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Save Now and Minimize the Tax Bite

CHICAGO — Whether you’re just getting started in your dry cleaning business or you’ve been around for years, you can’t afford to let your hard-earned dollars get eaten up at tax time. It’s tough enough to earn a decent income these days, and it can be even harder to keep what you earn. That’s why it’s so important to take advantage of every legitimate way to minimize the tax bite on your earned income.

Worrying about your retirement today when the business demands on you are so high may not be at the top of your priority list, but it’s important to understand that retirement savings plans have the double benefit of reducing today’s tax load, thus effectively increasing today’s income, while helping to build that all-important retirement nest egg.

For every dollar that you put into your retirement plan, you save 28 cents or more in today’s taxes, and every dollar in that plan is protected from Uncle Sam until you retire and start withdrawals. That’s why it’s so important to contribute the maximum amount possible to your existing retirement plan, or get to work right away in establishing your plan if you don’t already have one.

If you’re working as a sole proprietor with no employees, setting up a retirement plan couldn’t be easier. Just go to any broker or mutual fund company and ask them to set you up with an individual 401(k). It’s that easy. In that situation, the best plan for you would be what is known as a solo 401(k).

In all 401(k) plans, the maximum amount you may save is determined by a formula based on your compensation. An employee earning, say, $100,000 would be allowed to contribute up to $17,000 in 2012. Sole proprietors get an extra benefit. Since you are both employee and employer, your company may contribute approximately an additional $18,000 to your 401(k) for a total of about $35,000, all of which is sheltered from taxes.

And if you’re age 50 or older, there’s a little more icing on the cake. In that case, Uncle Sam allows you to contribute an additional $5,500, making a total allowable contribution of about $40,500 in 2012 to your solo 401(k), all of which gets both individual and company tax benefits.

There are other forms of retirement plans for sole proprietors known as the SEP IRA and the SIMPLE IRA, but they do not allow contributions as high as the 401(k).

Of course, it gets a bit more complicated if you have employees. In that case, you should turn to a certified public accountant for advice on such things as record keeping and submitting form 5500 for your 401(k), which is required by the IRS and the Labor Department. You can get the form and more information about this requirement at the Labor Department website.

If your business has fewer than 100 employees, launching your first 401(k) plan qualifies the business for up to a $500 tax credit for each of the first three years of your plan. Business owners need have only one participating employee, not including the owner, to qualify. Owners who match their employees’ contributions can also deduct that amount as a business expense.

Whether you work as a sole proprietor or the head of your own corporation, failure to participate to the fullest extent possible in a government-sponsored retirement plan will put you at a financial disadvantage in an economy where you need to trim every possible dollar from your tax bill while saving for a comfortable retirement.

Obviously, not everyone will be able to save the maximum allowable contribution to a retirement plan. If you are in that position, you should contribute the maximum amount that your personal circumstances will permit. While the burden may seem heavy at contribution time, it’s important to remember that the corresponding reduction in your income taxes is increasing your net income.

If you haven’t yet set up your own retirement savings plan, you can’t afford to delay. The annual deadline for setting up 401(k) plans is Oct. 1, so the clock is ticking.

“Don’t wait until tax filing time to fund your retirement account” each year, says CPA Carol I. Katz, Baltimore. “Making the maximum allowable deposits into your 401(k) or IRA account as early in the year as possible not only reduces your tax load, it also adds months to the tax-deferred compounding of your investment.”

According to the Employee Benefit Research Institute (EBRI), many Americans nearing retirement age have saved nowhere close to the amount they will need to provide for a comfortable retirement. In an EBRI survey, more than half of respondents said they have less than $25,000 in savings. Many Americans approaching retirement age are losing confidence that retirement is even possible, according to EBRI.

In truly astonishing statistics, EBRI’s 2010 Retirement Confidence Survey revealed that 27% of Americans report having less than $1,000 in savings, 43% say they have less than $10,000 set aside, and more than half (54%) have less than $25,000 saved.

As one financial planner puts it, “In the new economy, you have to provide for your own retirement. If you don’t do it, no one else will.”

The only practical way for you to provide for your own retirement is to make sure that you are participating to the fullest possible extent in your own savings plan.

Information in this article is provided for educational and reference purposes only. It is not intended to provide specific advice or individual recommendations. Consult an accountant or tax adviser for advice regarding your particular situation.

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Have a question or comment? E-mail our editor Dave Davis at [email protected].