Small Business Taxes & Management^TM--Copyright 2023, A/N Group, Inc.

Introduction

"I'm set for retirement. I've got a Roth" That's great. How much is in there? A Roth, a 401(k), an IRA, or any type of plan is just a vehicle. Some are better than others, it depends on your situation. But unless you fund them and the amount grows to what you need in retirement, no tax advantaged plan will secure your retirement. The discussion below contains observations and myths based on many experiences. This is not an in-depth discussion of the tax benefits of various plans.

Start Early

There is nothing better than time to accumulate a large retirement balance. No matter what type of plan you decide on investing early and consistently will yield the best results. Starting early also gets you into the habit of putting money away. And there will be times when you can't--unforeseen expenses, a home improvement, etc. but putting something aside even in though years will keep you on track. How important is starting early? For example, if you invest $1,000 per year at 8%, you'd have $172,316 at the end of 35 years. To end up with the same amount and just investing for 15 years at the same 8%, you'd have to contribute $6,346 per year. The point is that starting early is the key. Another point. The stock market has its ups and downs. Over time the ups and downs will average out to a net gain. With onliy 10 or 15 years you might not be able to fully recover from a downturn.

Your Situation

What's your situation? Many financial planners don't ask enough questions about your personal and financial situation and your retirement plans. Have three kids? A savings vehicle for college is likely to be important. Is there a history of certain illnesses in your family? If so you might want to make sure you have sufficient life insurance. Are you or your spouse a professional that could be unable to work if you're injured? For example, a surgeon or dentist relies on his or her hands, eyes, ability to stand for extended periods, etc. That suggests a substantial disability policy. Other skilled workers such as carpenters, plumbers, etc. may have to take early retirement or disability if they can't work. Some other professions such as a lawyer or CPA aren't as concerned.

Other financial considerations include how long do you intend to work? At 25 your goal may be to retire at 50 to a tropical isle. At 50 you may want to continue to work long past 65. Your family's financial status is important. Going to inherit $8 million from your parents? You may not be as worried about retirement. Consider your lifestyle. Some couples can't live on $200,000 a year; their neighbor may be able to feel comfortable with $90,000. Want to travel? Could be expensive. Want to retire to that country home and read? A lot cheaper.

As in dealing with any professional, the more focused your goals and questions, the easier it will be to communicate them. Before consulting anyone make a list and write down the bullet points at least. If you're married make sure you and your spouse agree on the basics.

Some things are sure to change over time. Your job, maybe even your career, additions to the family, unexpected illness, even aspirations such as early retirement, may change, but in many cases your financial plan will usually need tweaking, not an overhaul. And, over the long term, good luck tends to offset bad.

You've got to strike a balance between current aspirations and retirement. Some individuals oversave at the expense of enjoying life currently. You don't want to buy that 40 foot boat to go fishing in Florida at 60 only to learn you only have a year to live. Conversely, you don't want to live high now and find the money gone at 75. Pick your battles. Go for the boat, but cut back on dining out. But make sure you and your spouse agree.

Liquidity First

A big 401(k) may be nice, but it's less desirable if you're facing a big plumbing bill or other emergency where you need cash. Even if you could get the money out of your 401(k) in time, it's going to be a hassle and there can be tax consequences. You may think that keeping cash in the bank is losing out on income, the cost of not having cash can be high. How much cash will depend on your lifestyle and your situation. If you have your own business you may be able to take some money out and return it in a week or a month. Not true if your only income source is a salary.

Think of liquidity as an upside-down wedding cake. You need a certain amount of real cash in the sock drawer, a somewhat larger amount in a money market or savings account, and then a bigger amount can be in securities in your own name (not in a 401(k) or IRA). You're hoping you won't have to touch the latter, but if you do, at least you can get the money quickly and there are no tax consequences. Moreover, money you pull out of an IRA or other plan may not be replaceable down the road since there's a limit to your annual contribution.

