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. A married couple can save over $17,000 more with Individual 401(k) plan contributions and health-insurance deductions (see the example later in this chapter).

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% excise tax penalty in addition to ordinary income tax rates. (A few exceptions apply.)

Small business traders can rollover a 401(k) plan from their previous job or an IRA into an Individual 401(k) plan and then take withdrawals starting at age 55, without triggering a 10% excise tax penalty. A qualified plan allows withdrawals at age 55, whereas IRA holders have to wait until age 59½. Many traders can benefit from that difference.

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 gains are considered earned income subject to SE tax (Section 1402i). Business traders use entities to create earned income if they don’t have another source (see Chapter 7).

There’s one caveat with all retirement plans: You need to cover all employees in your company and other “affiliated service groups” such as a related entity you own. Some traders own the majority of equity in another business that hires many employees. They can’t set up a high-deductible retirement plan for themselves in a trading entity without also offering a similar employee benefit to their employees in that other business, too. You can limit this problem by using employee vesting schedules. Consult an employee benefits attorney.

INDIVIDUAL 401(K) RETIREMENT
PLANS ARE BETTER THAN SEP IRAS
Individual 401(k) plans — also called Mini 401k plans — often generate the most tax savings for traders. An Individual 401(k) plan minimizes the SE tax while maximizing income tax savings. (The SE tax consists of the FICA and Medicare tax for a self-employed person.) The net differential in tax savings is far greater than with a SEP IRA. The main reason is because a trader can determine what amount of his trading gains will be earned income, starting with none. Conversely, with other types of small business, the entire income is considered earned income, and it’s often over the maximum needed anyway.

Profit-sharing plans such as a SEP IRA limit “defined contributions” to 20% of net earned income. They require a materially higher fee subject to the SE tax to drive a lower allowed contribution. SEP IRAs can be established up until the due date of your tax return, including extensions.

An Individual 401(k) plan, on the other hand, adds a 100% 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. In an Individual 401(k), taxpayers can contribute the elective deferral maximum ($17,000 for 2012 and $17,500 for 2013), plus a 20% net profit-sharing plan. Individual 401(k)s have a “catch-up” provision for taxpayers 50 years of age or older ($5,500 for 2012 and 2013). SEP IRAs do not have this.

Individual 401k plans require an annual 5500 or 5500-EZ filing, whereas IRAs and SEP IRAs do not. Most brokers provide this form and they are usually not too complex. Don’t miss that separate tax filing due date of July 31 for calendar year taxpayers.

THE MATH ON INDIVIDUAL 401(K) TAX SAVINGS........

This is an excerpt - the first few paragraphs from chapter 8 - from Green’s 2013 Trader Tax Guide • Copyright © 2013