The #1 Tax Strategy For Active Traders [Step by Step]

Consistently high-income traders will usually have tax problems. This is why they should consider what I would call the #1 tax savings strategy.

It is a little-known retirement strategy called a defined benefit plan or cash balance plan. These plans have the ability to offer significant tax deferrals and large savings that can be used for additional trading activities. Yes you can have your cake and eat it too.

Defined benefit plan advantages

The calculations are more technical when compared to a profit-sharing plan. Having a defined benefit plan, an actuary must consider various factors in determining retirement benefits and annual contributions to the plan.

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What about actually opening up an investment account? For an after-tax account, you would just open up an account at a brokerage of your choosing. 

The issue is that most brokers or custodians do not allow retirement plans to have margin accounts privileges. As such, the three-day settlement rule (Reg T) limits the day trading activity. Shorting stocks is also not allowed at most brokerages as well.

If the retirement trust is a member to an LLC, you could use the LLC to open a margin account. The LLC can then short stocks and day trade without regard to the three day settlement rule.

This of course assumes the custodian allows the LLC to have a margin account. This is usually allowed because the account is in the name of the LLC and not established in the name of the retirement plan trust. 

What’s the catch?

A defined benefit plan requires annual financing contributions, whereas a defined contribution plan like a 401(k) will not. A defined benefit plan will normally have minimum annual required contributions that are determined by an actuary.

Closing a defined benefit plan without a justification could lead the IRS to disqualify the plan. On plan termination, you will normally do a tax-free rollover to an IRA. The 10% early withdrawal taxes guidelines apply on plan distributions before age 59 1/2.

You should consult your plan administrator on the timely basis – before June 30 or 1,000 hours of service – to change the plan when necessary. For instance, if you’re making considerably less income in the current year, the administrator might be able to lower required contributions.

Some plan administrators recommend maximum allowed funding in early years, which serves to reduce minimum amount funding requirements in later years.

You can certainly do direct-access investing or trading inside the plan account. Brokerages and custodians may allow trading in stocks, bonds, ETFs and limited trading in options.

But be careful. Investment losses in the defined benefit plan will require larger contributions to make up those losses. Conversely, large trading gains can serve to reduce contributions too.

Compensation defined

In an S-Corp, only wages are considered compensation and pass-through K-1 income is not. However, with a partnership, all self-employment income including guaranteed payments and pass-through income for active partners would be considered compensation.

Talk with a plan administrator ASAP to determine if a plan is right for you. You are able to fund the program until Sept. 15 of the next calendar year – the extended due date of the S-Corp tax return.

Additionally, you need to execute officer compensation payroll before year-end.

Types of defined benefit plan plans

For an S-Corp trading company with an individual owner or a spousal S-Corp with two employees and no outside employees, you should consider a solo defined benefit plan or a cash balance plan.

Two spouses employed in an S-Corp trading company may take benefit of what we would call a “combo”: A defined benefit plan integrated with Solo 401(k) (elective deferral and 6% profit-sharing as opposed to the normal 25% profit-sharing).

Non-discrimination rules

There are non-discrimination rules and requirements for high-deductible qualified plans designed to limit the owner from obtaining huge benefits with “top-heavy plans” while omitting or short-changing non-owner employees. Plan designers offer options like vesting over many years for complying with these guidelines but nonetheless favoring owners where possible.

Scrabble pieces spelling TAX

Affiliated service group (ASG) rules apply in an identical context. In the event that you own a company with many employees, you can’t exclude those employees by running a separate (affiliated) S-Corp trading company with a high-deductible certified arrange for you by itself.

Consult your tax advisor

After you consult with a defined benefit plan administrator, actuary, and perhaps an employee-benefit plan attorney, seek advice from your tax advisor on choosing the compensation amount, which drives the related targeted retirement savings goal under the plan. For S-Corp operating businesses, official compensation must abide by IRS suggestions for reasonable compensation, too.

Make sure you are comfortable investing in the annual minimum funding amounts of the plan. If you need a lower commitment, choose a lesser compensation amount.

If you are looking to contribute only $50,000 or less to a plan then you are most likely better off choosing a Solo 401(k). This is because they generally do not require complex annual administration and they are inexpensive to maintain.

Your S-Corp must qualify for trader taxes status (business expense treatment), in any other case you can’t have official settlement and retirement plan efforts in an investment company.

Costs and taxes filings

Defined benefit plans are more expensive to maintain compared to 401k plans. They will typically run around $2,000 per year. Net tax cost savings much exceeds these reasonable fees. In many cases, the DB administrator also covers the cost of an independent actuary.

Much like all qualified plans, the sponsor of the plan probably must file an annual IRS Form 5500 taxes return due July 31 of the following year for twelve months entities and plans. A 2½-month tax extension until Oct. 15th is allowed using Form 5558. Your administrator will help with this tax form.

Tax-deferred growth and retirement distributions

If you don’t are making non-tax-deductible contributions to a Roth IRA or Roth Single 401(k) plan, with traditional retirement plans including experienced plans and IRAs, you get an income tax deduction from revenues for the contribution amount.

For investors who do more short-term investing, this annual taxes cost savings is huge. Make use of a retirement plan calculator and you’ll see the power of tax-free compounded development. Consider the time-value of money with taxes deferral as well.

Under current tax regulation, retirement-plan distributions are ordinary taxable income. “Early withdrawals”(before retirement years age 59½ within an IRA or age group 55 in certified programs) are also subject to a 10% excise taxes penalty on IRS Form 5329.

Certified plans including Single 401(k) and defined benefit plan can provide experienced plan loans, which avoid early withdrawals. Qualified plans are a kind of deferred settlement, but there are no payroll fees on retirement plan distributions or efforts.

Final Thoughts

If you have consistently high trading income, can afford to invest in large tax-deductible efforts and want to steady your taxable income in retirement taxed at lower tax brackets, a defined benefit plan may be for you. The taxes savings is enormous and with tax-free compounded development it’s an unbelievable retirement cost savings tool.

Paul Sundin

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