Tag Archives: retirement plans

How Some Traders Double-Up On Retirement Plan Contributions

June 23, 2021 | By: Robert A. Green, CPA | Read it on

Increased limits for 2022: The Solo 401(k) combines a 100% deductible “elective deferral” (ED) contribution of $19,500 for 2021 and $20,500 for 2022 with a deductible profit-sharing plan contribution (PSP) of 25% of wages up to a maximum of $38,500 for 2021 and $40,500 for 2022. There is also an ED “catch-up provision” of $6,500 for 2021 and 2022 for taxpayers age 50 and over. Together, the maximum tax-deductible contribution is $58,000 for 2021 and $61,000 for 2022, and $64,500 for 2021 and $67,500 for 2022 when the catch-up provision is included.

Profitable traders are keen on maximizing retirement plan contributions in trading activities and also in their full-time jobs. Traders are pros at investing, and they understand the power of tax-free compounding while saving for retirement. However, wages are required to make contributions to a retirement plan.  Active traders eligible for trader tax status (TTS) can use an S-Corp structure to pay themselves the necessary wages.

Those who have a job in addition to trading can double their retirement savings by maximizing their employer 401(k) and contributing another $58,000 to an unaffiliated TTS S-Corp Solo 401(k) or profit-sharing plan.

The TTS S-Corp pays officer compensation, which engineers the earned income required for employee benefit tax deductions, including health insurance premiums and retirement plan contributions. Conversely, trading gains from capital gains or Section 475 ordinary income are considered unearned income, for which the IRS does not permit retirement plan contributions.

An individual TTS trader deducts business expenses on Schedule C. However, a sole proprietor TTS trader cannot arrange AGI deductions for health insurance premiums and retirement plan contributions because underlying trading gains are not self-employment income (SEI) or earned income. A sole proprietor of any kind cannot pay himself payroll (salaries). It’s also tricky for a TTS partnership to create SEI since partnership compensation and other expenses reduce it. Whereas S-Corp payments do not reduce SEI, making the S-Corp the structure of choice for TTS traders for arranging employee benefits.

In the examples below, full-time Trader A contributes the $64,500 cap to a Solo 401(k) retirement plan for 2021. Part-time Trader B doubles up on retirement benefits, maximizing an unaffiliated employer 401(k) plan for $19,500 and contributing up to the $58,000 cap in her TTS S-Corp profit-sharing plan. Unfortunately, part-time Trader C is out of luck; his consulting company is affiliated with his TTS S-Corp, so he must include consulting company employees in his retirement plan.

Full–time Trader A
This person owns a single-member LLC (SMLLC) taxed as an S-Corp, eligible for TTS business expense deductions.

In December 2021, based on sufficient annual profits, a TTS S-Corp can pay maximum-required officer compensation of $154,000 to make the Solo 401(k) retirement plan contribution cap of $58,000 ($64,500 for age 50 or older; 2021 limits). Trader A’s Solo 401(k) plan comprises a $19,500 elective deferral, $6,500 catch-up elective deferral for age 50 or older, and a $38,500 profit-sharing contribution for an overall plan limit of $64,500.

Trader A’s W-2 wage statement deducts the Solo 401(k) elective deferral amount of $26,000 from taxable income (box 1), and the S-Corp deducts the profit-sharing contribution of $38,500 on Form 1120-S. The profit-sharing contribution is 100% deductible, but it represents 25% of wages, translating to $38,500 of officer wages (25% of $154,000). The elective deferral of $26,000 is 100%  deductible, and it looks to gross income. If the 401(k) plan only provided for an elective deferral (no profit-sharing contribution), then Trader A would only need wages (net of required deductions) of $26,000 before contribution on a pre-tax basis to the 401(k) (a higher amount may be necessary for a Roth IRA).

Alternatively, if Trader A did not make an elective deferral, the TTS S-Corp could contribute $58,000 to the Solo 401(k) plan on officer wages of $232,000 ($58,000 is 25% of $232,000).