Theory to Deferring Income

The theory to deferring income is that you'll be in a lower tax bracket when you retire. For most taxpayers that's a good bet. But not for everyone. Some taxpayers defer so much income or their retirement or savings plans grow so large that they generate more income than during their working years. Business owners in a pass-through entity (e.g. an LLC) may find the business doing far better in their senior years. Or they inherit a substantial amount from a relative. Don't forget, while the 35-room home on the water uncle Fred left you may come to you tax free, the annuities and IRAs you inherited may generate substantial taxable income. If that's your situation you might want to put a Roth or nondeductible IRA higher on your list.

401(k)

If your company offers it, or you can manage a plan for your company, a 401(k) plan may just offer one of the most attractive retirement plans. No matter what your income, your contributions are excluded from income (you do pay social security and medicare tax on the income). That is, contributions are made with pretax income and you can elect to exclude $22,500 for 2023 (indexed for inflation). That's considerably more than many other common plans (e.g., IRAs) offer. In addition, taxpayers age 50 and older can defer another $3,500 under the "catch-up" rules. Many employers "match" a portion of your contributions. That's a benefit on top of your pretax contributions. Employer contributions vary, but if your company offers it you have to seriously consider a 401(k).

There's another benefit to the 401(k). Since the income never shows up in the taxable income line on your W-2, it's not in your adjusted gross income (AGI). That can be important since many benefits that have income limitations are based on your AGI. For example, if your modified AGI (MAGI) is above $150,000 you can't deduct your rental losses that fall under the passive activity rules. A 401(k) contribution will reduce your MAGI, but a IRA deduction doesn't.

You can also contribute to a Roth through a 401(k) if your employer allows it. The rules are similar, but here the contribution doesn't reduce your income.

Another advantage to a 401(k) is that you may be able to access the funds by borrowing from the plan. There are limitations and it can be a trap if you're in poor financial health and can't pay it back. The details are involved and you should consider this an advantage only in a dire situation.

Deductible IRA

If your company doesn't offer a plan this may be the best backup. Contributions are limited to $6,500 per individual (2023 amount, indexed for inflation) with catch-up contributions of up to $1,000 for those 50 and older. The limit applies to all IRAs, traditional and Roth combined. Thus, assuming all the other requirements are met, you can contribute $3,000 to a deductible IRA and $3,500 to a Roth, but no matter how you spread it, no more than $6,500. And you must have enough earned income--that's from salary or a sole proprietorship. If you can use the deduction, it can be a good option. The deduction is limited by your income with different limitations depending on whether or not you or your spouse is covered by a pension plan. (Deductible and nondeductible IRAs are known as "traditional" IRAs.)

Nondeductible IRA

There are no income limitations here. Not covered by another retirement plan? You could have any amount of adjusted gross income and still make a contribution. There's no deduction here, but since your contributions are after tax, there's no tax on your "basis" when you take the money out. This is also where the drawback comes. First, you've got to elect to designate your contribution as nondeductible. You do so on Form 8606. Save the forms because you'll need them when you eventually take the money out. And when you do, you have to calculate the taxable amount based on the full amount in your traditional IRAs. For example, you contributed $10,000 to a nondeductible IRA $65,000 to a deductible IRA and have enough earnings to bring the total in your deductible and nondeductible IRAs to $100,000. Every distribution for that year is 90% ordinary income and 10% nontaxable. Without those forms there's no way to prove any part of the distribution is nontaxable. As a result, a nondeductible IRA has drawbacks. But it could be your only option. And, there's no question that a nondeductible IRA still retains the advantage of growing tax-deferred until the money is withdrawn.

There's a back door to a Roth here. Assume you're covered by a pension plan and your AGI is $350,000. You can make a contribution to a nondeductible IRA, but not a deductible or Roth because of income limitations. Make the contribution to the nondeductible IRA and soon after convert that into a Roth IRA. There's no limitation on a conversion. This is going to require some coordination between you, your financial adviser and your tax adviser.

