If you are nearing retirement age and have a substantial nest egg in a qualified plan like a 401(k) or a Regular IRA, you may be facing some tax issues that need attention. If utilizing what many call Tax Advantaged Retirement Plans, you always pay the tax at one time or another.
I’m going to repeat that, so that everyone understands me. No matter what your financial planner tells you, there is always a tax. Let’s use a few examples to illustrate this fact.
401(k) Or Other Qualified Plans
These are plans where you don’t pay income tax today, so that you can pay regular income tax on an increased amount tomorrow.
In our example, Joanne B. Owner has a W-2 of $100K and is able to put $20K into her qualified plan. This means three things.
1 – She is still required to pay both Social Security and Medicare Taxes on the entire $100K.
2 – She will only pay income taxes this year on $80K.
3 – But if she retires in 20 years and earns 5% on her money, she will have a little over $54K for her retirement. She will then pay regular income tax on that entire amount.
Regular IRA’s
This is basically the same example, You can pay the tax man now, or pay him later on a much larger amount.
Most financial planners will say that this phenomenon of paying the regular income tax later is fine because in retirement you’ll need less money. Your home should be paid off and your kids will hopefully be out of school and out of the house, so naturally you won’t need as much income.
My response is normally one where I look at the financial planner and say that they must be rather lousy at their job. Why? Because when I retire, I don’t want to take a pay cut.
If anything I’ll want to vacation more, party my socks off, and maybe spend even more than during the years when I needed to save. Trust me. I’ll be on a catamaran in Caribbean aptly named the, “Sayonara Sister”.
I’ve always defined a successful retiree as one who doesn’t get their income docked just because they decide to stop working.
Social Security
This is subject to income tax as well. As an Entrepreneur, you pay both sides of the tax for yourself, so that you can probably pay income taxes on it later. When you earn more than $32K annually on a MFJ Return, you begin paying taxes in 2024 on Social Security proceeds.
Roth IRA’s
There’s certainly something to be said about the advent of Roth’s. In these plans you pay now, so that you don’t have to pay later.
In most instances, using our prior example, it makes more sense to pay income tax on $20K today so that you don’t have to pay the income tax on $54K tomorrow. Also, the regular IRA deduction phases out once you earn too much money, so a Roth may be your best bet.
Roth Conversions
In a Roth Conversion from a Regular IRA, you pay the income tax on the amount converted in the year of the transition. In most instances, this doesn’t make a lot of sense.
If you are currently paying tax at the Federal Level at the 24% bracket, and the amount you’re converting pushes you into the 37% bracket, then it might not be a great idea. If you had waited until you retired and didn’t have regular income from a W-2 or K-1, then maybe you would only pay at your regular rate of 24%.
Let me leave you with this…
I recently had a couple of conversations with entrepreneurs about this phenomenon. The clients were taken aback to say the least.
Why? Because when you talk to these retirement specialists, they act like it’s free. Obviously, that’s never the case, but there are three saving graces to consider.
1 – The Employer Match
401(k)’s and other qualified plans are the best things since sliced bread when dealing with employees because of the Employer Match. But things are different when dealing with entrepreneurs because we need to pay the 15.3% Social Security and Medicare Tax as well on the payroll in order to put into a, “Tax Advantaged Plan.”.
When you add in the fully tax deductible matching amount, it lessens the blow to an entrepreneur, but you’re still getting smacked rather hard.
2 – Capital Gains
Let’s use the prior example once again. Joanne B. Owner now puts $20K away into a regular stock account and pays income tax on it in the year it’s saved. She then takes $54K out of the account at retirement and only pays a 20% Federal Capital Gains Tax on the gain of $34K.
That’s normally a lot better than paying Regular Income Taxes on the entire $54K. And if the money she saved came out of the distributions from her S Corp, she also saved the 15.3% in payroll taxes as well.
3 – Loss Carry-Forwards
Using the prior example again, maybe Joanne won’t have to pay that Cap Gains Tax when she withdraws that money because in the 20 year period when the account was growing, she farmed her investment losses when the market was down. The losses then carried forward to negate the potential Cap Gains Tax on her withdrawal.
I’ve given you a lot to think about, but my point is that there isn’t one right or wrong answer in retirement planning. It all comes down to your individual facts and circumstances.
My other point is that your accountant should be helping you with these issues. Being a successful entrepreneur is about three things.
You need to learn how to make money, to save it, and to retire successfully paying the least amount of tax possible. If you can’t learn to do all three of these things, you should pack it in and get a job.
And if your current accountant isn’t helping you with all of these issues, you should give me a call.
We’re all going to get through this. Let’s get through it together.
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