One of the best ways traders can reduce their tax liability and build their wealth is by contributing to a qualified retirement plan such as an IRA or 401K plan.
Retirement plans for traders can be used in several ways:
- Traders can keep trading the funds built up in their retirement plans and generate tax free or tax deferred wealth.
- Traders can borrow money from a qualified plan to start a trading business, pay down debt, invest in their professional training or use it for any other purpose they see fit.
- Traders can convert the funds from Traditional accounts to Roth for a permanent tax-free build-up.
However, there are many pitfalls to avoid when deciding how to manage your retirement plan as a trader, like early withdrawals subject to ordinary income tax rates and 10% excise tax penalties, and penalties on prohibited transactions. Tax planning is highly recommended when selecting the appropriate retirement plan and how to use it.
You will have to have earned income in order to qualify for a retirement plan. However, your trading gains aren’t considered to be earned income and are exempt from Self Employment tax (Social Security + Medicare). The exception to this is futures traders who are full-fledged dealer/members of options or futures exchanges. Therefore, in order to qualify for a retirement plan and make contributions to the plan, traders will need to use entities like an S-Corp trading company and issue payroll for themselves.
A caveat with all retirement plans is, if you want to set up retirement plan for yourself, you will also have to cover all employees in your company and other affiliated service groups, such as a related entity you own. For traders who own most of the equity in another business that hires 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. There are, potentially, ways to limit this requirement which your attorney or tax advisor can explain.
What is the best retirement plan? Generally, the best retirement plan for business traders is a defined-contribution Solo 401(k). The plan is only allowed if you achieve Trader in Securities Status and is not allowed for investors.
It allows the trader to make a 100% tax deductible elective deferral contribution of $18,500 for 2018 with a 25% tax deductible profit-sharing plan contribution. There is also an Elective deferral catch-up provision of $6,000 for taxpayers over age 50. The combined maximum tax-deductible contribution for 2018 is $55,000, and $61,000 for those above age 50.
Example: Say you have $80,000 in trading gains, you can issue payroll for yourself and your spouse at $40,000 annually per person. This will allow you to each make an elective deferral of at least $18,500 ($24,500 if over 50 years old). Your trading company can make a matching contribution of $20,000. Now, the taxable portion of the gains is reduced from $80,000 to only $23,000. Based on federal and state tax liability of 30%, you will be saving more than $17,000!
Which Provider should you use to set up the 401K Plan? Many leading brokers and financial institutions offer Solo 401K plans on a cookie-cutter basis. These plans typically are very restrictive, limiting traders to mutual funds and ETFs. These plans may not allow you to trade options, forex, futures or cryptocurrencies. Often, these plans do not allow traders to achieve the style of trading they want which reduces your ability to get high ROI.
The good news is that you can create your own 401K plan and allow yourself maximum freedom to invest in almost any asset class including real estate, international investments, gold and silver, peer to peer lending and many other investment options. Also, by having your Solo 401K plan you will be saving thousands of dollars in custodian fees. For more information on how you can create your own plan contact OTA Tax Pros.
What retirement plan suits high income traders? Consistently high-income business owners, including trading businesses with owner/employees close to age
50, should consider a defined-benefit retirement plan (DBP) for significantly higher income tax and payroll tax savings vs. a defined-contribution retirement savings plan (DCP) like a Solo 401(k). DBP calculations are more complex than a DCP profit sharing plan. With a DBP, an actuary is required to consider various factors in calculating retirement benefits and annual contributions to the DBP. The maximum yearly contribution can be up to $250,000.
Clearly, retirement plans offer substantial tax savings and are a tremendous tool to build wealth. Traders should consult a tax advisor to see what retirement plan is the best fit for their goals and needs.