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- Having access in retirement to taxable and tax-free assets is one of the best ways for successful entrepreneurs to keep and manage the money they spend a lifetime earning.
- Having access in retirement to taxable and tax-free assets is one of the best ways for successful entrepreneurs to keep and manage the money they spend a lifetime earning.
There’s one quote that resonates with me and weaves a thread through my lifelong study of business, finance, investments, and taxation. It’s by investor and successful businessman, Robert Kiyosaki, who perhaps is best known for his ‘Rich Dad Poor Dad’ series of motivational books. He stated: “It’s not how much money you make, but how much money you keep, how hard it works for you, and how many generations you keep it for.”
Early in my career as a CPA I had the privilege of preparing tax returns for many very successful entrepreneurs. During those years I observed firsthand how important tax planning became as clients grew fledgling small businesses into an enterprises employing hundreds – each of whom with a family to shelter, feed, and educate. The enormous financial responsibility the entrepreneur faces each day never escapes me.
And for this reason, I find great satisfaction in sharing ways to help successful entrepreneurs improve their bottom lines and ultimately increase how much money they get to keep. Retirement tax planning is a very effective way to do just that. To this end, I believe entrepreneurs should consider developing separate pools of assets to draw upon in retirement. By doing so, they may be more able to control if, when, and how they pay federal income taxes.
This is part one in a two-part series about retirement tax planning strategies for entrepreneurs. This post addresses retirement tax planning strategies for entrepreneurs with relatively high incomes in terms of W-2 earnings and business net profit. The second post will address retirement tax planning strategies for small business owners.
SEP IRA and Solo 401K Plan Contributions Increase to $53,000 in 2015
Recently the IRS released the 2015 contribution limits for the SEP-IRA Plans. The limit established for 2015 is $53,000 and will be subject to the annual cost of living adjustment in subsequent years.
The Solo 401K Plan (aka the Individual 401K Plan) also has a $53,000 contribution limit in 2015. This retirement plan is only available to the single business owner who has no employees, with the exception of their spouse.
Given the fact that both plans have the same contribution limitation, it would be logical to assume the contribution computations would also be identical. But this is not the case. Who ever said the federal tax code is logical? The SEP-IRA plan requires a circular computation which essentially reduces the maximum deduction from 25% of compensation or net self-employment income to 20%. In order to utilize the maximum contribution limit of $53,000 in 2015, the entrepreneur who desires to use a SEP-IRA retirement plan will need to have a higher level of W-2 Compensation or net self-employment income from his or her business than if he or she chose to use the Solo 401K retirement plan.
The SEP-IRA plans typically involve less administrative responsibilities and lower fees than the Solo 401K retirement plans. Whereas the Solo 401K retirement plans allow for individual tax free loans.
Deferring the federal income tax on $53,000 per year by contributing to either a SEP-IRA or Solo 401K plan is much more attractive than what is available to most employees in a 401K plan. In 2015, the 401K plan limitation is set at $18,000 with an additional $6,000 catch up provision for taxpayers over 50 years of age.
For those solo-entrepreneurs who may be married to a spouse with sufficient income to support the family, contributing all or a major portion of their income to either a SEP-IRA or a Solo 401K can be a powerful way to save money for retirement. Similarly, if one is supplementing their income with secondary employment while participating in an employer-sponsored retirement plan, the net earnings from the side business may be used to fund a SEP-IRA.
Layering Retirement Plans to Maximize Tax Deduction and Retirement Account
Retirement plan design, contribution limitations, and compliance issues are horrendously complex on a good day. In fact, it’s been my experience while working with entrepreneurs who desire retirement plan advice for themselves and their employees, that very few financial advisors fully understand the complexity of the task. Nonetheless, if an entrepreneur has significant income and desires to defer his or her income taxation until withdrawn in retirement, then layering retirement plans may be a very attractive strategy.