Roth IRA

This is touted as the ultimate IRA. Contributions are not deductible, but qualified distributions are tax free (subject to certain limitations). And, unlike a traditional IRA or qualified plan you need not take any distributions during your lifetime. The problem is that contributions are limited based on the taxpayer's income. For a married couple phaseout begins at $228,000; for a single taxpayer or head of household the phaseout begins at $138,000. There are two main rules as to distributions. The account must be open for at least five years and the distributions must be after age 59-1/2. Distributions are deemed to first come from contributions. That means even for nonqualified distributions, at least some amounts will be nontaxable. If you anticipate substantial income in your retirement years, a Roth has two advantages--you don't have to take the distributions and if you do the amounts are tax free. But to minimize taxes you may need some careful planning.

Tips and Traps

More Options. There are more options available to employees and employers. The 401(k) plan requires a special filing along with some relatively complex rules. Small businesses can opt for a SIMPLE plan which involves an special IRA for the employee. The employee elects to defer part of his salary, like a 401(k) plan and the employer makes matching contributions. Setup is very simple and there's no special filing. Contribution limits are lower. The employee controls his investment package because it's really an IRA. Another option for the employer is a SEP (simplified employee pension). Again, no special filing, an IRA is the vehicle, and the contributions can be much higher. But here the employer is the only contributor to the plan and you must cover all employees (recent hires and those under a certain age excepted). The plan is attractive if you're the only employee or it's just you and your relatives or a few valued employees.

Ordinary Income vs. Capital Gains Capital gains are taxed at lower rates--in fact if you're income is below a threshold they're not taxed at all. Unfortunately, all the distributions from a 401(k), IRA, etc. are taxed as ordinary income. Thus, while the earnings have been growing tax free, it's time to pay the piper. There are a few steps you can take. One is to pick your IRA or other plan investments carefully.

First, if you're a savvy investor and are good at picking growth stocks, put them in your own name. Gains will be long-term capital gains rather than ordinary income out of an IRA or other plan. Investments that throw off current income or are short-term in nature can be put in your qualified plan. Putting some stocks in your own name will also mean you won't have to tap an IRA or 401(k) if you need funds in excess of your regular savings. Don't forget capital losses in your own name can be used to offset capital gains. If you're careful you may be able to avoid any taxes for a long time. Losses can be carried forward to offset gains. In a qualified plan they're still netted, but the planning benefit is lost.

Second, if you're a business owner, have an secure job that's not secure, or your spouse may be taking an unpaid leave of abscence, you may have an ideal opportunity to convert to a Roth. For example, if your income from your business and salary fluctuates you can take advantage of downturns to convert a deductible IRA to a Roth. That way you're taking a deduction when you're in a high tax bracket and "cashing in" when you're in a low bracket. That's a win-win.

Real Estate. No, not to be put in an IRA or other other qualified plan, but holding in your own name. If you pick a good property and don't have to sell to raise cash, rental real estate can be an excellent way to plan for retirement. This is not for everyone. Renting a two-family home that needs constant work makes sense only for someone handy. Losses that can't be used currently because your income is too high can be carried forward and can offset gain on the sale. You may also be able to defer gain by exchanging the property for a different one should markets change. This is not a step to be taken lightly. Talk to your financial and tax adviser and make sure you're up to the challenge.

Asset Choices. We hit on this earlier, but it bears repeating. All the tax deferral or avoidance in the world doesn't do you much good if your assets don't grow or generate income. Investment choices come first. Some years ago a client was badgered into investing in a tax shelter through his IRA. That made less than no sense. Tax-advantage investments often have a lower return because taxes are deferred or avoided, but that's the purpose of the IRA or other plan. Several years later the individual recouped some of his investment losses through the settlement of a class action suit.

Don't Overthink. Plan, but don't try to anticipate every eventuality. Because you can't. If you're only 30 you could be planning for 40 years down the road. Aunt Sue could pass 15 years from now and leave you the those oil wells in Texas--or she could leave them to that lawyer she's been dating half her age.  

--Last Update 6/15/23