Higher wages trigger an additional Medicare tax of 2.90% (plus a 0.9% Obamacare Medicare surtax over the ACA income threshold). The Medicare tax of 3.8% on earned income (wages) often replaces the 3.8% Obamacare net investment tax for upper-income traders.

If Trader A is married and the spouse provides employment services to the S-Corp, the spouse can also participate in the S-Corp retirement plan. The same goes for working-age children rendering services negotiated at arm’s length.

There’s also an option for a Roth 401(k) (after-tax) plan for the elective deferral portion only. Suppose you are willing to forgo the upfront tax deduction. In that case, you’ll enjoy permanent tax-free status on contributions and growth within the plan — subject to satisfying certain IRS conditions —  and minimum distributions at age 72 are not required.

Of course, W-2 wages are subject to payroll taxes. For 2021, on the Social Security wage base amount of $142,800, 6.2% of Social Security taxes are paid and deducted by the employer, and 6.2% are withheld from the employee’s paycheck. Thus, in most cases, the taxpayer saves more in income taxes than they owe in payroll taxes while at the same time accumulating Social Security benefits for retirement.

Part-time Trader B working for Big Tech
This trader has a full-time job with a Big Tech company earning a W-2 salary of $300,000 per year. Trader B seeks to maximize participation in her employer’s 401(k) retirement plan, with an elective deferral of $19,500 (under age 50), plus an employer matching contribution of 6%, which does not count towards the elective deferral limit.

Trader B also operates a TTS S-Corp and makes $400,000 in capital gains for 2021. In addition to her employer’s 401(k), Trader B wants to utilize a Solo 401(k) retirement plan to maximize her savings.

The critical issue is whether Trader B’s TTS S-Corp is affiliated with her employer. Assuming it is unaffiliated, Trader B can maximize multiple employer retirement plans, with an essential restriction: An individual can only defer the limit ($19,500 plus $6,500 catch-up, if over 50) regardless of the number of plans. So, Trader B skips the elective deferral in her Solo 401(k) and makes a $58,000 (2021 limit) profit-sharing contribution to her Solo 401(k) plan or contributes to a SEP IRA. Trader B would need $232,000 in wages to maximize the profit-sharing contribution of $58,000 ($232,000 divided by a 25% rate for an S-Corp). Trader B’s TTS S-Corp shows a net profit after deducting officer compensation and the retirement plan contribution. (See Retirement Topics – 401(k) and Profit-Sharing Plan Contribution Limits.)

When a taxpayer receives wages from more than one employer, there might be duplicate Social Security taxes for the employer share if over the Social Security wage base amount. The individual tax return identifies excess employee Social Security taxes and reclassifies them as a federal tax credit, avoiding redundancy on the employee share.

Part-time Trader C with an Affiliated Company
This trader owns 100% of a consulting business S-Corp with 10 full-time employees. The consulting S-Corp does not offer a retirement plan to its employees. Trader C wonders if the TTS S-Corp can establish a Solo 401(k) plan and deny participation by consulting business employees. The answer is no because these two employers are affiliated.

The controlled group non-discrimination rules prevent an owner from discriminating against his employees by excluding them from retirement benefits. It is wise to consult an employee benefits attorney about vesting and other means to work within the constraints of the non-discrimination, controlled group, and affiliated service group rules. 

Q&A with Employee-benefits Attorneys    

I asked the following questions to employee-benefits attorneys Rick Matta, David Levine, and Joanne Jacobson of Groom Law Group.

  1. Do you agree with the retirement plan strategy for full-time Trader A?

    Yes, with the caveat that a TTS trader must have earned income (W-2 wages) for this retirement plan strategy. 

  2. Can Trader B maximize her Big Tech employer’s 401(k) plan while contributing the maximum allowed $58,000 to a TTS S-Corp profit-sharing plan for 2021?

    Yes, as long as the two employers are unaffiliated. Multiple employers can have various retirement plans, but a taxpayer is limited to one 401(k) elective deferral limit.

  3. If Trader B only contributes $10,000 to his Big Tech employer’s 401(k), can he contribute the remaining $9,500 to a TTS S-Corp Solo 401(k)? If yes, is there a formal integration required?

