If you’re planning a trip or a wedding, presumably, that plan comes to fruition once you’ve set sail or said your “I do’s.” But if you’re planning for retirement, the finish line isn’t actually retirement. So, sure, you have to plan for what leads up to retirement, but you also need to consider retirement plan distributions, rollovers, conversions, and related tax consequences after you retire.
According to the latest data from the Bureau of Labor Statistics (BLS), 18.9% of the US population aged 65 or older is still in the labor force. Still, even if you can retire at 65, the SSA estimates, on average, you can expect to live about another 20 years.
A study by GOBankingRates found that the average retirement age in Massachusetts is 66; the annual cost for a comfortable retirement is $77,122; and the total retirement savings needed is $1,079,710. So a tax-efficient approach is vital in every stage of retirement planning, especially for small business owners.
Retirement Plans for Small Business Owners
Small business owners have additional considerations based on the types of retirement accounts available to them. And the ones that are viable options do not always offer the same level of benefits and plan administration as their larger employer-sponsored counterparts.
Some of the most common plans small business owners participate in include Traditional Individual 401(k)s, Roth Individual 401(k)s, Roth IRAs, Simplified Employee Pensions (SEP-IRAs), and Savings Incentive Match Plan for Employees (SIMPLE-IRAs).
Retirement Plan Distributions & Withdrawals
Under all the plan types above, any earnings, capital gains, or dividends are not taxed as long as they remain in the account. Except for Roth accounts, you can expect to pay ordinary income tax on any taxable distributions.
A “distribution” occurs when you receive money from a retirement account after you’ve retired. A “withdrawal” occurs when you take money out before reaching the age of 59½. As such, withdrawals are also referred to as “early distributions.”
Most early distributions are subject to income tax plus an additional 10% early withdrawal tax. When an early distribution is made, the IRS typically requires a 20% mandatory withholding tax. If the withholding does not cover your entire tax liability, the remainder will be due when you file your income tax return.
Required Minimum Distributions
With traditional retirement accounts, you defer paying taxes until you take retirement plan distributions during retirement. Once you reach a certain age (72 for taxpayers born after July 1, 1949), you must take required minimum distributions (RMDs) from your tax-deferred accounts. The amount is determined based on the balance in your account and your IRS-determined life expectancy during the distribution year.
With Roth retirement accounts, RMDs are not required during the owner’s lifetime. As long as you have had the account for more than five years, distributions from your Roth account are tax-free and penalty-free (if taken after age 59½). So you won’t see the tax break on the front end when you make contributions, but retirement distributions, including any gains from your investments, are not taxed. Roth retirement accounts are often used in estate planning, as your account can grow tax-free for your heirs.
The Tax Situation & Your Income for the Year
RMDs are included in your annual taxable income and will factor into your tax bracket. So when you add your RMDs to your income from other sources, they could put you into a higher marginal tax bracket. While you won’t pay higher taxes on your income from other sources, you will pay a higher rate on the retirement plan distributions.
You are allowed one tax-free rollover per tax year. So it’s an opportunity to move money from a Roth 401(k) to a Roth IRA, for example, without paying taxes on the distribution. However, a rollover can be taxable if the money is sent to you as opposed to the financial institution. There are often other ways to minimize the taxes due as well. For example, you may be able to use capital losses on some investments to offset capital gains on others.
When considering whether to convert some or all of a Traditional IRA to a Roth IRA, you need a clear view of the entire picture. A common draw for conversions is that, after the initial event, you won’t have to worry about paying taxes on that IRA for qualified distributions, even if future tax rates are higher. But the conversion itself is a taxable event and could trigger a significant tax bill.
In addition, the money must stay in the Roth IRA for five years after the year you make the conversion before you can take a tax-free distribution. Depending on your circumstances, keeping those savings in a Roth 401(k) could be a better option. Taking money out before the five-year period ends could leave you paying an extra 10% penalty on the entire distribution, not just the amount you converted.
Managing Expectations & Reality
According to Gallup’s research, 49% of non-retirees expect to rely on retirement accounts like 401(k)s and IRAs as a major source of retirement income. But only 35% of retirees report they are actually relying on the same. In addition, 38% of non-retirees expect to rely on Social Security as a major source of retirement income. But a whopping 57% of retirees report they are relying on the same.
Because the Trustees of the Social Security and Medicare trust funds project the Old Age and Survivors Insurance Trust Fund (which funds retirement and survivor benefits) will become depleted in 2034, the disparity between expectations and reality is an eye-opener. And that’s one of the reasons why small business owners need a CPA by their side that understands small business and individual taxation, general retirement planning, and post-retirement planning.
Contact Smith, Sullivan & Brown
At SSB, our tax professionals work with small business owners to develop retirement planning tactics ahead of and throughout their retirement. Whether you have general questions or are considering the tax consequences of retirement plan distributions, RMDs, rollovers, or Roth conversions, we want to help you determine a tax-efficient solution for your situation. Contact us today to learn more.
Maureen Sullivan, CPA is a Partner at Smith, Sullivan & Brown. Maureen manages the firm’s small business and individual accounting and tax services. She is also responsible for supervising the SSB’s peer review program and ensuring the firm’s compliance with industry-wide standards.