Self-employed people have a unique opportunity to maximize their after-tax income later in life. While most self-employed people use traditional 401(k) plans and SEP IRAs to save for the future, I’m encouraging my clients who work for themselves to consider an Individual Roth 401(k) instead.
Death and Taxes: Not So Certain
Later in life, as you scale down, sell or retire from your business, three things typically happen, which may cause you to end up in the same or higher tax bracket than you were in during your prime earning years:
- You’re making withdrawals from your IRA where every dollar is subject to ordinary income tax rates.
- Many of your tax deductions start to fade away (fewer business write-offs, little to no mortgage, etc.).
- There may be a perpetual stream of taxable income from sources such as Social Security, an inheritance, a portfolio and consulting work.
Wouldn’t it be nice if you could hedge your bets about future tax rates and have the option to receive some of your future income completely tax-free?
Executing an Individual Roth 401(k)
An Individual Roth 401(k) is essentially a 401(k) plan with two buckets—one bucket resembles an IRA and one resembles a Roth IRA. With the formula that’s used, most people will be able to sock away more money into an Individual Roth 401(k) than with the more common SEP IRA. For example, a sole proprietor who is age 50 or over with net business earnings of $100,000 could contribute just over $40,000 to his 401(k), more than twice the amount he could contribute to a SEP IRA.
Planning with the End in Mind
When your business winds down, it’s generally best to shut down the Individual Roth 401(k) plan and roll each of the accounts over to an IRA and a Roth IRA respectively. Now you can creatively control your taxable income by pulling from either bucket in order to minimize your overall taxes. For example, if you continue to have big tax deductions that place you in a low tax bracket, you can take taxable distributions from your IRA that will be subject to a very low tax rate. If, on the other hand, you end up in a higher tax bracket, you can make tax-free withdrawals from your Roth IRA.
Two other perks accompany the Roth IRA. Unlike all other retirement plans that require initial withdrawals by age 70½, you aren’t ever required to make withdrawals from a Roth. Second, your beneficiary will receive the entire account income-tax free. Keep in mind that tax laws change often. As with any investment decision that has tax implications, please consult with your financial planner and CPA to see if this strategy makes sense for you.
Happy planning.
