Small business owners 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 for business owners. With a variety of available accounts, and different tax rules that apply to them, 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. A financial advisor is typically focused on managing the money already in your account, not finding ways for you to contribute more. And tax preparers don’t typically specialize in retirement plan tax so they are not the best source either. Unfortunately, the tax implications of retirement plan savings straddle the two professions and thus tends 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 all. 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 five implications to consider:
The 401(k) Plan
Until a few years ago, the 401(k) wasn’t really an option for solo business owners due to high management fees, so they were typically relegated to using a SEP IRA. However, with growing popularity of the solo 401(k) and online discount brokers, the fees are now minimal or zero regardless of which account you set up. Outside of a few specific situations, almost all business owners will be better off with a solo 401(k).
Tax-Free Growth
The biggest tax advantage of a Roth plan, which also applies to 401(k)s and IRAs, is that 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 can pay tax on $10,000 today, and assuming that money triples in about 20 years, you’ll have $80,000 of tax-free money. If you use a traditional account, you get $10,000 of tax-free money today but you pay tax on $80,000 later.
After-Tax Contributions
When you work a regular W2 job, employers control the rules of your 401(k). 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). These are almost a third type of account for 401(k), however you should 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 convert the after-tax contributions to a Roth, you won’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)s let you contribute $19,500, plus any catchup contributions if applicable. After-tax contributions limit is $58,000 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)s 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, like non-qualified plans and defined benefit plans.
S-Corp 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) 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!
This article originally appeared on Forbes