    Yes, the $19,500 / $26,000 limit is based on the individual across all plans in which he or she participates. Therefore, coordination of these limits across plans is required.

  4. Do you agree that Trader C’s consulting S-Corp is affiliated with his TTS S-Corp? How does affiliation restrict Trader C?

    From the facts presented, it appears that they are affiliated, and the IRS non-discrimination rules could limit the amounts Trade C could save for retirement.  However, it is essential to keep in mind that there are many ways that “affiliation” can occur. For example, it can be due to common ownership (commonly called “controlled group”), sharing of services (commonly called “affiliated service group”), or even common governance or control (especially for non-profits). Therefore, a careful review of each structure is vital to avoid potentially costly failures.

  5. Do you recommend that Traders A, B, and C also consider a nondeductible IRA if they are not eligible for deductible IRA contributions?

    Nondeductible IRAs are always on our list to consider when speaking with TTS traders with earned income. 

  6. Do you support converting IRAs and 401(k) rollovers to Roth IRAs?

    These types of IRAs – called “back door Roth IRAs” by some in the industry – are popular planning tools.  While each individual’s tax planning varies, they are often seen as advantageous.  We also note that there are in-plan Roth conversion opportunities in 401(k) plans that can have other benefits that can be worth considering.

  7. Are defined benefit plans appropriate for upper-income TTS traders? Defined benefit plans – when carefully designed – can provide significant tax-advantaged savings vehicles and are almost always worth consideration.

Many of our TTS trader clients operate in an S-Corp, and they select a Solo 401(k) retirement plan and execute the strategy through year-end payroll. Adding a traditional IRA, Roth IRA, or nondeductible IRA contribution by April 15 tax time is generally a good idea, too.

Consider consulting with an employee benefits attorney to discuss multiple employer retirement plans, affiliate service group rules, defined benefit plans, and back door Roth strategies.

Contributions by Adam Manning, CPA, and Groom Law attorneys Rick Matta, David Levine, and Joanne Jacobson.

Active Traders Should Consider An Entity For Tax Savings

May 3, 2016 | By: Robert A. Green, CPA

Click to read Green's blog post in Forbes.

Click to read Green’s blog post in Forbes.

Forming an entity can save active investors and business traders significant taxes. Active investors can limit wash sale losses calculated between their individual taxable investment accounts and IRAs with an entity account. Business traders solidify trader tax status (TTS), unlock employee-benefit deductions, gain flexibility with a Section 475 election and revocation and limit wash-sale losses with individual and IRA accounts. For many active traders, an entity solution generates tax savings in excess of entity formation and compliance costs.

An entity return consolidates your trading activity on a pass-through tax return (partnership Form 1065 or S-Corp 1120-S), making life easier for you, your accountant and the IRS. It’s important to segregate investments from business trading when claiming TTS, and an entity is most useful in that regard. It’s simple and inexpensive to set up and operate.

Additionally, entities help traders elect Section 475 MTM (ordinary-loss treatment) later in the tax year — within 75 days of inception — if they missed the individual MTM election deadline on April 15. And it’s easier for an entity to exit TTS and revoke Section 475 MTM than it is for a sole proprietor. It’s more convenient for a new entity to adopt Section 475 MTM internally from inception, as opposed to an existing taxpayer whom must file a Form 3115 after filing an external election with the IRS.

Don’t worry, prior capital loss carryovers on the individual level are not lost; they still carry over on your individual Schedule D. The new entity can pass through capital gains if you skip the Section 475 MTM election to use up those capital loss carryovers. After using up capital loss carryovers, your entity can elect Section 475 MTM in a subsequent tax year.

Business traders often use an S-Corp trading company or an S-Corp or C-Corp management company to pay salary to the owner in connection with a retirement plan contribution, which otherwise isn’t possible in a partnership trading company (unless a trader has other sources of earned income or is a dealer member of a futures or options exchange).

Trading in an entity can help constitute a performance record for traders looking to launch an investment-management business. Finally, many types of entities are useful for asset protection and business continuity. A separate legal entity gives the presumption of business purpose, but a trader entity still must achieve TTS.

