There’s still ample time in 2015 to rearrange the timing of your investments, trading, retirement and business affairs to improve your overall taxes for 2015 and surrounding years. In this second blog post of our year-end tax planning series I focus on retirement plans.
Retirement plans for traders can be used several ways. You can trade in the retirement plan, build it up with annual tax-deductible contributions, borrow money from it to start a trading business and convert it to a Roth IRA for permanent tax-free build-up. Whatever the use, traders often need help through these important planning opportunities. There are plenty of pitfalls to avoid like early withdrawals subject to ordinary income tax rates and 10% excise tax penalties, and penalties on prohibited transactions.
Many Americans invest in the stock market through their 401(k), IRA or other types of traditional retirement plan. Capital gains and losses are absorbed within the traditional retirement plans with zero tax effect on current year tax returns. Only withdrawals (or distributions) generate taxable income at ordinary tax rates. The retirement plan does not benefit from lower long-term capital gains rates. Traditional retirement plans aren’t disenfranchised from deducting capital losses, since a reduction of retirement plan amounts due to losses will eventually reduce taxable distributions accordingly.
Defined contribution plan vs. defined benefit plan
Most private companies switched to defined contribution plans, whereas public-sector unions still use richer defined benefit plans. In a defined contribution plan, the contribution is defined as a percentage of compensation, whereas in a defined benefit plan, the retirement benefit itself is defined.
If you own and operate a small business, consider a Solo 401(k) defined contribution plan. It combines a 100% deductible “elective deferral” contribution ($18,000 for 2015) with a 25% deductible profit-sharing plan contribution on an employer-level plan. There is also a “catch up provision” ($6,000 for 2015) for taxpayers age 50 and over. Together, the maximum tax-deductible contribution is $53,000 per year and $59,000 including the catch up provision (based on 2015 and 2016 IRS limits).
Consistently high-income business owners, including trading businesses with owner/employees close to age 50, should consider a defined-benefit retirement savings plan (DBP) for significantly higher income tax and payroll tax savings vs. a defined-contribution retirement savings plan (DCP) like a Solo 401(k). Read our blog post Defined-benefit plans offer huge tax breaks.
Get started before year-end
Contact your tax advisor in early November as these plans take time to consider, establish and fund. Several large online brokers offer Solo 401(k) plans, otherwise known as Individual 401(k)s. Paychex, our recommended service provider for payroll tax compliance, also offers the Solo 401(k) product and integrates it with payroll tax compliance. The Paychex Solo 401(k) product contains the plan loan feature, whereas I only know of one large broker that also offers a plan loan feature (TD Ameritrade). Direct-access trading is allowed with all these options. (Paychex has a team dedicated to GreenTraderTax clients – brochure.)
Only a few top brokers offer a defined benefit plan product.
Solo 401(k) defined contribution plans and defined benefit plans must be established before year-end, so get started by early December. IRAs can be established and funded after year-end by April 15. A SEP IRA can be established and funded by the due date of the tax return including extensions, so if you miss the Solo 401(k) deadline, that could be a last resort option.
A Solo 401(k) is better for most traders in most situations than a SEP IRA, because it has a 100% deductible elective deferral in addition to profit sharing plan and the SEP IRA only has the profit sharing plan. In a Solo 401(k), it takes a lower amount of wages to maximize the higher contribution amount versus a SEP IRA. Because traders are in control of the compensation amount they can achieve a higher income tax benefit versus a lower payroll tax cost with a Solo 401(k).
Contributions to IRAs
Traditional and Roth IRAs allow a small annual contribution if you have earned income: $5,500 per person if under age 50 and $6,500 if 50 and older (2015 and 2016 limits). If you (and your spouse) are not active in an employer-sponsored retirement plan, or if either of you are active but your modified adjusted gross income (AGI) doesn’t exceed certain income limits, you may contribute to a traditional tax-deductible IRA.
Non-deductible IRA. If you have earned income, you should also consider making a non-deductible IRA contribution, which doesn’t have income limits. The growth is still tax deferred and you are not taxed on the return of the non-deductible contributions in retirement distributions. The general rule applies: If you deduct the contribution, the return of it is taxable, but if you don’t deduct the contribution, the return of it is non-taxable. Income growth within the plan is always taxed unless it’s inside a Roth IRA.
