Tom is an Indy. This year, Tom’s single-member S-corp will earn $100,000 in net income after expenses. Tom paid himself $80,000 of that $100,000 as a salary. But he has to pay taxes on the full $100,000, including the $20,000 in extra profits sitting in his business account. As tax time approaches, he wonders: can he factor that extra $20,000 into his year-end tax minimization strategy?
Yes, he can. Because Tom has his eye on the future, he makes regular contributions to a solo 401(k) plan. In 2018, he made the maximum allowable elective deferral contribution (employee contribution) under IRS rules: $18,500. That reduced his total taxable income (before any other deductions) from $100,000 to $81,500 — not bad.
Under IRS rules, Tom can also dramatically reduce or entirely eliminate the $20,000 in S-corp income he didn’t take home. The secret: matching his employee deferral contributions with profit-sharing contributions made in his capacity as an employer. This arrangement is known as an “employer match.” Since Tom is self-employed, we’ll call it a “self-employer match.”
In the following sections, we’ll take a closer look at employer matches for independent professionals: what they are, important limits on their use, and common match options and formulas.
What Is an Employer Match?
Matched contributions pair with employees’ elective deferral contributions to eligible employer-sponsored retirement plans, such as 401(k)s, SEP IRAs, and SIMPLE plans. The employer “matches” each elective deferral according to the formula set out in the plan document: for instance, 100% of elective deferrals up to 3% of compensation (the standard for SIMPLE IRAs), or 50% of elective deferrals up to 6% of compensation (a typical arrangement for 401(k) plans).
Depending on the plan type, employer matches may be:
- Matched elective deferral contributions
- Nonelective deferral contributions
- Profit-sharing contributions
Each contribution type is subject to IRS annual contribution limits. Consult your tax professional about the respective tax implications of deferred compensation and profit-sharing contributions.
Larger companies typically debit employee retirement plan contributions from each paycheck, but that’s certainly not required for independent professionals. If you pay yourself monthly, and especially if your gross income and net pay (what you actually transfer to your bank account each pay period) is irregular, it may not make sense to schedule regular contributions.
Limits on Employer Matches by Plan Type
Employers can’t make unlimited matching contributions, unfortunately. The IRS’s annual limits on plan contributions apply to matching contributions too. Here’s the breakdown by plan type:
For the 2019 tax year, total annual additions (contributions) cannot exceed the lesser of $56,000 or 100% of the employee’s total compensation, per the IRS. For participants eligible for catch-up contributions, the total contribution limit is $62,000.
Profit-sharing contributions may not exceed 25% of compensation under any circumstances, and self-employed individuals (that’s you!) must make an additional calculation to figure total allowable contributions.
Employers are required to make matching contributions to SIMPLE IRA plans, so SIMPLE is a great option for Indies who want to force themselves to save more.
You have two employer match options, per the IRS:
- Dollar-for-dollar salary reduction contribution match, up to 3% of employee compensation (with no upper compensation limit)
- Nonelective contributions of 2% of employee compensation, up to the $280,000 annual limit in 2019
You can temporarily reduce the 3% match, provided you:
- Don’t reduce the match below 1%
- Don’t reduce the match for more than 2 years of the 5-year period ending with the year in which the election is effective (inclusive)
- Notify employees within a “reasonable time” before the election period (to be safe, you will want to give yourself formal notice)
SEP IRA plans only allow employer contributions. However, you can “match” employee deferral contributions made on another plan, such as a SIMPLE IRA, up to the 2019 total annual addition limit of $56,000 across all qualified plans. You may use whatever formula you like to calculate this match. Don’t forget to use the IRS self-employment calculation to determine how much you can legally contribute each year.
Remember that these contribution limits change each year. They apply no matter how you’ve structured your business finances.
Employer Match Options and Formulas
How you match your own employee contributions is up to you. Consider these common options:
- Fixed percentage match: Simply match a fixed percentage of each employee contribution — say, 50% — up to a set dollar limit or the allowable contribution limit.
- Dollar-for-dollar match: This is the easiest to calculate. If your aim is to max out your eligible contributions, you’ll contribute half the allowable limit via elective deferral and the other half via your self-employer match.
- Stepped match: Love math? Implement a multi-tier match that steps down as contributions increase. For instance, you might match 100% of the first $2,500 in employee contributions, 75% of the next $2,500, and 50% of the third $2,500.
Lastly: it’s not pretty, but you can also just spitball your employer match, as long as you’re doing right by the IRS and your own internal accounting processes. Under IRS rules, you have until tax filing deadline (mid-April) to make profit-sharing contributions.
A Little Goes a Long Way
Now that you’re up on the “self-employer match,” it’s time to figure out exactly how much — and how frequently — you’ll contribute to your independent enterprise’s retirement plan.
Start by taking a hard look at your cash flow. How much can you afford to sock away each pay period? Personal finance experts love to recommend setting aside 10% of compensation for long-term savings, but that’s not attainable for all Indies, especially those planning to reinvest profits for growth. Though, who knows: if your independent business is thriving, but you’re not aiming for explosive growth anytime soon, perhaps you can afford a healthier set-aside.
Ultimately, that’s between you, your business budget, and your accountant. Just don’t forget about your “self-employer match.”