EDUCATION CENTER
Retirement Plans For Traders

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Business traders can save additional income taxes by contributing to a tax-deductible retirement plan. The taxpayer pays a self-employment (SE) tax on administration fees from a partnership, or payroll taxes on salaries in an S-Corp on the earned income component, but usually winds up saving significantly more than that in income taxes.

It’s wise to save for retirement for many reasons. You can invest or actively trade those retirement assets tax-free until you take normal withdrawals as early as age 59½ and as late as age 70½. Avoid early withdrawals before age 59½ in an IRA — they’re subject to a 10-percent excise tax penalty in addition to ordinary income tax rates. (A few exceptions apply.)

Retirement-plan contributions can only be made if that taxpayer has earned income, which is subject to the SE tax. 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 trading gains are considered earned income subject to SE tax (Section 1402i). Business traders use entities to create earned income, unless they have another source of earned income.

INDIVIDUAL 401(K) RETIREMENT PLANS
Individual 401(k) plans — also called Mini 401k plans — often generate the most tax savings for traders. An Individual 401(k) plan minimizes the self-employment (SE) tax while maximizing income tax savings. Profit-sharing plans, such as a SEP IRA, limit “defined contributions” to 20 percent of net earned income.

An Individual 401(k) plan, on the other hand, adds a 100-percent deductible 401(k) “elective deferral” to a profit-sharing plan, and that’s where most of the tax savings come from. Individual 401(k)s are only available to small businesses and the plan needs to be established before year-end, but funding can wait until the extended due date. Taxpayers can contribute the elective deferral maximum ($16,500 for 2011 and $17,000 for 2012), plus a 20-percent net profit-sharing plan. Individual 401(k)s have a “catch-up” provision for taxpayers 50 years of age or older ($5,500 for 2011 and 2012).

ROTH IRAS
Roth IRAs and Roth Individual 401(k) plans are attractive to traders too. Annual contributions to Roth retirement plans aren’t tax-deductible, but they aren’t taxable either when distributions are taken in retirement. Traders can generate permanently deferred income in these plans with active trading and enjoy permanent tax-free income in retirement (and even in early retirement).

Roth IRA conversions. Starting in 2010, the IRS income threshold was waived for Roth IRA conversions, making it possible for taxpayers at any income level to convert money from traditional IRAs, 401(k)s, and other tax-deferred accounts for 2010 and subsequent years.

TRADING WITHIN YOUR RETIREMENT ACCOUNTS
If you’re a close call on trader tax status, consider alternative strategies.

Trade actively in your retirement plans and seek to deduct your investment expenses and trading losses within the retirement plan, rather than suffer investment expense restrictions on your taxable account.

This is an excerpt from Green’s 2012 Trader Tax Guide • Copyright © 2012