The Roth IRA Peter Thiel used to amass billions in tax-free dollars has renewed interest in using tax-advantaged retirement plans as a means for accumulating wealth. What hangs up entrepreneurs is they don’t want to set aside wealth only to have it be taxed away. Whether you think of this as greed or good business, taxes are legitimately an issue in growing wealth – particularly wealth to be used for retirement income.
For many entrepreneurs saving wealth starts later in life and runs headlong into a desire to retire within a few years. The business is finally generating excess profits, the kids have graduated from college, and some serious retirement saving can begin. The question is whether there will be enough time to grow the desired retirement capital in a short period of time? The simple fact is that saving for retirement only a few years before actually retiring is of limited value. There is little time for the magic of compound interest to yield results and taking on too much investment risk is foolhardy right before retirement.
There’s a way to leverage last minute retirement savings plans, and it doesn’t involve investing in aggressive tax shelters. These days, the only tax shelter that is truly safe is the qualified plan. It’s a legal way to defer taxes on earnings without exposing the underlying investments to unnecessary risk. And, contrary to common belief, an entrepreneur can sock away a lot of earnings in a qualified plan.
The Solo 401(k)
Many entrepreneurs have more than one source of wealth. Take the example of an affluent real estate investor who also has a consulting business on the side that annually generates about $125,000 in earnings. He is five years out from retirement and wants to zero in on retirement savings. The problem is that these earnings in his corporation are “wages” for tax purposes and exposed to ordinary income tax. If the entrepreneur doesn’t need this consulting income currently and wants to put it away for retirement, the challenge is that taxes can chew up a sizeable chunk of this income.
A tax-advantaged solution is a solo 401(k). This retirement platform first became available 20 years ago, and for many solo practitioners has proven to be a successful means of sheltering self-employment money for retirement. It allows up to 25% of a business’ payroll to be contributed to a profit-sharing plan, plus salary deferrals to be made by the employees.
In the case of the real estate investor’s consulting business, he is the only employee in his corporation. As a result, he can contribute the 25% maximum profit-sharing allocation of the firm’s $125,000 payroll, therefore, $31,250. Additionally, as an employee, he can make a salary deferral of $19,500, the maximum individual 401(k) deferral limit in 2021. And to top it off, because he is over age 50, he can contribute a maximum catch-up election of $6,500. All told, he can defer $57,250 into his solo 401(k).
The downside to this transaction is the administrative cost and the fact that when he takes his income out at retirement (including appreciation), it will be taxed as ordinary income. These challenges may be well worth it because this plan gives the entrepreneur a leg up in compounding savings shortly before retirement.
There’s More Than Tax In Play
Deferring tax on income is reason enough to consider a solo 401(k). For the entrepreneur, however, there are other considerations. These owners are subject to enough risk running their enterprises. Any excess capital they can set aside for retirement is better suited to being protected from further risk, particularly when retirement is close at hand.
A tax-advantaged plan like a solo 401(k) doesn’t require the owner to expose income to loss by placing it in a risky investment. This entrepreneur isn’t Peter Thiel, and he doesn’t want to expose his retirement capital to the risk of investing in a string of start-up businesses. Rather, the owner’s retirement savings can be directed to managed or indexed investments, whether in safe or aggressive assets. Even if aggressive investments are utilized, risk is reduced since the entrepreneur is diversifying retirement dollars away from his business.
An additional benefit is that qualified plan assets are generally safe from creditors. Since the solo 401(k) plan is a qualified plan – versus a Simplified Employee Pension (SEP) or individual retirement account (IRA) – the plan assets enjoy a high level of protection against general creditors.
Tax Diversification With A Roth
The solo 401(k) is a powerful idea, but let’s return to the hot topic of a Roth IRA. Would this technique make sense for this soon-to-retire entrepreneur? For most business owners, it’s counterintuitive to pay taxes now, when they can be deferred until later. There is something to be said, however, for paying tax currently when either values or tax rates are expected to rise. A solo 401(k) can allow for a Roth election, making some of the contributions currently taxable but free from tax on future appreciation.
This tax diversification strategy may be particularly appealing to the business owner who earns too much to contribute to a Roth IRA. Take the example of our entrepreneur with the consulting business. As part of a Roth 401(k) plan (simply an additional feature in his solo 401(k)), he can elect to pay taxes currently on both his $19,500 salary deferral and his $6,500 age 50 catch-up contribution. He can do this even if he is making too much money to otherwise qualify to contribute to a Roth IRA. Why would he do so?
· The future appreciation on this $26,000 Roth contribution will be completely sheltered from income taxes.
· If tax rates rise, certainly a major concern these days, he avoids paying higher marginal taxes on his earnings.
· Roth accounts are not subject to the hated required minimum distribution (RMD) rules. He can pass any excess wealth to his heirs rather than being forced to take distributions when he turns age 72.
When you work for yourself, it’s sometimes hard to make money until your business has had years to grow. Once you can focus on retirement saving, you need to maximize the growth of your dollars. The solo 401(k) can be a tax efficient way to build your nest egg quickly and yet hold on to what you have.