Most investors are familiar with the Roth IRA or a traditional IRA, but there are three other accounts that have vastly superior options for deferring income and lowering your taxes. This is also a great introduction to the two retirement accounts you can create if you own your own business or sole proprietorship.
Roth 401(k) Account
A Roth 401(k) is similar to a Roth IRA in that contributions are not tax deductible, but any future gains are tax free when withdrawn. However, you contribute more to a Roth 401(k) which has maximum contribution levels equal to a regular 401(k) account. Both the Roth IRA and the 401(k) are explained on this site. You can split your annual contributions between a regular 401(k) and a Roth 401(k) getting some tax deductions now and hoping to have nontaxable withdrawals in the future. This is permitted, if each of the contributions do not exceed the maximum employee contribution levels for the year, $19,500 for 2020.
I have not invested heavily with a Roth 401(k) because I am in a higher tax bracket and prefer to lock in the tax-free status on the money now with a regular 401(k). Tax laws change regularly and the federal government may decide in the future to tax the distributions from a Roth IRA or Roth 401(k). Tax laws are not set in stone and distributions that were not taxed can become taxable. I know my 401(k) withdrawals will already be taxed and when they are, I plan to have little or no wage income that would push me into a higher marginal tax bracket, so the tax paid on these withdrawals should be relatively low.
If you want to hedge you risk you can put half of your contributions in a 401(k) and half in a Roth 401(k). At the rate the U.S. national deficit is growing, it surpassed $25 trillion in 2020, taxes will be higher in the future to service this debt. Early retirement requires knowing about taxes which is covered in the book Become Loaded for Life! available on this website.
Simplified Employee Pension (SEP) IRA Account
Simplified Employee Pension (SEP) Individual Retirement Accounts (IRAs) are similar to traditional IRAs, but for individuals who are self-employed or own a small business. The contributions are made pre-tax and the contribution levels are significantly higher than a traditional IRA. In 2020 an employer could contribute up to $57,000 or 25% of the employee’s income, whichever is less. A business owner must contribute the same percentage of income for all employees, including themselves. The business owner cannot allocate 25% of their income to the SEP IRA, but only 10% for their employees, these percentages must be the same. A married couple who works in a business together with no other employees could each contribute the maximum amount shielding $114,000 of income from taxes. Yes, that is correct, you can shield $114,000 from taxes. Owning a business, even a small business can offer many tax advantages.
Solo 401(k) Account
If you and your spouse are the sole proprietors of a business, you can create a Solo 401(k) account with the option of having it function like a traditional 401(k) or a Roth 401(k). But, to remain eligible for the Solo 401(k) the business can’t have any other full-time employees than the sole proprietors, although part-time employees are permitted, but check relevant laws. One benefit of a Solo 401(k) is that they are relatively inexpensive to create and maintain but allow the proprietors to defer a significant amount of income from being taxed. In 2019 a sole proprietor could contribute up to $57,000 or 20% of their self-employment income, whichever is less. If you are over 50 years old there is a $6,500 catch up bringing the total to $63,500. Solo 401(k) are used by some small business owners to effectively invest in real estate. This is a great option to explore with a tax professional who is expert in this specific strategy. Many tax professionals are not familiar with this approach so take the time to find one well versed in this subject.