Save thousands in taxes with a high-deductible retirement plan deduction and grow your retirement funds tax-free until retirement.
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 a qualified plan 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 essential 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.
You need “earned income”
Retirement-plan contributions can only be made if that taxpayer has earned income, which is subject to the self-employment (SE) tax or wage income. Trading gains aren’t earned income and are exempt from SE tax in a partnership or payroll taxes in an S-Corp. The exception to this is futures traders who are full-fledged dealer/members of options or futures exchanges; their futures gains on that exchange are considered earned income subject to SE tax (Section 1402i). Business traders can use entities like an S-Corp trading company or S-Corp or C-Corp management company to pay compensation to claim employee-benefit deductions (see Chapter 7).
Solo 401(k) plan
The best retirement plan for business traders is a defined-contribution Solo 401(k) for S-Corps and C-Corps in connection with officer compensation (payroll). This plan is only allowed with TTS or another business purpose (it’s not for investment companies). It combines a 100% deductible “elective deferral” (ED) contribution of $18,000 for 2017 and $18,500 for 2018 with a 25% deductible profit-sharing plan contribution. There is also an ED “catch-up provision” of $6,000 for 2017 and 2018 for taxpayers age 50 and over. Together, the maximum tax-deductible contribution limit for a defined contribution plan is $54,000 for 2017 and $55,000 for 2018, and $60,000 for 2017 and $61,000 for 2018 including the catch-up provision.
Defined benefit plans
Consistently high-income business owners, including trading businesses with owner/employees close to age 50, should consider a defined-benefit retirement plan (DBP) for significantly higher income tax and payroll tax savings vs. a defined-contribution retirement savings plan (DCP) like a Solo 401(k). DBP calculations are complex. DBP calculations are more complicated than a DCP profit-sharing plan. With a DBP, an actuary is required to consider various factors in calculating retirement benefits and annual contributions to the DBP.
The first factor is three-year average annual compensation, and the IRS limit is $265,000 (2016 limits). W-2 compensation may be higher, but the actuary may only input the IRS limit. Compensation determines the accumulated retirement benefit and retirement plan distributions/income during retirement years. The IRS limits retirement benefits per year to $215,000 for 2017 to $220,000 for 2018. Based on the maximum factors possible, the accumulated retirement benefit would be approximately $2.7 million for 2017 and 2018.
Roth retirement accounts 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 to maximize use of lower tax brackets, offset business losses and fully utilize itemized deductions.
Do’s and don’ts
For more in-depth information on retirement solutions for traders, read Green’s 2018 Trader Tax Guide.