Contributions require SEI or wages
Many traders are interested in making tax-deductible contributions to retirement plans for immediate income tax savings in excess of payroll tax costs and to actively trade those accounts with tax deferral and growth until retirement. But, there is an obstacle: Trading gains and portfolio income are not self-employment income (SEI) or compensation, either of which is required for making contributions to a traditional or Roth retirement plan. (The exception to this is futures traders who are full-fledged dealer/members of options or futures exchanges; their individual futures gains are considered SEI.) You can overcome this obstacle with a trading business entity — S-Corp trading company or C-Corp management company — paying compensation to the owner/trader. This strategy does not work for investment companies, though.
Early withdrawals vs. a qualified plan loan
If you need to withdraw money from a traditional retirement plan before retirement age 59 ½ for IRAs and age 55 for a 401(k), in addition to the distribution being taxable income, you’ll probably owe a 10% excise tax penalty subject to a few limited exceptions (Form 5329). In lieu of an early withdrawal, consider a loan from a qualified plan like a Solo 401(k). IRAs are not qualified plans and loans would be a prohibited transaction blowing up the IRA, making it all taxable income. You can borrow up to the lower of $50,000 or 50% of plan assets, and you must repay the loan with market interest over no longer than five years and a quarterly basis.
Required minimum distributions
Per Thomson Reuters, “Take required minimum distributions (RMDs) from your IRA or 401(k) plan (or other employer-sponsored retired plan) if you have reached age 70½. Failure to take a required withdrawal can result in a penalty of 50% of the amount of the RMD not withdrawn. If you turned age 70½ in 2015, you can delay the first required distribution to 2016, but if you do, you will have to take a double distribution in 2016 — the amount required for 2015 plus the amount required for 2016. Think twice before delaying 2015 distributions to 2016 — bunching income into 2016 might push you into a higher tax bracket or have a detrimental impact on various income tax deductions that are reduced at higher income levels. However, it could be beneficial to take both distributions in 2016 if you will be in a substantially lower bracket that year.”
Roth retirement plans and conversions
A Roth retirement plan is different from a traditional retirement plan. The Roth plan has permanent tax savings on growth, whereas the traditional retirement plan only has deferral with taxes owed on distributions in retirement. Distributions from a Roth plan are tax-free unless you take an early withdrawal that exceeds your non-deductible contributions to the plan over the years (keep track well).
Consider annual contributions to a Roth IRA. The rules are similar to traditional IRA contributions. Also, consider a Roth IRA conversion before year-end 2015 to maximize use of lower tax brackets, offset business losses and fully utilize itemized deductions.
Here’s an example: Assume a trader left his job at the end of 2014 and incurred trading losses in 2015 with trader tax status and Section 475 MTM ordinary loss treatment as a sole proprietor. Rather than carry back an NOL that could draw IRS attention, or carry forward the NOL to subsequent years when income isn’t projected, this trader rolls over $300,000 from his prior employer 401(k) to a Rollover IRA and enacts a Roth IRA conversion for $300,000 before year-end. He winds up paying some taxes within the 15% ordinary tax-rate bracket. If the trader skipped a Roth conversion, he would lose tax benefits on his itemized deductions including real estate taxes, mortgage interest, charity, and miscellaneous itemized deductions. This trader’s Roth account grows in 2016 and he chooses to skip a recharacterization. (If a recently converted Roth account drops significantly in value in the following year, a taxpayer may reverse the Roth conversion with a “recharacterization” by the due date of the tax return including extensions (Oct. 15).
Also, after recent market corrections in indexes and many individual stocks, consider a Roth conversion at lower amounts to benefit from a potential recovery in markets inside the Roth IRA where that new growth is permanently tax-free. Converting at market bottoms is better than market tops.
DOs and DON’Ts of using IRAs and other plans
Learn the DOs and DON’Ts of using IRAs and other retirement plans in trading activities and alternative investments (read our blog post). Many traders may be triggering IRS excise-tax penalties for prohibited transactions including self-dealing and/or UBIT (unrelated business income tax) by using their IRAs and other retirement funds to finance their trading activities and alternative investments. Spot these problematic schemes early, like the IRA-owned LLC. Avoid “blowing up” your IRA, which means it becomes taxable income; plus there are severe penalties.
When it comes to retirement plans and tax savings, it’s wise to do tax planning well before year-end to maximize your available options. The door closes on many at year-end.