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Small business owners may find themselves in extremely unique situation for maximizing 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 stays the same even if you have employees. If you’re single and make less than $125,000 you can also make a Roth IRA contribution of $6,000 or $7,000, if you are over 50.
The table below shows you many, but not all, scenarios based on marital status, whether you’re over 50 and whether you’re not phased out by income.
The table below shows only the employee contribution opportunity based on one spouse having 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 numbers increase.
In a prior article, I explained that contributions to a 401(k) plan are made up of employee and employer contributions. The employer contributions can be viewed as a profit-sharing contribution. When does a company learn about how much they made the previous year?
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In the next calendar year. Employers pay profit sharing bonuses the next year. Employers have up to their tax filing dates, including extensions to make those contributions.
This may be beneficial if you receive cash flows in the following year, that may be delayed because of contract or other reason. This gives you more flexibility in how you boost your contributions.
You make your employer contributions with pre-tax dollars or more clearly stated, gross pay. Now your account has both pre-tax and Roth dollars. If you aren’t one for tax diversification, you can convert your employer contributions to Roth contributions using a Roth conversion.
What is a Roth conversion?
You pay the taxes that you would have paid on the contributions. That’s it. You could do this inside of your plan or do it directly to your Roth IRA.
Monies inside of your plan have the creditor protections of the Employee Retirement Income Security Act. That protection is more extensive than for the Roth IRA.
If your plan document allows, you can take a loan of 50% of your balance up to $50,000. If you want that option, you likely want to keep the money in the plan. You can also rollover some funds into the Roth 401(k) from another IRA you may have already had.
If you have IRAs or 401(k)s from other employers, you can roll those over into your plan too. Simplifying your typical financial life is a good thing. You’re running a business and likely don’t have time to keep up with multiple accounts from multiple employers.
How Roth contributions work
Currently, Roth contributions in your solo Roth 401(k) are subject to required minimum distributions. Unlike the traditional 401(k) contributions, there are no taxes to be paid on these distributions.
They simply stop the tax deferred status for the monies that you withdraw. Originally, the required minimum distributions were the government’s way of getting tax dollars back that had been allowed to grow tax deferred.
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 roll off your Roth IRA has no required minimum distribution requirement.
While you may be more familiar with even having a SEP IRA, you cannot make any Roth contributions. They will also be subject to required minimum distributions in the future. IRA monies, 401(k)s, 403(b)s, etc., passed to beneficiaries will be taxed at their marginal tax bracket.
As these monies will be added to their regular income, this could push this inheritance into a higher federal tax bracket. These monies are also subject to state taxes further whittling away your wealth transfer intentions. Using Roth contributions allows you to pass any unused contributions to the beneficiary’s tax free.
Will you pay less in taxes when you retire?
First, your tax rate will likely be based on your lifestyle spending. If your lifestyle isn’t decreasing and it needs to be funded from your assets, you likely won’t see much decrease in tax rates assuming tax rates stay what they are today.
Second, tax rates have fluctuated constantly over the last few decades. Likely they will go up and down over decades long retirement. My mom is about to go over her third decade of retirement!
If you have health events or need expensive long-term care funded by your assets, those withdrawals will likely eat up more in taxes if funded from pre-tax dollars. Managing taxes now rather than in your retirement years appears much easier.
Why wouldn’t you want to maximize a strategy that not only reduces your lifetime taxes, but also provides a tax-free wealth transfer to your heirs? Don’t delay getting started today!