — that is, the average percentage of income taxes you pay for the year — is higher than 12%, you’ll want to evaluate whether investments that earn most of their returns in the form of long-term capital gains might be better held outside of a tax-deferred account. That’s because withdrawals from tax-deferred accounts generally will be taxed at your ordinary income tax rate, which may be higher than your long-term capital gains tax rate (see “Income vs. Capital Gains”).

Income vs. Capital Gains

Generally, interest income is taxed as ordinary income in the year received, and qualified dividends are taxed at a top rate of 20%. (Note that an additional 3.8% tax on investment income also may apply to both interest income and qualified (or nonqualified) dividends.) A capital gain or loss — the difference between the cost basis of a security and its current price — is not taxed until the gain or loss is realized. For individual stocks and bonds, you realize the gain or loss when the security is sold. However, with mutual funds, you may have received taxable capital gains distributions on shares you own. Investments you (or the fund manager) have held 12 months or less are considered short term, and those capital gains are taxed at the same rates as ordinary income. For investments held more than 12 months (considered long term), capital gains are taxed at no more than 20%, although an additional 3.8% tax on investment income may apply. The actual rate will depend on your tax bracket and how long you have owned the investment.

Consider Government and Municipal Bonds

Interest on U.S. government issues is subject to federal taxes but is exempt from state taxes. Municipal bond income is generally exempt from federal taxes, and municipal bonds issued in-state may be free of state and local taxes as well. An investor in the 32% federal income tax bracket would have to earn 7.35% on a taxable bond, before state taxes, to equal the tax-exempt return of 5% offered by a municipal bond. Sold prior to maturity or bought through a bond fund, government and municipal bonds are subject to market fluctuations and may be worth less than the original cost upon redemption.

Pitfalls to avoid: If you live in a state with high state income tax rates, be sure to compare the true taxable-equivalent yield of government issues, corporate bonds, and in-state municipal issues. Many calculations of taxable-equivalent yield do not take into account the state tax exemption on government issues. Because interest income (but not capital gains) on municipal bonds is already exempt from federal taxes, there’s generally no need to keep them in tax-deferred accounts. Finally, income derived from certain types of municipal bond issues, known as private activity bonds, may be a tax-preference item subject to the federal alternative minimum tax.

Look for Tax-Efficient Investments

Tax-managed or tax-efficient investment accounts and mutual funds are managed in ways that may help reduce their taxable distributions. Investment managers may employ a combination of tactics, such as minimizing portfolio turnover, investing in stocks that do not pay dividends, and selectively selling stocks that have become less attractive at a loss to counterbalance taxable gains elsewhere in the portfolio. In years when returns on the broader market are flat or negative, investors tend to become more aware of capital gains generated by portfolio turnover, since the resulting tax liability can offset any gain or exacerbate a negative return on the investment.

Pitfalls to avoid: Taxes are an important consideration in selecting investments but should not be the primary concern. A portfolio manager must balance the tax consequences of selling a position that will generate a capital gain versus the relative market opportunity lost by holding a less-than-attractive investment. Some mutual funds that have low turnover also inherently carry an above-average level of undistributed capital gains. When you buy these shares, you effectively buy this undistributed tax liability.

Put Losses to Work

At times, you may be able to use losses in your investment portfolio to help offset realized gains. It’s a good idea to evaluate your holdings periodically to assess whether an investment still offers the long-term potential you anticipated when you purchased it. Your realized capital losses in a given tax year must first be used to offset realized capital gains. If you have “leftover” capital losses, you can offset up to $3,000 against ordinary income. Any remainder can be carried forward to offset gains or income in future years, subject to certain limitations.

Pitfalls to avoid: A few down periods don’t necessarily mean you should sell simply to realize a loss. Stocks in particular are long-term investments subject to ups and downs. However, if your outlook on an investment has changed, you may be able to use a loss to your advantage.

Keep Good Records

Keep records of purchases, sales, distributions, and dividend re-investments so that you can properly calculate the basis of shares you own and choose the shares you sell in order to minimize your taxable gain or maximize your deductible loss.

Pitfalls to avoid: If you overlook mutual fund dividends and capital gains distributions that you have reinvested, you may accidentally pay the tax twice — once on the distribution and again on any capital gains (or under-reported loss) — when you eventually sell the shares.

Keeping an eye on how taxes can affect your investments is one of the easiest ways you can enhance your returns over time. For more information about the tax aspects of investing, consult a qualified tax advisor. Example does not include taxes or fees. This information is general in nature and is not meant as tax advice. Always consult a qualified tax advisor for information as to how taxes may affect your particular situation. Our firm does not offer registered investment advice. We work with advisers as part of your team to ensure appropriate advice is given.