‘Begin with the end in mind’ – Retirement plan options

by Sally Colby

Although farmers may consider financial planning overwhelming, those who want to establish a retirement plan have some good options. Paula Ledney, education program associate and financial analyst in business, energy and community vitality at Penn State, described investment vehicles for the self-employed.

“Retirement plans are considered vehicles,” said Ledley. “They’re a legal framework in which you can accumulate your retirement savings. Within the legal framework there are investments, or passengers, contained in the vehicle. Within your chosen retirement plan, you can invest in a variety of different assets, the most common being individual stocks, bonds, mutual funds, exchange-traded funds, real estate and real estate investment trusts. The critical aspect to understand is that retirement plans are simply the vehicle in which you save.”

Plans such as IRAs (individual retirement accounts), solo 401Ks (simplified employee pensions), simple IRAs and defined benefit plans allow individuals to save money on a pre-tax basis. The money invested is not taxed before it’s put into the plan. “This feature reduces your taxable income in the year you contribute to the plan and the money inside the plan grows tax-free until you take your mandatory distributions,” said Ledley. “The IRS eventually receives tax on the money when you withdraw the money in retirement. This is why mandatory distributions exist – the IRS wants to collect taxes on your income at some point.”

An IRA is either “regular” (traditional) or Roth. Contributions to an individual IRA allow a current tax year deduction of up to $6,000 for 2022 or $7,000 for those over age 50. Ledley explained some constraints on this deduction: First, such plans require at least $6,000 of earned income. Second, assuming you are not covered by retirement plan at an off-farm job, you receive a deduction for an IRA contribution only if your modified, adjusted gross income is less than $214,000 for 2022. Income tax is paid on the distributions when they’re withdrawn in retirement, and under current law, the required minimum distribution starts at age 72.

Roth IRAs have the same contribution limits but allow no tax deduction for the current year. However, with a Roth plan, there is no income tax when distributions are received after 59.5 years of age. To avoid a 10% penalty, a five-year waiting period between the first contribution and the first withdrawals is required.

Because of compounding interest, Roth contributions appeal to younger farmers. Another major benefit of a Roth IRA is there are no required minimum distributions during the account owner’s lifetime because the holder has already paid tax on the money.

Roth plans allow individuals to continue saving and investing as well as passing assets to children and spouses without penalty or tax implications. However, the beneficiaries of a Roth IRA need to take the required minimum distributions to avoid penalties within a certain timeframe. Ledley said there are exceptions for spouses, and holders of Roth IRAs should be aware of some recent changes in regulations for 2022.

Ledley explained the simple IRA plan, which can be used by those operating a farm corporation and paying themselves a salary. “It allows you as the employee to defer up to $14,000 of wages into the plan for 2022,” she said. “You can also contribute another $3,000 as a wage deferral if you are over age 50. This plan also 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 you receive current tax deductions and pay income tax on the distributions in retirement.” The simple IRA allows up to 100 employees, making the plan a little more complex. It would likely require outside assistance and is potentially more expensive to maintain.

The solo 401K is similar to 401K plans used by large businesses. The major difference is that individuals do not need to receive wages from their business to qualify to make contributions, making this plan a good fit for a sole proprietorship. While the solo 401K is for a one-person business that has no full-time W-2 employees, a spouse who works in the business can also be covered. The overall contribution limit is the same as a regular 401K, which is $61,000 each for 2022.

The defined benefit plan, also known as a pension plan, may appeal to some due to the high savings potential. “Maximum annual benefit can be up to $245,000 for 2022,” said Ledley. “Contributions are calculated by an actuary based on the benefit you set and other factors such as your age and expected returns on planned investments. No annual contribution limit applies.” Starting and administering a pension plan is complex and requires testing, monitoring and IRS reporting requirements. This plan is not often used by farmers or small businesses, but it’s an option that large farms may want to use. Such plans are very expensive to maintain; other plans are less costly.

Having an investment plan instead of simply investing in farm assets allows three major options. “The first is diversification,” said Ledley. “You can invest in retirement plans in addition to a farm asset. Individual retirement plans give you the ability through stocks, bonds, real estate, mutual funds and exchange-traded funds to invest in assets that are not positively correlated to agriculture markets. If agricultural markets are rising, investments in other accounts may not be rising, and vice versa. It’s similar to not putting all your eggs in one basket.”

Having money set aside in retirement accounts may mean not having to liquidate all or a large percentage of business assets to retire. The farmer may be able to pass on the farm as a viable “going concern” to children and other family members. A third option when there are separate retirement accounts is keeping land in farming. “Even if you don’t have a family successor, you may still want to see your land kept in farming,” said Ledley. “Being able to access separate retirement accounts and separate incomes quickly gives you the ability to enter into leases and other longer-term transition strategies, increasing the odds that your property will remain as farmland.”

According to Ledley, the key to selecting a plan is knowing what you can do on your own and when professional assistance is needed. “Setting up an IRA is a pretty simple process with no reporting requirements to the IRS,” she said. “If you feel confident in your knowledge, you can go to a bank or an online financial company to set up an IRA.”

Ledley suggested talking with fellow farmers to find a self-employed accountant who specializes in farmers. “Many trade organizations, Farm Bureaus and agricultural lenders have accountants on staff to direct you to professionals in the ag industry,” she said. “Ideally, you want an accountant who’s familiar with farmers.” Suitable brokers can be located online through brokercheck.finra.org.

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