Everyone is asked this question at some point in their journey to retirement. Especially when you set up a retirement plan for your business, it is important to understand the differences between traditional and Roth-style accounts. Contributing to the wrong account could cost thousands in taxes over the lifetime of a business owner. To combat that risk, we need a framework to understand where our savings for the future should go.
3 Tax Buckets
From a tax perspective, there are three main “buckets” or accounts that we should focus on.
- Tax-deferred – think of traditional IRAs and 401ks, SEP IRA, etc.
- Tax-free – think about Roth 401ks or Roth IRAs.
- Taxable – think about bank accounts, CDs, your home or other real estate, etc.
Tax-deferred means you have not paid taxes on that money yet and will have to in the future. On the front end, it feels good to contribute to these accounts because each contribution is generally deductible. Saving $69,000 in a Solo 401k could reduce your taxes by more than $20,000 this year (assuming you have a 30% tax rate).
All money inside tax-free accounts like a Roth IRA have already been taxed. No matter how large the account grows, the funds will never be taxed again. No one enjoys paying taxes up front, but Roth-style accounts are popular because of the “never taxed again” status.
The last bucket, the taxable bucket, is outside the typical bounds of retirement accounts. Both traditional and Roth retirement accounts get the benefit of tax-free growth, thereby avoiding capital gains tax. With “taxable” accounts like a brokerage account, you trade the benefit of tax-free growth for liquidity (or access to your money). For example, a brokerage account doesn’t penalize you for withdrawing money before you turn 59.5, like a Traditional IRA would.
When Should You Choose the Traditional Route?
Business owners always want to reduce their taxes. The thought of reducing the check to the IRS is an easy sell for many, especially when you tell them they can save for retirement and reduce their taxes this year. Choosing to contribute to a tax-deferred account is usually best when you are in a high marginal income tax bracket. As of August 2024, the top federal income tax bracket is 37%. If you add 4% for state tax, that means every additional dollar you earn will push 41 cents to the IRS for income taxes alone (and possibly more after factoring everything in). I would probably take the deduction in that scenario too.
The purpose of contributing to tax-deferred accounts is to save money for the future, specifically retirement. If you are in your peak earning years at the top tax bracket, do you think you will stay at that income after you reach your 60s? Some people will, and some will not. If retirement means selling the business and only living on $5,000 to $10,000 a month in retirement, it’s possible to be in a significantly lower tax bracket. A good tax strategy would defer paying 40% now if it is possible to pay 25% later.
For many of these tax-deferred accounts, there is a preferred window that the IRS wants you to withdraw from your accounts. IRAs and 401k’s are generally meant for retirement, which the IRS defines as somewhere into your 60s. There is a 10% penalty if you withdraw funds before age 59.5, and before age 55 for certain situations with 401k plans. If you are funding an IRA or 401k in your 30’s and 40’s, plan not to use those funds for a few decades. On the flip side, they are not going to let you go indefinitely without paying taxes either. At age 73, the IRS requires you to distribute part of your account each year. It is important to have proper tax planning so you maximize your flexibility and do not get stuck in a higher bracket if you can avoid it.
How to Grow the Tax-Free bucket
Back in 1997, Senator William Roth introduced the original Roth IRA. In 2006, 401k’s came into the picture and allowed business owners to access tax-free growth. We may even see Roth SEP IRAs and Roth Simple IRAs available in the near future. Within the last three decades, a new savings vehicle has emerged with the possibility to grow retirement money completely tax-free. Imagine a point in your life when income taxes are not relevant because all of your savings are tax-free.
Right now, in 2024, the IRS allows each person to contribute up to $7,000 per year into a Roth IRA ($8,000 if over 50), if you are making less than $240,000 as a married couple. While that is nice, it may not inspire too many business owners who want to contribute ten times that amount to retirement each year. If you also set your retirement plan up at work to include a Roth 401k, you could contribute another $23,000 each year ($30,500 if over 50). Roth 401k’s do not have any income limit to contribute to, so the maximum contribution is available even if you make more than $240,000 this year. Even with only a few thousand in contributions each year, good financial planning is simply doing the small stuff right consistently over time.
More commonly, many current and former W-2 professionals have a significant amount of money in a pre-tax 401k. If today it is better to defer taxes, then we focus on other opportunities to fill the tax-free bucket, like Roth conversions and other strategies. Roth conversions let you take your Traditional IRA and convert it to a Roth IRA. If it is wise to pay the taxes on the conversion now, you can move significant chunks from the tax-deferred bucket into the tax-free bucket quickly. Many owners also contribute Roth money after all the deductible contributions are maxed out, like using the Backdoor Roth strategy. Talk with a professional about creative ways to grow your tax-free bucket.
What Is the Point?
Remember, the goal is to have a healthy amount in each bucket. The exact amount in each will depend on your ideal future. When the goal of retiring becomes a reality, you want to have the flexibility to choose which bucket of money you draw on. If you retire early, it’s helpful to pull from the taxable bucket. If you go part-time early in retirement and still make a good income, then drawing tax-free from the Roth IRA may be a good option. When you are fully into your new chapter in retirement, look into pulling out tax-deferred money when your tax rate is lower. Traditional or Roth accounts are a great way to tactically save thousands on taxes over your lifetime. At the end of the day, it is about the constant financial actions to reach your goals in life.
TC Falkner 