Chances are, save for retirement has a near-permanent spot on your to-do list. You know saving for retirement makes sense, but deep down, your retirement plan is to live off (or sell) the business you are busy building today. As a serial entrepreneur, I get it. Saving for retirement is more of an insurance plan than a core strategy.
If that sounds like you, then the Roth 401(k) is ideal. It differs from a traditional 401(k) in that you do not get a tax deduction on contributions. But it also differs from a traditional plan in that you do not pay tax on your investment returns. And it gets better, especially for entrepreneurs: With one easy maneuver, you can eliminate the obligation to ever take distributions from it.
The retirement-account giant Vanguard says that nearly half of the 401(k) plans it handles offer a Roth option, but fewer than 10 percent of folks have signed up. My educated guess is that the pickup is equally slow among entrepreneurs. I think that's a big missed opportunity.
Roth Rules of the Road
Though there are income limits on who can make direct contributions to a Roth IRA, there is no such hurdle with the Roth 401(k). That provides a front-door opportunity for high-income entrepreneurs to create a tax-free income flow in retirement.
Besides, even if you are eligible to contribute directly to a Roth IRA (which means a modified adjusted gross income below $112,000 for individuals and $178,000 for married couples filing a joint tax return), the maximum you can set aside this year is just $5,500 if you are younger than 50, and $6,500 if you are older.
You can invest much more in 401(k)s. The base contribution limit to a 401(k) is $17,500 this year; anyone at least 50 years old can tuck away $23,000. Those are the same limits as with a traditional 401(k). Entrepreneurs under age 50 without employees (other than a spouse) can contribute as much as $51,000 this year in a special breed of these retirement plans called a Solo 401(k) or Individual 401(k). That's a whole lot more security building than $5,500.
The Later-Year Payoff
Come age 70 and a half, you must make annual required minimum distributions, or RMDs, from traditional retirement accounts, and those distributions are treated as ordinary income. That's going to boost your adjusted gross income, which could push your marginal tax rate higher. This year, as I probably don't have to tell you, the top marginal tax rate bumped up to 39.6 percent.
This is where the Roth 401(k) can be a great advantage for entrepreneurs. Let's say everything does play out as you expect, so you don't need to tap your retirement savings. With a traditional 401(k), you're out of luck. There's no way to get around those RMDs. But with a Roth 401(k), all you need to do is transfer the money into a Roth IRA before you reach age 70 and a half--there will be no tax bill for this move--and you completely circumvent the RMD issue.
That not only avoids unnecessarily boosting your adjusted gross income in your retirement years, but it also becomes a nice backdoor estate-planning tool. The money can keep growing untouched--and untaxed--for your heirs.
There is, of course, a big tradeoff. If you've been contributing to a traditional 401(k) or a SEP-IRA, the tax deduction on those contributions has been reducing your adjusted gross income, which plays into all sorts of other tax breaks. If you opt for the Roth 401(k), your adjusted gross income will rise, and that can potentially have a cascading effect on your current tax bill.
Having a trusted tax pro run some scenarios for you is vital. You may find contributing to both traditional and Roth accounts is a good compromise of short-term and long-term tax-planning goals.