Avoid wash sales with an entity
Active investors in securities are significantly impacted by permanent and deferred wash sale losses between IRA and individual taxable accounts.

Trading in an entity helps avoid these problems. The entity is separate from your individual and IRA accounts for purposes of wash sales since the entity is a different taxpayer. An individual calculates wash sales among all their accounts. Ring fencing active trading into an entity account separates those trades from the individual wash sale loss calculations. The IRS is entitled to apply related party transaction rules (Section 267) if the entity purposely tries to avoid wash sales with the owner’s individual accounts. In that case, the entity will not avoid wash sale loss treatment.

If you don’t purposely avoid wash sales, you can break the chain on year-to-date wash sales in taxable individual accounts by switching over to an entity account mid-year or at year-end, and prevent further permanent wash-sale losses with IRAs. If the entity qualifies for TTS, it can consider a Section 475 MTM election exempting it from wash sales (on business positions, not investment positions); that also negates related party rules.

Play it safe on related party transaction rules by avoiding the repurchase of substantially identical positions in the new entity after taking a loss in the individual accounts.

Business traders: consider an entity
Many active traders ramp up into qualification for TTS. They wind up filing an individual Schedule C (Profit or Loss from Business) as a sole proprietor business trader the first year. That’s fine. They deduct trading business expenses on Schedule C and report trading gains and losses on other tax forms. They can even elect Section 475 MTM by April 15 of a given tax year to use ordinary gain or loss treatment (recommended on securities only). But a Schedule C owner may not pay himself compensation and the Schedule C does not generate self-employment income, either of which is required to deduct health insurance premiums and retirement plan contributions from gross income. (The exception is a full-fledged dealer/member of an options or futures exchange trading Section 1256 contracts on that exchange; they have SEI per Section 1402i.) The business trader needs an entity for those employee-benefit plan deductions.

Safeguard use of Section 475

Pass-through entities
We recommend pass-through entities for traders. A pass-through entity means the entity is a tax filer, but it’s not a taxpayer. The owners are the taxpayers, most often on their individual tax returns. Consider marriage, state residence and state tax rules including minimum taxes, franchise taxes and more when setting up your entity. Report all entity trading gains, losses and expenses on the entity tax return and issue a Schedule K-1 to each owner for their respective share — on which income retains its character. For example, the entity can pass through capital gains to utilize individual capital loss carryovers. Or the entity can pass through Section 475 MTM ordinary losses to comprise an individual net operating loss (NOL) carryback for immediate refund.

The best types of entities
We like the S-Corp because it pays compensation (officer’s salary) to the owner, which efficiently unlocks health insurance premium and retirement plan contribution deductions. You can form a single-member LLC or multi-member (spousal) LLC and the LLC can elect S-Corp tax treatment within 75 days of inception or by March 15 of the following tax year. (Another option is to form a corporation and it can elect S-Corp tax treatment, too.) A general partnership can also elect S-Corp status in every state except Connecticut, the District of Columbia, Michigan, New Hampshire, New Jersey and Tennessee.

But the S-Corp is not feasible alone in some states or cities, including California and New York City. In those places, we suggest a trading company partnership return — either a general partnership or LLC — and a management company S-Corp or C-Corp. You can convey interests in the pass-through entity to family revocable trusts or even irrevocable trusts. (See our blog post Business Traders Maximize Tax benefits with an S-Corp.)

Year-end Entity planning
There are important tax matters to execute with entities before year-end. For example, S-corps and C-corps should execute payroll before year-end. A Solo 401(k) defined contribution plan or defined benefit retirement plan must be established before year-end. (Watch our Webinar recording: Year-End Planning For Entities: Payroll, Retirement and Health Insurance.)

This is an excerpt from Green’s 2016 Trader Tax Guide.

Webinar 5/17:  Entity & Benefit Plan Tax-Advantaged Solutions 2016. We plan to offer a recording afterwards. 

