Note: this article is derived from our friends at Provident CPA and Advisors, a tax firm we recommend to all of our clients
Even if you’ve been doing everything you can to plan for retirement, expenses can add up fast if you’re not prepared in every area. Unfortunately, taxes can be one of the biggest unexpected expenses for retirees.
Retirement planning can be especially challenging for small business owners. It’s easy to focus on growing your business in the present and deprioritize saving for the future. Even more challenging is saving the same amount each month when you’re not sure if you’ll be making the same kind of money from one month to the next.
Retirement accounts: Better to pay taxes now or later?
First of all, understand the types of retirement accounts available to you and their advantages. A big benefit of a 401(k), 403(b), or IRA is that you can avoid paying income tax on contributions now. For the self-employed, who may not have access to an employer-sponsored, traditional 401(k), a Solo 401(k) provides similar benefits. These solo accounts are often used by those who run a business with no employee program, and they can cover you and your spouse.
Of course, the above examples are tax-deferred accounts—avoiding income tax now but paying taxes on that income later, when you’re in retirement and receiving distributions.
This is how a Roth IRA can provide big benefits once you’re in retirement. You pay taxes on this money now, so the income you’re receiving in retirement is tax-free. Roth IRAs can be a good option for the newly self-employed or those with new businesses, because they take advantage of the tax bracket you’re in now when you’re starting out, versus when you’re in retirement.
That said, many people start saving for retirement assuming that they’ll be in a lower tax bracket when that time comes. However, that may not always be the case. Required minimum distributionson your tax-deferred accounts require that you start withdrawing money when you’re 70 ½, even if you don’t want to—so this added income can push you into the next bracket if you have significant income from other sources.
A Simplified Employee Pension Plan (SEP-IRA) is another option to consider if you’re an entrepreneur. This account is an IRA that gives business owners a simpler way to contribute to both their own retirement savings and their employees’ retirement savings. You can contribute up to 25 percent of your annual compensation, with a cap of $56,000 in 2019. That’s almost 10 times the amount you can put away with a traditional IRA ($6,000 if you’re under 50, and $7,000 if you’re 50 or older).
However, these accounts are generally better for the self-employed or those with few or no employees, since the percentage of your compensation that you contribute to your plan has to be the same percentage you contribute to your employees’ plan.
Life insurance isn’t just protection for your loved ones after you’re gone. There are certain benefits that you can take advantage of along the way, including avoiding taxes on investment income. One strategy to help you build your retirement savings but avoid a big tax burden is to use tax-free loans from life insurance earnings. You are essentially borrowing money from yourself instead of a lending institution, and then paying yourself the interest plus repaying the loan to your life insurance policy.
This benefit is possible because your life insurance policy has been financed with money that’s been taxed, meaning its growth and your access to the funds are tax-free. Another benefit is that this money doesn’t have the required minimum distribution requirements that other retirement accounts impose.
Defined benefits and cash balance plans differ from IRAs and 401(k)s in that they allow you to make larger contributions for retirement. Those contributions lower your income and thus lower your current tax burden.
There are of course many considerations for retirement planning outside of tax obligations, such as creating a will and a healthcare directive and assigning a financial power of attorney. But tax minimization is key, allowing you to realize huge savings that can be used for things like housing, travel, and healthcare in retirement.
It is never too early to begin your estate planning; whether you’re married or single, have kids or not, if you have a business, you simply MUST have your affairs in order. If you don’t, you’re leaving your loved ones with a lengthy, expensive, and heart-wrenching probate process to fight through.
If you are a small business owner who does not have an estate plan in place, or who simply wants more information on the topic, contact Paige Hulse Law and firstname.lastname@example.org. If you’re a small business owner who needs to develop a smart tax strategy, get in touch with Provident today to create a plan that’s best for you.