We know you should be saving for retirement and you know that there are (way too many) options. Your co-working space neighbor even said that she opened an IRA online and it was super easy, so you smile, nod, and commit to check it out because it is a step in the right direction. Wait, but what is an IRA actually? Are you even eligible? Which one should you choose? Like most things in the US tax world and small business the answer is, “it depends”. Like a philips or a flat head screwdriver each IRA fits the tax screw in a slightly different way.
Here is the nutshell version. An IRA is a retirement account that should have a tax benefit. Tax money saved is just like money earned now or later and we all like to earn more money (especially easy money). The tax benefit either comes now (Traditional) or later (Roth). As a general rule everybody can contribute the smaller of $5500 or their taxable compensation each year to either Roth or Trad (or a combination of both). If you do make too much for either one than there are tricks that add steps but work to get you the same or similar tax benefits (at least as of the date of this article).
Traditional IRA – The Trad IRA reduces your tax NOW with a current period deduction so it is akin to the pre-tax deductions for your old 401(k) or 403(b) retirement plan when you were employed. However, now that you are self-employed, you actually see the money first then you contribute the bucks just before the filing deadline and get an immediate tax bang in the form of a reduced tax bill. Oh. Yeah. Your $5500 contribution now only cost $4,125 if it works the way it should (assuming 25% tax bracket).
You only getting this tax benefit if your income is low enough to allow your contribution to be deductible (link here), this means it shows up on your tax return front page as an adjustment to your income. This adjustment makes it the right tool if your goal is to keep your AGI low for any reasons (like tuition or financial aid). However, if you can’t deduct the contribution than you should not use a Trad because you are losing the tax benefit
PRO TIP: Because you are a small business owner you can get an immediate tax benefit by using another “tax deferred" style of retirement account (like a SEP) that will duplicate the traditional IRA benefits while you use your annual IRA allowance to cash in on Roth benefits.
Roth IRA – With the Roth you get nothing now but you keep everything later. You pay the tax on $1000, put it in the Roth, let it grow for 30 years, then take out $3000 totally tax free when you retire. We don’t know what the tax rate will be in 30 years but you won’t be paying it.
HISTORY: Senator William Roth had an idea to boost the Federal budget by reducing the use of traditional IRAs so that the government would be able to spend tax money sooner than later. Favorably to you, it worked. Now the government will now have to pay you by giving up the tax when you retire because all those earnings (growth, dividends, etc.) will be coming out of your Roth and filling your sails (tax free) while you watch the sunset shine through Old Glory waving behind your sailboat.
A benefit to having tax free income when you retire is that you might just keep more of your Social Security income free from tax. A little more history tells us that ALL Social Security used to be tax free but then the changed it to “save social security”. Now, if your other income is more than $34,000 on a single return or $44,000 on a joint return, up to 85% of your benefits could be taxed. We won’t speculate (here) what it is going to take to “save social security” once the silver tsunami baby boomers have been collecting for a few years.
If you are considered a high-income earner and your Roth allowance starts to phase out at $118k and once your AGI reaches $133k then you are not allowed to make direct Roth contributions. This is where the Back-Door Roth comes in handy.
Back-Door Roth – This little tax trick allows those who earn more than the Roth AGI limits (and pay more taxes) to avoid being discriminated out of their $5500 annual IRA allowance. This can be done because there is no income limit when you convert Traditional IRA funds into a Roth IRA funds. So, by making an otherwise lame duck non-deductible traditional contribution with your allowance and immediately converting it to a Roth you get your annual gift with a little tax swagger.
PRO TIP: Combinations. Speaking of saavy, if you know what income level you are shooting for than you can tailor your tax return with Traditional IRA contributions and take the rest in Roth. For example, if you kid’s school gives you a 20% tuition discount if your AGI is $50k or under and you make a $55k salary, you can contribute $5k to your Traditional and $500 to your Roth. Now you have your tuition discount AND your full $5500 annual gift from Uncle Sam. Cha-Ching!
Summary – It is never too soon to start saving for retirement so try to use some or all of your annual IRA allowance even when it feels like you need the cash as a security blanket for your new business. Talk to a lender about emergency options and a tax adviser to see if you can get the best of both worlds to balance the need for cash and the need to invest. Spend the time to plan and allow your business to pay you (for your IRA) first to feel more stable during the ups and downs of small business ownership.