2021 Last-Minute Year-End Retirement Deductions

The clock continues to tick. Your retirement is one year closer. 

You have time before December 31 to take steps that will help you fund the retirement you desire. 

Take a few minutes to review the four retirement plan tax-reduction strategies in this article. 

You might find several thousand dollars (and maybe much more) in your pocket by taking the actions in this article. But you’ll need to act now to get the cash. 

Big Picture 

Here are the four opportunities we explain in this article: 

1. Establish your 2021 retirement plan before December 31 so you can make both an employee and an employer contribution.  Yes, you can do this even if you are the sole owner/worker in a proprietorship or a corporation.
2. Claim up to $15,000 in tax credits by having your business create a retirement plan that covers you and your employees.
3. Claim up to $1,500 in tax credits by enabling the automatic contribution.
4. Convert to a Roth IRA. 

1.  Establish Your 2021 Retirement Plan 

First, a question: As you read this, do you have your (or your corporation’s) retirement plan in place? 

If not, and if you have some cash you can put into a retirement plan, get busy and put that retirement plan in place so you can obtain a tax deduction for 2021.

For most defined contribution plans, such as 401(k) plans, you (the owner-employee) are both an employee and the employer, whether you operate as a corporation or as a sole proprietorship. And that’s good because you can make both the employer and the employee contributions, allowing you to put a good chunk of money away. 

In general, your plan document will define when you can make employee or employer contributions that will produce 2021 tax deductions. Make sure you know exactly when you can make both 

· your employer contributions, and

· your employee contributions. 

Example. You operate as a one-owner S corporation and you want an individual 401(k) plan deduction for the 2021calendar year. To obtain the maximum 401(k) deduction for this calendar year, you must have an individual 401(k)plan in place on or before December 31. 

If you have your S corporation 401(k) plan in place on or before December 31, 2021, then you can make your personal employee contribution on or before December 31, 2021. You also can make the employer contribution onor before December 31 or anytime before the 2021 tax return is due, such as on March 15, 2022 (or with extensions, say, on September 15, 2022). 

For more on the 401(k) plan and why it’s terrific for the solo owner/operator of a business, incorporated or not, seeSolo 401(k) Could Be Your Best Retirement Plan Option. 

2. Claim the New, Improved Retirement Plan Start-Up Tax Credit of Up to $15,000 

Two questions: 

1. Are you the sole worker in your business?

2. Is your retirement plan in place as you read this? 

If you can answer no to both questions, consider this: by establishing a new qualified retirement plan (such as a profit-sharing plan, 401(k) plan, or defined benefit pension plan), a SIMPLE IRA plan, or a SEP, you can qualify fora non-refundable tax credit that’s the greater of1 

·  $500 or11/22/21, 1:25 PM 2021 Last-Minute Year-End Retirement Deductions ·

the lesser of (a) $250 multiplied by the number of your non-highly compensated employees who are eligible to participate in the plan, or (b) $5,000. 

The credit is based on your “qualified start-up costs,” which means any ordinary and necessary expenses of an eligible employer that are paid or incurred in connection with 

· the establishment or administration of an eligible employer plan, or

· the retirement-related education of employees with respect to such plan. 

The credit applies to the year of start-up and for the next two years (capped at $5,000 a year, or $15,000maximum). You may deduct any costs in excess of the tax credit as ordinary and necessary expenses. 

You are an employer eligible for the credit if, for the preceding year, 

· you had no more than 100 employees, each with compensation of $5,000 or more, and

· your plan had at least one employee eligible to participate who is not a highly compensated employee. 

The solo business operator with no employees is not eligible for the small business retirement plan start-up credit. 

IRS form. You claim the tax credit on IRS Form 8881. The new credit was enacted for taxable years beginning after December 31, 2019, by the Setting Every Community Up for Retirement Enhancement Act of 2019 (SECUREAct).

3. Claim the New Automatic Enrollment $500 Tax Credit for Each of Three Years($1,500 Total) 

The SECURE Act added a non-refundable credit of $500 per year for up to three years, beginning with the first taxable year (2020 or later) in which you, as an eligible small employer, include an automatic contribution arrangement in a 401(k) or SIMPLE IRA plan.3 

The new $500 auto-contribution tax credit is in addition to the start-up credit and can apply to both newly created and existing retirement plans.4 Further, you don’t have to spend any money to trigger the credit. You simply need to add the auto-enrollment feature.5 

In its report on this provision, the U.S. House of Representatives Committee on Ways and Means stated:

Studies show that automatic enrollment increases employee participation in section 401(k) and SIMPLE IRA plans, resulting in

higher retirement savings. 

