I used to buy into the concept that we either still buy into or are changing our opinions of. The concept of a retirement plan, at least when I learned tax, for the self-employed was to sock as much money away into these plans during your income-earning years when your tax bracket is higher. And then when it comes time to retire, you take the money out of retirement, and your income tax bracket is lower.
However, after all of those years, laws have changed, and we now have plenty of retirement plans.
The Roth IRA was introduced, which made withdrawals tax free. In the beginning a Roth had certain adjusted gross income (AGI) limitations. What followed was an evolution with Roths for those who were self-employed. You could open either a Solo 401(k) or a Safe Harbor 401(k). These plans allow for the best of both worlds. You could, through salary deferrals, put the maximum amount into the Roth portion of the 401(k), and then match your salary by 25 percent, which is deductible to the company. The contribution limit between the Roth salary deferral and 25 percent match, though, could only be $54,000.
Then we invented backdoor Roths, in which a person would open a new IRA account, make a non-deductible contribution to a traditional IRA and then convert it to a Roth the following day. The result of this transaction was tax free.
Somewhere along the way, the government needed money and made it advantageous to convert a traditional IRA to a Roth IRA. In the conversion, the government received tax money.
Outside of defined-benefit plan (DBP), which can only be used for some businesses, I have changed my mind about retirement plans based on several factors. First of all, I read an article that said 60 percent of all expenses paid by retirees were healthcare related. As a consequence, I began giving the advice for clients to maximize Health Savings Accounts (HSA) — even if the client was healthy.
HSAs can be invested in securities, and if you don’t use them, they just roll over and earn money tax free. When you use the HSA, provided it is for medical expenses, it is tax free. The other way around, you would have to take money out of your IRA to pay these expenses, and that withdrawal would be taxable.
Then we have the fact that over the past 20 years the tax laws have been changed three times, with rates going up or down. I am 45 years old and who knows where the tax rates will be when it is time for me to retire. I would be a horrible tax professional to give the same ole advice that I gave 20 years prior when there are so many options.
Now if you have a client who is in a tax situation, the sound advice to give them is a DBP. A DBP works by letting the client decide how much money they want to retire on. Based on the client’s age and other factors, an actuary determines the life of the plan and the amount that the client needs to contribute each year to the plan. The most that can be contributed to the plan is $250,000. Conceivably, your client can pay themselves $250,000 and contribute the same to the DBP.
There are some downsides to a DBP. First of all, the old rule is that what you do for yourself you have to do for your employees as well. With a DBP, you have to contribute a lesser amount to the most senior employee on your staff. The other caveat is that if you have a down year and cannot make the contribution to the plan, there is a 10 percent excise tax that you have to pay.
As you can see, there are many choices when it comes to retirement plans. Whether you still believe the old advice, or take a different approach, there are tons of options.