Writing an article about the use of a retirement plan in a publication distributed to farmers and ranchers may seem unusual. For most agricultural producers, your “retirement plan” is the land you own, and to some degree, machinery, and other agricultural assets. One may ask, where could a retirement plan fit in my operation? On the Internal Revenue Service website, I found 16 different types of plans for which the IRS publishes guidance and rules. In this article I will focus on the plans we see utilized by some agricultural producers.
Individual Retirement Accounts (IRA)
Let’s start with the easiest plans: IRAs. There are two types—traditional and Roth. Traditional IRAs are tax deductible for most individuals. The maximum annual contribution is $6,000, and if you are age 50 or over, you contribute an additional $1,000. The primary differences between the two is that distributions from a traditional IRA are taxable, but distributions from a Roth IRA are not taxable as long as the Roth has been in place five or more years and you are age 59 ½ or older.
The traditional IRA is used is to help cut your tax bill while building another source of retirement plan money. The Roth IRA is used is to build retirement plan assets that can be withdrawn tax free. The contribution deadline for both is your tax filing deadline. In both cases the idea is build retirement assets that are not agriculturally based.
Simplified Employee Pensions (SEP IRA)
Contribution maximums for SEP IRAs are set by the IRS. If you are self-employed, you can contribute 20% of net earnings to a SEP with a cap on contributions of $58,000/year (2021 rules). If you have employees who have reached age 21, worked for you for three of the last five years and receive at least $650 of compensation, you must contribute the same percentage that you made for yourself. Example: If you contributed 15% of net earnings to your SEP, you must contribute 15% of wages to an eligible employee’s SEP. There is no Roth SEP and SEPs are not eligible for catch-up contributions.
Most SEP IRA plans are used by farms where there are no eligible employees. Since contribution amounts are much larger than an IRA and contributions do not have to be made each year, they can be helpful to tax plan in years of higher income. In years of lower income, either elect not to contribute or reduce from the amount contributed. We do work with some farms who have eligible employees with a SEP plan in place, which can be a nice retention tool. Both employer and employee can invest SEP contributions on their own. They do not need to invest the same way.
SIMPLE IRA and SIMPLE 401(K)
To be eligible, an employee must have wages of $5,000 in any two years preceding the current year or is expected to have wages of $5,000 during the current calendar year. Both plans allow employees to contribute up to $13,500 per year. Under a Savings Incentive Match Plan for Employees (SIMPLE) IRA, employers are required to match employees who participate dollar-for-dollar up to 3% of compensation. With a SIMPLE 401(k), the same 3% requirement is in place but employers have another match option which is 2% for anyone that is eligible to participate. A $3,000 catch-up contribution is allowed on both plans for anyone age 50 or older. There is no Roth SIMPLE plan available.
We do not see these used as much as a SEP or the regular IRA, but SIMPLES can be a nice way to install a benefit plan for employees without the compliance that comes with a traditional 401(k). Where these can be beneficial is when a retirement plan is desired by employees and employer where the employee can decide what they want to contribute, and the employer is not obligated to make large contributions (although they can if they want). Since compliance is minimal, so are potential headaches. For the most part SIMPLES are used for employee retention, building employee retirement plan assets, and minimal administration
401(k)
A number of years ago, legislation was passed that allowed self- employed individuals to have what is called a “solo” or individual 401(k). This allowed a lot of farmers who have no employees an opportunity to open a 401(k). Solo plans are simple and uncomplicated to administer. But, if you have employees who are age 21 or older, worked 1,000 hours or more per year for you, and have been with you for one year, there are more complexities and compliance rules to consider. However, there are ways of reducing the complexities. Space does not allow us to get into all of the details about 401(k)s but I’ll touch on an idea later on in the article. The maximum contribution to a 401(k) in 2021 is $19,500 per year. If you are over age 50 you can contribute an additional $6,500 per year. Employers can match the 401(k) at a rate determined by the employer. The maximum annual contribution to a 401(k) if you are under age 50 is $58,000. Those 50 or over have a maximum of $64,500 for 2021. And, yes, you can have a Roth 401(k) and, there are no income restrictions for a Roth 401(k) contribution as is the case with the Roth IRA.
A 401(k) is another great tool for employee retention. This can be useful for farms that have a need to cut the tax bill and a desire to grow additional retirement assets. I keep talking about compliance when it comes to a 401(k). What the government is trying to avoid is for an employer to set up a 401(k) that just benefits the employer with little or no benefit to the employee. Employer contributions are tied to what the employees put in. Usually, an employer cannot contribute more than 2% of the average for all employees. If the average is 5% the most the employer can contribute is 7% (there are other rules that govern employer contributions). You can, however, “safe harbor” your 401(k). If the plan is safe harbored, then you must contribute at least 3% of wages for any eligible employee, or 4% for anyone who participates, or 100% of the first 3% of contributions plus 50% of the next 2% of an employee’s contribution. If you elect one of the three options above and provide proper notices to employees, your contribution as an employer is not limited to what employees contribute. You could go up to the $26,000/year maximum (age 50 or older).
Defined Benefit Pension
This is the granddaddy of retirement plans. Annual contributions can be very large. Unlike IRAs, SIMPLEs, SEPS and 401(k)s, the IRS does not publish a maximum dollar amount that can be contributed on an annual basis. Contributions are instead calculated by an actuary. The IRS sets the rules for how to calculate contributions that are a function of your age, interest rates, income, and gender among other less pertinent factors. When we have contribution amounts calculated, we see the minimum contributions of around $65,000 per year with maximums as high as $550,00 per year. The plan must be in place for three years. If you have employees who are eligible (age 21, working 1,000 hours or more with one year of service) they must participate.
Think about the last few years of farming or ranching—especially if you do not have a successor. For many producers, the machinery is for the most part fully depreciated as well as buildings, bins and other assets. In the last year of production, what expenses will you have to control the tax bill when selling off inventory? Your production and pre-paid expenses are usually gone. If an auction is planned, what can be put in place to control the tax bill?
This is where a pension can help. When you lose all or most of your deductions, pensions can be used to cut taxable income and thus cut the tax bill. For some farms, pensions have proven themselves to be good at keeping you from creeping into higher tax brackets, which is what they are designed to do. By way of example, consider the last year of farming where you may have $500,000 of grain inventory and another $500,000 of machinery and vehicles. In this case we are working with $1,000,000 of taxable income that will generate a sizable amount of tax even if sold over a few years. In this case let’s assume the pension contribution is $150,000 per year. Over a three-year timeframe, this results in $450,000 of tax deductions for the farm and further results in the generation of an asset than can provide another source of retirement income. Pensions can also be used to equalize the estate by leaving them to non-farming children at death. The downside, of course, is that distributions from a pension are taxable. However, the entire pension account is not required to be liquidated. You can draw income out over time.
The ideal pension “candidate” is someone in their late 50’s or early- to mid-60’s, with no employees, little debt and a desire to trim the tax bill. We recommend engaging your tax professional while considering if the pension is for you. They don’t always work for everyone so input from the accountant is very important.
Conclusion
As you can see, there are a lot of choices and applications for retirement plans at a farm or ranch. In the right circumstance they can be effective at employee retention, building another source of retirement income, or tax reduction. If you have a farming heir and need to leave more assets via your will to the farming heir and want to find a way to make the estate feel fairer, retirement accounts can be left to non-farmers as a way to equalize the estate. Careful consideration needs to be taken before jumping into a plan. Consult with someone who works with retirement plans and be sure to ask a lot of questions.
