Supercharge Your Small-Business Retirement Account

I am a CPA specializing in helping busy business owners decrease the amount of time and energy they need to manage their accounting system.

Small-business owners generally start out investing the majority of their money back into their own business. This makes sense since you want to grow the business and benefit from the growth in the future. As the business grows, there has to be a shift to more diversification and retirement planning. With a variety of available accounts, each with their own tax rules, it can be hard to determine the most tax-advantaged way to save for retirement.

The rules for retirement plans are complex and not always fully understood. Unfortunately, the tax implications of retirement plan savings straddle the financial advisor and tax preparer professions and thus tend to fall through the cracks.

To add more complexity to tax and retirement planning, there are traditional and Roth accounts. Traditional accounts let you deduct your contributions now, but you’ll pay tax on them when you withdraw the money. Roth accounts are funded with after-tax dollars, but you will not pay tax when you take the money out. Not all employers offer Roth plans, but if you own a business, you control what plans you offer.

While there are many tax implications, a CPA or tax preparer that specializes in small business should be able to guide you through it. However, before you can begin the discussion with your CPA, first determine how much money you want to set aside each year for retirement. Knowing this number will make your tax planning smoother. Here are six implications to consider:

The 401(k) Plan

Until a few years ago, the 401(k) plan wasn’t really an option for solo business owners because of high management fees, so they were typically relegated to using a simplified employee pension (SEP) individual retirement account (IRA). However, with the growing popularity of solo 401(k) plans and online discount brokers, the fees are now minimal or zero regardless of which account you set up. Outside a few specific situations, a solo 401(k) is generally a good fit for business owners.

Tax-Free Growth

The biggest tax advantage of a Roth plan, which also applies to 401(k)s and IRAs, is the returns are not just tax deferred but will never be taxed. This implication is constantly underestimated because the benefits don’t show up until you start to take distributions. Consider this: You could pay tax on $10,000 today, and assuming that money doubled three times in about 20 years, you’d have $80,000 of tax-free money. If you used a traditional account, you would get $10,000 of tax-free money today, but you would pay tax on $80,000 later.

After-Tax Contributions

When you work a regular W2 job, employers control the rules of your 401(k) plan. When you work for yourself, you are the employer and thus control the rules. After-tax contributions are now a widely used aspect of 401(k) plans. These are almost a third type of account for 401(k)s; however, it’s recommended to instantly convert them to a Roth account. Unlike a Roth account, the growth part of after-tax contributions will be taxable but not the original contribution. Thus, if you instantly converted the after-tax contributions to a Roth, you wouldn’t pay any additional tax.

Beyond $19,500

The contribution limits vary depending on your account type. IRAs allow a $6,000 contribution, and 401(k) plans let you contribute $19,500, plus catch-up contributions if applicable. In 2021, the after-tax contributions limit is $58,000 (not including catch-ups) or your W2, whichever is smaller. Depending on how much you want to contribute, you might need a mix of accounts and strategies to maximize the tax benefits.

High Earners

While 401(k) plans are the cheapest and easiest to implement for small-business owners, they are not the only option. If you find yourself earning a lot of money from your business, it’s prudent you have a team of professionals that can help you manage the tax implications. There are a variety of specialized accounts that can be utilized, such as non-qualified plans and defined benefit plans.

S Corporation Income

Solo business owners, with a company that’s taxed as an S corp, will need to balance their retirement plan contributions with their reasonable salary. You are only allowed to contribute money to your 401(k) plan that is taxable as wages, which means that S corp flow-through income does not count. For small-business owners who wish to contribute more than their current W2, there is the added complexity and tax burden of increasing your wages.

Retirement planning is complex. You have to consider a lot of factors and decide how to invest your money. Small-business owners need to also consider the tax implications, which adds another layer of complexity. To avoid going in a circle, start with retirement planning and then move on to tax planning. And regardless of your strategy, the most important aspect is to make sure you save for retirement.

The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.

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