Retirement plan options for farmers

Some farmers love what they do so much that they intend to do it until the end. Others would like to retire for health reasons or to have time for other interests. A portion of retired farmers will be able to live comfortably on the combination of farm rents and Social Security. If that won't work for you, consider establishing and funding a retirement plan.

Establishing an official retirement plan can help you save on current or future income taxes. You can always invest unlimited after-tax dollars into certificates of deposit, stocks, bonds, mutual funds, and so on. However, that doesn't improve your tax situation. (One exception would be investing in municipal bonds, for which interest income is federally tax exempt.)

Let's look at retirement plan options for self-employed farmers.

IRAs, or individual retirement accounts, come in two types: regular (aka traditional) IRAs and Roth IRAs.

A regular IRA contribution gets you a current-year tax deduction of up to $6,000 for 2022, or $7,000 if you're over 50 years old. There are constraints on this deduction. First, you have to have at least $6,000 of earned income. Second, assuming you're not covered by a retirement plan at an off-farm job, you can get a deduction for an IRA contribution only if your modified adjusted gross income is less than $214,000 for 2022. You will pay income tax on the distributions when you withdraw them in retirement; required minimum distributions start at 72 years old under current law.

A Roth IRA contribution, which has the same contribution limits, gets you no tax deduction for the current year. However, you will pay no income tax when you receive distributions after 59.5 years old. A five-year waiting period between when you make your first contribution and when you start taking withdrawals is required to avoid a 10% penalty. Because of compounding, small contributions early in life can turn into huge dollars 40 years later. Therefore, in my opinion, Roth contributions for young people are a no-brainer. Some financial planners even have clients older than 60 making Roth contributions or converting regular IRAs into Roth IRAs. I believe, however, the Roth conversion decision becomes much more complex and questionable for people near retirement or in retirement.

Simple Plan

Many other options for retirement plans exist for small businesses, including SIMPLE IRA plans, 401(k) plans, and Simplified Employee Pension (SEP) plans. If you are operating a farm corporation and getting a salary, you can use the SIMPLE (Savings Incentive Match Plan for Employees), which allows you, as the employee, to defer up to $14,000 of your wages into a retirement plan for 2022. You can also do an extra $3,000 wage deferral on top of that if you're over 50. In addition, the plan allows you, as the employer, to match up to 3% of your wages as a tax-deductible employer contribution into the plan.

The SIMPLE plan works like a regular IRA, in that it gets you a current tax deduction, and you pay income tax on the distributions in retirement. I think this is a low-cost, effective plan for small corporations to fund a retirement account for the owners and employees. The administrative cost is frequently zero.

401(k) Plan

Another option for a small business taxed as a corporation is the 401(k) plan, which allows tax deferrals of up to $20,500 for 2022 and up to $27,000 if you are over 50. Those elective deferrals are limited to 100% of the employee's wages. For the employer, it does cost to set up the plan: $500 to $1,500 depending on the administrator. It also has annual reporting requirements that your administrator will have to perform, which may cause annual fees of up to 1% of the plan assets or more. However, you get the benefit of higher contribution limits. Like the SIMPLE, the 401(k) has a provision for employers to make matching contributions. As the employer, you can contribute 5%, 10%, 20%, or more of participants' wages to bring total contributions up to $61,000 a year each. Deferring tax on $61,000 a year can be a huge benefit.

Eliminating tax on the gains may be even better. Fortunately, employers have the option of adding a Roth 401(k) plan, along with the regular 401(k). This sort of plan allows you to get much more into a Roth-type plan on an annual basis. All the same contribution limits apply as with the regular 401(k), but all the future gains will not be taxed, provided you wait until after age 59.5 to make distributions. There's also an advantage to the Roth-type accounts related to required minimum distributions — there aren't any. You can leave the Roth-type money invested and growing forever.

Keep Farmhands Happy

One downside to both the SIMPLE and the 401(k) plan is that whatever percentage of match you are making for yourself also has to be made for your qualified employees. The match is an employee benefit out of your pocket that wouldn't otherwise be paid. However, you might view this aspect more as an upside. Offering a retirement plan and making employer matches may keep some good farmhands happy. It may prevent them from wandering off to the farm next door that funds a retirement plan.

Many farms are operating via the Schedule F, a farm sole proprietorship. This entity has some good retirement options as well, the Solo-401(k) and the SEP. Unlike the SIMPLE and regular 401(k), you don't need wages to qualify to make contributions. The Solo-401(k) is for a one-person business that has no full-time W-2 employees. The spouse can also be covered if he or she works in the business. The overall contribution limit is the same as the regular 401(k), $61,000 each for 2022. That includes the $20,500 you may contribute as an employee and an employer contribution up to $40,500.

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The SEP, or simplified employee pension plan, "does not have the start-up and operating costs of a conventional retirement plan and allows for a contribution of up to 25% of each employee's pay," according to IRS. gov. For a Schedule F farmer, that means your net earnings from self-employment not including contributions for yourself. There are no filing requirements for the employer, and the employee is always 100% vested.

Like other plans, the percentage that you contribute for your employees has to match the percentage that you contribute for yourself. Unlike other plans, all the contributions are from the employer; no salary deferrals are taken out of employee pay. The farmer decides that all eligible employees (including the farmer) are getting a certain percentage of their pay (up to 25%) as an employer profit-sharing contribution this year. The employer contribution is, of course, tax deductible.

This list of options can be dizzying, but a CPA or a financial planner can help you figure out the perfect retirement plan for your operation.