Layer 1: Safe Harbor 401K Plan The 401K retirement plan is used by many small and large businesses alike. It offers business owners an effective way for them and their employees to save for retirement by deferring compensation. Additionally, businesses with a 401K plan have several ways to contribute to the employees’ individual 401K account based upon how the plan is designed when it was established. It can require the employer to either match employee contributions or make a contribution of all eligible employees W-2 compensation. And while the 401K plan is used widely by many businesses, the limits established for deferring compensation may not be sufficient for the business owner’s retirement needs. That’s why the Safe Harbor 401K option usually is used as the foundation when layering retirement plans.
Layer 2: Cross-Tested Profit Sharing Plan Cross-tested plans require the employer to take current contributions to the profit sharing plan and convert them into a projected benefit at retirement age for each employee. Then benefits are tested according to non-discrimination rules established by the IRS. Generally speaking, if the ownership pool of employees is on average more than five years older than the non-ownership pool of employees, cross testing will result in a large portion of retirement plan contributions going to the business owners. Business owners also tend to like the flexibility of the profit sharing plan component because they allow contributions to vary from year-to-year, based on their business’ profitability.
Layer 3: Defined Benefit Plan (or Cash Balance Plan) Establishing a Defined Benefit Plan for the business in addition to the 401K and Cross-Tested Profit Sharing Plan is a very powerful way to boost the retirement savings accounts for the business owner and his or her employees. This strategy works very well if the business owners are older than the majority of his or her employees and generally speaking over the age of 45.
It’s not unheard of to find successful entrepreneurs in their late 40s and 50s using a retirement plan layering strategy to put away upwards of $200,000 annually into their own retirement accounts. For those interested in this tax-saving strategy, please don’t try this at home! Seek and hire the most experienced retirement plan expert you can find. And be certain this is all they do.
Enter the ROTH Individual Retirement Plan Through the Backdoor
The last tax strategy related to retirement planning for successful entrepreneurs is very useful if the entrepreneur does not have a traditional IRA account or if the value of their IRA accounts is less than or equal to the tax basis (the amount they contributed) in their IRA accounts.
Although our Congress goes to great lengths to limit the level of retirement plan contributions for highly compensated earners and taxpayers with income in excess of certain Modified Adjusted Gross Income (MAGI) limits, they left the backdoor open on the ROTH IRAs.
Before I explain how to take advantage of this strategy, let’s review ROTH IRA basics:
ROTH IRAs are non-deductible, grow tax free while held and tax free when withdrawn as long as the Roth account meets the IRS five year rules. ROTH IRAs are only available to Single and Married Filing Separately taxpayers if their MAGI is less than $116,000 and phases out when it reaches $131,000 in 2015. For Married Filing Jointly taxpayers, the ROTH IRA availability phases out when their MAGI is between $183,000 and $193,000 in 2015. So for most successful entrepreneurs, making a direct ROTH IRA contribution is not an option.
Unless you enter the ROTH IRA through the back door—here’s how:
Although the MAGI limitations are clearly defined for ROTH IRAs, there is no income limitation for making a non-deductible IRA contribution. In 2015, the non-deductible IRA contribution limit is $5,500; and if you are over age 50, you may contribute another $1,000 under the catch-up contributions provisions for a total contribution of $6,500.
In 2010 Congress lifted the income restrictions for converting IRAs to ROTH IRAs. Accordingly, regardless of a taxpayer’s income, you may make a non-deductible IRA contribution, subject to the limits stated above, report it to the IRS on Form 8606 and then immediately convert it to a ROTH IRA.
It’s very important to understand if you have a traditional IRA account with appreciated investments, this tax strategy is not as attractive as it would be if you didn’t have a traditional IRA account previously established because a portion of the ROTH IRA conversion would be taxable.
Two Pools of Money For Retirement My crystal ball is broken and frankly I cannot begin to guess what the federal tax rates will be when I retire. So for my money, I believe a good common sense strategy is actively building two distinct pools of money—one which would be taxed when withdrawn and the second which may be withdrawn tax free. Having access in retirement to taxable and tax-free assets is one of the best ways for successful entrepreneurs to keep and manage the money they spend a lifetime earning.
