Because it is tax-FREE when you need it.
All of the plans we’ve discussed in part 1 and part 2 assume that you’re better off taking a tax deduction for plan contributions now, then letting plan assets accumulate tax-free over time. When you need them for retirement, then you pay tax on withdrawals, at ordinary income rates.
That’s a great strategy if your tax rate is higher now than it will be in retirement. You benefit now by avoiding tax on contributions, which puts more to work for you today. And you benefit later by paying less tax on withdrawals.
But that traditional pattern doesn’t always hold true.
Maybe you’re young, just starting your career, and your income is low.
Maybe you’re transitioning from one career or business to another, and your income is temporarily low.
Maybe you think that tax rates in general will rise. Click here for our thoughts on higher income tax rates in the near future.
Today’s top marginal rate for federal taxes may seem high at 37%, but that’s actually quite low by historical standards. Sometimes, contributing to a traditional retirement plan creates a ticking tax time bomb and actually costs you money over the long run.
Therefore, here are two groups of alternatives you might consider if standard qualified plans don’t fit the bill.
Group I – ROTH Accounts
“Roth” accounts take the traditional defer-now, pay-later arrangement and turn it on its head.
1. Roth IRA
The basic Roth IRA doesn’t give you any deduction for contributions you make today. But your withdrawals are generally tax-free so long as they’ve “aged” at least five years in the account.
Tax-free income sounds great, right? However, contributions are limited to $6,000 per year, with catch up to $7,000 if you’re 50 or older. Additionally, you can’t contribute at all if your income is over $139,000 for single filers, or $206,000 for joint filers.
If your income is above those limits, you can still fund a Roth by contributing the maximum to a nondeductible traditional IRA, then immediately convert it to a Roth.
If you sponsor a 401(k), you can choose to designate your salary deferrals up to $19,500 as “Roth” deferrals. You won’t get any deduction today, but your withdrawals down the road will be tax-free. (Any employer contributions will continue to be treated as deductible now and taxable later.)
2. Roth Solo 401K
This option is not tax-deductible, but you can withdraw the money tax-free in retirement. Given the national deficit and debt level, it is more likely than not the tax rates would rise in the future. If you think that is the case, this may make sense for you.
Pro:
Similar to a Roth IRA, your contributions to a Roth solo 401(k) are not tax-deductible, but you can withdraw the money tax-free in retirement. Having a pot of tax-free money to tap in retirement can be particularly helpful if most of your savings are in tax-deferred 401(k)s and traditional IRAs, and if your income is too high to contribute to a Roth IRA – there are no income limits to be able to contribute to a Roth solo 401(k).
Con:
The contribution rules for the Roth solo 401(k) are tricky: You can only have a Roth solo 401(k) option for the $19,500 in employee contributions (or $26,000 if 50 or older). If you make employer contributions too (the 25% of net income from self-employment), those must be traditional contributions – which are tax-deductible now and then taxable when withdrawn.
You also have to do some researches as not all administrators offer a Roth version of the solo 401(k).
3. Roth SEP
If you have a SEP, you can create a backdoor “Roth SEP” by making a deductible SEP contribution, then immediately converting it to a Roth. Roth conversions in general are a subject for another book – I just want you to be aware that the possibility exists.
4. Roth SIMPLE
You can do the same thing with a SIMPLE, but you have to wait at least two years from the time you contribute the money until the time you convert it to a Roth.
Group II - Insurance
Permanent life insurance policies that include a cash value can offer several significant tax breaks for supplemental retirement savings. There’s no deduction for premiums you pay into the contract. But policy cash values grow tax-deferred. And you can take cash from your policy, tax-free, by withdrawing your original premiums and then borrowing against remaining cash values.
You’ll pay nondeductible interest on your loan but earn it back on your cash value. Many insurers offer “wash loan” provisions that let you borrow against your policy with little or no out-of-pocket costs.
“Whole life” resembles a bank CD in a tax-advantaged wrapper, with required annual premiums and strong guarantees. Remember when we said the defined benefit pension was your father’s pension plan? Well, this is your father’s life insurance.
“Universal life” resembles a bond fund in a tax-advantaged wrapper, with flexible premiums but less strong guarantees.
“Variable life” lets you invest cash values in a series of “subaccounts” resembling mutual funds in a tax-deferred wrapper. You can choose “variable whole life” with required premiums and stronger guarantees, or “variable universal life” contracts with flexible premiums and less strong guarantees.
These advantages aren’t completely unlimited. If you stuff too much cash into the policy in the first seven years, it’s considered a “modified endowment contract” and all withdrawals are taxed as ordinary income until you exhaust your inside buildup.
Insurers offer three main types of cash-value policies with three different investment profiles to suit different investors. The key is finding a policy that matches your investment temperament:
I’m not here to make you an expert in retirement plans or alternatives. My goal is simply to open your eyes to the wide variety of plans and options so that you, as a tax-smart business owner and investor, can evaluate if the plan you have now is really the right plan for you. I also want to keep you from falling into the common trap of assuming that deferring today’s income is always the right retirement planning strategy.