As with the start-up credit above, you are an employer eligible for the credit if, for the preceding year,7 

· you had no more than 100 employees, each with compensation of $5,000 or more, and

· your plan had at least one employee eligible to participate who is not a highly compensated employee. 

The solo business operator with no employees is not eligible for the automatic enrollment credit. 

4. Convert to a Roth IRA 

Consider converting your 401(k) or traditional IRA to a Roth IRA. 

If you make good money on your IRA investments and you won’t need your IRA money during the next five years, the Roth IRA over its lifetime can produce financial results far superior to the traditional retirement plan. 

You first need to answer this question: How much tax will you have to pay now to convert your existing plan to aRoth IRA? With the answer to this, you know how much cash you need on hand to pay those taxes. 

Here are four reasons you should consider converting your retirement plan to a Roth IRA: 

1. You can withdraw the monies you put into your Roth IRA (the contributions) at any time, both tax-free and penalty-free, because you invested previously taxed money into the Roth account.8

2. You can withdraw the money you converted from the traditional plan to the Roth IRA at any time,tax-free. (If you make that conversion withdrawal within five years, however, you pay a 10 percent penalty. Each conversion has its own five-year period.9)

3. When you have your money in a Roth IRA, you pay no tax on qualified withdrawals (earnings), which are distributions taken after age 59 1/2, provided you’ve had your Roth IRA open for at least five years.

4.  Unlike with the traditional IRA, you don’t have to receive required minimum distributions (RMDs)from a Roth IRA when you reach age 72—or to put this another way, you can keep your Roth IRA intact and earning money until you die.

Here are four reasons keeping your money in a traditional retirement plan or IRA (versus the Roth IRA) can cost you: 

1. You’ll generally pay tax and a 10 percent penalty on withdrawals before age 59 1/2.12

2. You could owe big taxes when you withdraw your money from your traditional IRA.

3. Before the SECURE Act, you generally had to start taking RMDs from your traditional IRA or qualified retirement plan in the tax year you turned age 70 1/2.13 Now you can wait until the tax year you turn age 72.14 This change applies to RMDs after December 31, 2019, if you turn age 70 1/2 after that date.15 Once you turn age 72, the law requires you to start taking out money annually—even if you don’t need it or want it.16

4. If you die and leave a traditional IRA to your heirs, they could owe big taxes on the accumulated monies as they take the money from the inherited IRA. 

Make sure you have the cash to pay the tax on the conversion to a Roth IRA. Don’t invade your existing 401(k) or traditional IRA for the cash to pay the taxes, because that is likely to trigger the double whammy of paying both income taxes and the 10 percent penalty on the withdrawal.17 

Planning note 1. If you are going to have a business loss this year, consider converting your traditional IRA to aRoth IRA, as we explain in Five Strategies for Your Business Loss after Tax Reform. 

Planning note 2. For additional insights on the pros and cons of Roth IRAs and traditional IRAs, read Roth IRA versus Traditional IRA: Which Is Better for You? 

Takeaways 

Having a retirement plan is a good money strategy for most business owners because it creates savings that you are unlikely to tap and that enable compound tax-free (Roth) or tax-deferred growth. 

So step one is to get your plan in place before December 31 so you, the business owner, can make both employer and employee contributions. This is true even when you operate as a one-person corporation or proprietorship. 

If you have employees, make sure to take advantage of the tax credits for (a) start-up of the plan and (b)establishing automatic contributions (opt-outs are available, of course). 

Seriously consider converting your existing accumulations to a Roth IRA. The long-term savings here can be huge.Make sure to leave the converted funds in the Roth for at least five years. 

Source: 1 IRC Section 45E.

2 Pub. L. No. 116-94, Section 104.

3 Notice 2020-68.

4 IRC Section 45T.

5 Notice 2020-68.

6 H. Rpt. 116–65, p. 51.

7 Ibid. We note that IRC Section 45T does not include the language about one employee who is not highly compensated, but the legislative history has Sections45E and 45T in the same section, as you see on p 50 of the House report. To us, this brings the same language to bear—making us believe you need that one employee in addition to yourself to qualify for this tax credit.

8 Reg. Section 1.408A-6, Q&A-9.

9 Reg. Section 1.408A-6, Q&A-5.

10 IRC Section 408A(d)(2)(A).

11 IRC Section 408A(c)(5).

12 IRC Sections 408(d)(1); 72(t).

13 Pub. L. No. 116-94, Section 114.

14 Ibid.

15 Pub. L. No. 116-94, Section 114(d).

16 IRC Section 408(a)(6).

17 IRC Sections 408(d)(1); 72(t).