With income potentially lower this year due to COVID-19, CRE brokers may be forced to reduce contributions to their retirement accounts. Depending on how the business is structured (Sole Proprietor or S-corp) and the type of retirement plan (SEP-IRA or Individual 401(k)), there may be a more beneficial way to make a contribution and thereby lessen the amount paid in income taxes.
For this discussion, we will focus on a S-corp with an Individual 401(k) plan. 401(k) plans have two contribution components: an employee (called a deferral) and an employer (called profit sharing). The due date for employee deferral is year-end, where the employer profit sharing contribution is due with the tax return, either March 15 or September 15 if an extension was filed.
The employee may contribute up to $19,500 this year as a deferral. The employer profit sharing contribution is based on 25% of salary. There is a maximum contribution of $57,000 between the employee deferral and employer profit sharing. Contributions can be increased by $6,500 if the employee is age 50 or older. If income is down this year and your 401(k) contribution will also be lower, it can be more tax efficient to make the contribution from only the employee deferral and ignore the employer profit sharing.
For example, a broker earning $100,000 of revenue and paying themself a $50,000 salary can make a maximum profit sharing contribution of $12,500, or 25% of salary. With no employee deferral and only the profit sharing contribution of $12,500, the income tax due will be $10,780.
A broker with the same numbers but who switches the contribution of $12,500 to be entirely employee deferral will owe income taxes of $10,230, an additional tax savings of $550 for simply changing the source of the contribution.
The reason behind the tax savings is the Qualified Business Income tax deduction. This deduction is based on business income, and the employer profit sharing contribution reduces business income. The employee deferral is captured on the W-2 and is not a business expense, which does not affect business income.
Deciding how much to save for retirement is only half of the decision. The type of retirement plan and the source of the contribution may provide additional tax savings. This is something our firm is keenly aware of and why we perform frequent tax projections for CRE brokers throughout the year.
