Here is our simple guide to retirement plans for partnerships. Defer taxes on your retirement savings just as if you were self employed or an employee.
Disclaimer: The information presented on this website is only a basic introduction to retirements plans and partnership taxes. We strongly recommend that you hire a professional to help you. The information provided here does not replace the IRS instructions for filing taxes. Incorrect filings could lead to large tax bills and penalties. Please hire a CPA or an EA to prepare and file your tax returns. Seek out a qualified financial professional to help with your retirement plans.
Understanding the benefits of a retirement plan for a partnership
Generally, the idea behind a retirement plan is to “defer” taxes on savings to a later date. For example, if a partner earns $70,000 in self employment income and contributes $10,000 to a qualified retirement plan that defers taxes, that partner pays income tax only on $60,000.
Not only does it reduce a partner’s taxes, but it grows tax free as well. All growth, capital gains, interest, dividends, etc, are not taxed until a distribution from the plan is taken.
This also allows for “more” savings to grow and compound tax free, because paying less tax to Uncle Sam allows for a large savings contribution.
In theory, taxpayers will be in a lower tax bracket upon retirement as compared to when they are working, and thus a retirement plan also creates an income tax savings because of the difference in tax rates.
The tax payer will generally have access to withdraw and distribute this savings before retirement, but the distributions will likely be subject to an additional 10% early withdrawal tax penalty. There may be some exceptions depending on the plan.
In most cases, at 59 1/2 year of age, a partner can withdraw the amount penalty free. At this point they pay ordinary income tax on all distributions from the plan.
Note that as a taxpayer gets older, there are requirements to take minimum distributions according to a formula.
Only “earned” partnership income qualifies for tax deferred retirement savings
Generally, contributions to tax-differed retirement plans may only be made on earned self employment income by general partners performing personal services for the partnership.
Limited partners, partners not paying self employment tax, and other types of pass through income that is not earned income does not qualify. Examples of income types that do not qualify as earned income include interest, dividends, rental income, royalties, and capital gains.
SEP IRAs for Partnerships
A SEP IRA, or “self employed pension” is a plan that allows self employed individuals to defer taxes on retirement savings.
Here are some highlights to SEP IRAs for partnerships:
The SEP IRA cannot be set up or funded by the individual partners. It is the partnership that contributes to the plan.
A partnership can contribute from 0 to 25% to each general partner receiving a share of self employment income up to the maximum amount for each year, reduced by 50% of the partner’s self employment tax liability.
In 2018, the maximum contribution is capped at $55,000.
We recommend having a tax professional calculate these amounts for you as there are large penalties for over-contributing.
Contributions are generally tax deductible to the partnership.
Note that the partners do not include the contribution as income subject to income taxes, but they still are subject to self employment tax on that income.
One disadvantage of a SEP IRA is that if the partnership has employees, the partnership must also contribute for each employee somewhat equally. It’s complicated and you should seek out a plan expert, but it’s good to understand that a SEP IRA might not be appropriate for a partnership with several active partners or (any) employees.
Another disadvantage of a SEP IRA is that the partner cannot take a loan from their savings.
Contributions are due when the partnership tax return is due, including extensions.
Solo 401k retirement savings plans for partnerships
The solo 401k (or individual 401K) is similar to the SEP IRA, including its maximum contribution limits, but they are only appropriate if the active partners consist of only you and your spouse (and there are no employees).
The contribution calculations for a solo 401k, however, may allow for a larger contribution than the SEP IRA for each partner.
The solo 401k contribution calculation allows for both a partner contribution (in 2018) of 100% of self employed income up to $18,500 ($24,500 for partners that are 50 and older) PLUS a profit sharing contribution from the partnership of up to 20% of net self employment income.
This will often result in a larger allowable contribution than as in a SEP IRA.
Another advantage of the solo 401k is that a partner can take a loan against their savings.
The disadvantages of this plan as compared tot he SEP IRA are the cost to administer the plan and the compliance requirements to run the plan.
Just like the SEP IRA, solo 401k plans also have rules about equal distribution requirements for all participants.
401k plans for partnerships
401k plans are generally best for partnerships with employees or many active partners.
401k compliance is extremely complicated and professional guidance is necessary. Due to the complexity, there is generally a management fee which can cut into the long term growth benefits of the plan for the partnership owners.
With a 401k plan, employees and active partners receiving income from self employment may contribute a certain percentage of their income to a cap each year and defer taxes on those contributions accordingly. The partnership may also match a certain amount of the contributions.
Employees and self employed partners can take loans from their 401k savings. Early distributions are subject to eh 10% penalty.
There are strict discriminatory rules with a 401k. You can’t just offer it to some and not others, and especially not in favor of higher-paid employees.
There is also a plan called a “simple 401k” plan. With a simple 401k, the employer (partnership) must make either a matching contribution of up to 3% of each employees or active partners’ pay – OR – a non-elective contribution of 2% of each eligible employees pay.
Simple 401ks are more advantageous concerning the non-discriminatory rules that apply to regular a 401k.
SIMPLE IRA plans for partnerships
Yet other retirement plan for partnerships is the SIMPLE IRA.
I’m not shouting – SIMPLE is capitalized because it stands for “savings incentive match for employees”.
SIMPLE IRAs for partners are similar to 401k plans as far as income deferral and distribution rules.
Employers MUST match with this plan (or at least make a contribution) – and the employees (partners with self employment income) are always 100% vested right away.
SIMPLE IRAs (like simple 401K plans) require that the employer either makes a 3% matching contribution or a 2% non-elective contribution.
SIMPLE IRAs generally have lower maximum contribution amounts as the other plans, but the rules for managing them are MUCH easier form a compliance perspective and therefore they are considerably less expensive.
SIMPLE IRAs have a low maximum contribution cap as compared to other plans, but there is no limit on the percentage of income a self employed partner can contribute as long as they stay within the max.
Other advantages of this plan is that there is virtually no compliance requirements (no reports to the IRS) and no top-heavy discrimination testing involved with them.
A disadvantage to the SIMPLE IRA is that partners cannot take loans form the plan. Another disadvantage is that there is a 2-year distribution rule that comes with a 25% penalty instead of a 10% penalty. This includes rollovers.
Before setting up any retirement plan you should seek advice form a small business financial specialist.
We can’t help you in deciding which plan is right for you – we are tax professionals, not financial advisers. A quick search will yield many results for help within your local area, I’m sure.