Small business owners can find themselves in an extremely unique position to maximize Roth savings, especially if you are an owner-only business. A Roth 401(k) or Solo Roth 401(k) allows you to make a Roth contribution of $26,500 in 2022.
This amount remains the same even if you have employees. If you’re single and earning less than $125,000, you can also make a Roth IRA contribution of $6,000 or $7,000 if you’re over 50.
The table below shows you many, but not all, scenarios based on marital status, if you are over 50, and not eliminated by income.
The table below shows only the employee contribution opportunity based on a spouse with access to a Roth 401(k). If your spouse does not work in the business but has access to a Roth 401(k), your household count increases.
In a previous article, I explained that contributions to a 401(k) plan are made up of employee and employer contributions. Employer contributions can be considered as profit sharing. When does a company find out how much it earned the previous year?
Over the next calendar year. Employers pay incentive bonuses the following year. Employers have until their tax filing dates, including extensions to remit these contributions.
This can be advantageous if you receive cash flow the following year, which may be delayed due to a contract or other reason. This gives you more flexibility in how you increase your contributions.
You pay your employer contributions in pre-tax dollars or, more clearly, gross pay. Now your account contains both pre-tax dollars and Roth dollars. If you don’t like tax diversification, you can convert your employer contributions to Roth contributions using a Roth conversion.
What is a Roth conversion?
You pay the taxes you would have paid on the contributions. That’s it. You can do this inside your plan or do it directly to your Roth IRA.
The funds inside your plan benefit from the creditor protection of the Employees Retirement Income Security Act. This protection is more extensive than for the Roth IRA.
If your plan document allows it, you can take out a loan for 50% of your balance up to $50,000. If you want this option, you’ll probably want to keep the money in the plan. You can also transfer funds into the Roth 401(k) from another IRA that you may have had before.
If you have IRAs or 401(k)s from other employers, you can transfer those into your plan as well. Simplifying your typical financial life is a good thing. You run a business and probably don’t have time to manage multiple accounts from multiple employers.
How Roth dues work
Currently, Roth contributions to your solo Roth 401(k) are subject to required minimum distributions. Unlike traditional 401(k) contributions, there is no tax payable on these distributions.
They simply stop tax-deferred status for the monies you withdraw. Originally, required minimum distributions were the government’s way of getting taxpayers’ money back that had been allowed to grow on a tax-deferred basis.
By making a Roth contribution to a Roth IRA, you may already have an existing Roth IRA, you can avoid it. At some point in the future, simply withdraw your Roth IRA with no minimum distribution requirement required.
Although you may be more familiar with a SEP IRA, you cannot make Roth contributions. They will also be subject to required minimum distributions in the future. IRA funds, 401(k)s, 403(b)s, etc., passed on to beneficiaries will be taxed at their marginal tax bracket.
As these monies will be added to their regular income, it could push this inheritance into a higher federal tax bracket. These funds are also subject to state taxes which further reduce your wealth transfer intentions. Using Roth contributions allows you to pass on any unused contributions to the beneficiary tax-free.
Will you pay less tax in retirement?
First, your tax rate will likely be based on your lifestyle expenses. If your lifestyle isn’t shrinking and it has to be funded by your assets, you probably won’t see much of a drop in tax rates assuming tax rates remain what they are today.
Second, tax rates have fluctuated constantly over the past few decades. They will likely rise and fall over decades of retirement. My mother is about to enter her third decade of retirement!
If you have health issues or need expensive long-term care funded from your assets, those withdrawals will likely consume more taxes if funded from pre-tax dollars. Managing taxes now rather than in your retirement years seems a lot easier.
Why wouldn’t you want to maximize a strategy that not only lowers your lifetime taxes, but also offers a tax-free wealth transfer to your heirs? Don’t wait to start today!