 

 

MLPs Can Generate Tax Bills In Retirement Accounts

October 31, 2014 | By: Robert A. Green, CPA

Forbes

MLPs Can Generate Tax Bills In Retirement Accounts

It’s a surprise to many people that MLPs generate taxable income in retirement plans requiring a tax filing and payment of taxes.

Traders and investors are interested in using their IRA and other retirement plan accounts (collectively referred to as “retirement plans”) for making “alternative investments” in publicly traded Master Limited Partnerships (MLPs). Most MLPs conduct business in energy, pipelines, and natural resources. (Learn more about publicly traded partnerships at The National Association of Publicly Traded Partnerships, see its list of PTPs Currently Traded on U.S. Exchanges and read its warning about MLPs and Retirement Accounts.) Retirement plans also make alternative investments in hedge funds organized as domestic limited partnerships or offshore corporations.

Publicly traded partnerships (including MLPs) and hedge fund LPs use the partnership structure as opposed to a corporate structure. That allows organizers to pass through significant tax breaks on a Schedule K-1, including intangible drilling costs (IDC) and depreciation to individual investors. Taxes are paid on the investor/owner level, so the partnership structure avoids double taxation. Conversely, corporations owe taxes on the entity level and investor/owners pay taxes on dividends received from the corporation. (Real Estate Investment Trusts do not use a partnership structure.)

Tax problems for retirement plans investing in MLPs
Most MLPs conduct business activities including energy, pipelines and natural resources. But hedge funds do not — they buy and sell securities, futures, options and forex, which are considered portfolio income activities. Private equity and venture capital funds using the partnership structure also may pass through business activity income.

When retirement plans conduct or invest in a business activity, they must file separate tax forms to report Unrelated Business Income (UBI) and often owe Unrelated Business Income Tax (UBIT). MLPs issue Schedule K-1s reporting business income, expense and loss to retirement plan investor/owners. That’s the problem! The retirement plan then has UBI, and it may owe UBIT. Instead of the MLP being a tax-advantaged investment as advertised, it turns into a potential tax nightmare investment.

Form 990-T
According to Form 990-T and its instructions “Who Must File,” when a retirement plan has “gross income of $1,000 or more from a regularly conducted unrelated trade or business” it must file a Form 990-T (Exempt Organization Business Income Tax Return). While the retirement plan may deduct IDC and depreciation from net UBI, gross income will probably exceed $1,000 causing the need to file Form 990-T. UBIT tax brackets go up to 39.6%, which matches the top individual tax rate. (See the UBIT rates and brackets in the instructions.) File Form 990-T to report net UBI losses so there is a UBI loss carryforward to subsequent tax years.

Don’t overlook the need to file Form 990-T
Noncompliance with Form 990-T rules can lead to back taxes, penalties and interest. It can lead to “blowing up” a retirement plan, which means all assets are deemed ordinary income. And if the beneficiary is under age 59½, it’s considered an “early withdrawal,” subject to a 10% excise tax penalty. Schedule K-1s are complex, and UBI reporting can be confusing especially if the retirement plan receives several Schedule K-1s from different investments. Don’t look to brokers for help; most have passed off this problem to retirement plan trustees and beneficial owners (and that is you!).

In our July 2013 blog and Webinar “The DOs and DON’Ts of using IRAs and other retirement plans in trading activities and alternative investments,” we cautioned investors on making alternative investments in their retirement plan accounts. We talked about UBIT, self-dealing and prohibited transactions. We explained that U.S. pension funds invest in offshore hedge funds organized as corporations since the offshore corporations are “UBIT blockers.”

If your retirement plan is invested in a publicly traded partnership, assess your tax situation immediately, catch up with Form 990-T filing compliance and consider selling those investments. It’s better to buy them in a taxable account.

Unrelated Business Income Defined by the IRS site.

“For most organizations, an activity is an unrelated business (and subject to unrelated business income tax) if it meets three requirements:

  1. It is a trade or business,
  3. It is not substantially related to furthering the exempt purpose of the organization.

There are, however, a number of modifications, exclusions, and exceptions to the general definition of unrelated business income.”

Darren Neuschwander CPA and Star Johnson CPA contributed to this article.