6 Tax-Efficient Strategies for Business Owners Nearing Retirement

Small business owners nearing retirement often encounter distinctive financial planning challenges. Beyond the expense and administrative hurdles involved with setting up a retirement plan, business income tends to be unpredictable.

This variability, combined with the ongoing demands of the business, can make it difficult to consistently save for future goals. As a result, many business owners find themselves playing catch-up as they approach their target retirement date.

Fortunately, there are a variety of tax-efficient strategies small business owners can leverage to boost their savings. In this article, we’ll explore these strategies in detail, providing a clearer path forward for anyone looking to maximize their financial resources in retirement.

Here are 6 tax-smart strategies for small business owners nearing retirement:

#1: Safe Harbor 401(k)

A Safe Harbor 401(k) Plan is a special type of 401(k) plan that allows business owners to maximize their own 401(k) contributions by ensuring the plan passes certain non-discrimination tests. To qualify, an employer must make contributions on behalf of all eligible employees, regardless of whether they contribute themselves.

One of the benefits of a Safe Harbor plan is that contributions are immediately 100% vested. In addition, the tax benefits of these plans can be substantial, particularly for small business owners nearing retirement.

For example, employer contributions are tax-deductible, thereby reducing the taxable income of the business. And, like a traditional 401(k) plan, contributions grow tax-deferred in the plan, and taxes are only paid on withdrawals.

However, keep in mind that while a Safe Harbor plan simplifies compliance with IRS testing requirements, it still requires diligent plan administration and record-keeping. Additionally, because employer contributions are mandatory, you should carefully consider the financial implications before adopting a Safe Harbor plan.

#2: New Comparability 401(k) Plans

For small business owners nearing retirement, particularly those who are older and higher paid, a New Comparability 401(k) Plan can be an effective tool for maximizing retirement contributions. Often referred to as a “cross-tested” plan, these plans are designed to be more flexible in how employers allocate contributions among their employees compared to a traditional 401(k) plan.

The primary advantage of these plans is that older, higher-paid employees (often including the business owner) can receive larger contributions, allowing for accelerated retirement savings. Since these individuals have fewer years until retirement, they’re allowed to “catch up” more aggressively under plan rules.

In addition, employer contributions are tax-deductible, thereby reducing the taxable income of the business. And, like a traditional 401(k) plan, contributions grow tax-deferred in the plan, and taxes are only paid on withdrawals.

However, unlike standard 401(k) plans, New Comparability 401(k) Plans tend to be more complex to administer and may have higher administrative costs. Moreover, the plan must pass annual non-discrimination tests, which can be complex and administratively burdensome.

#3: Cash Balance Plan

For small business owners with high income and the capacity to make large contributions, cash balance plans offer a way to rapidly accumulate retirement savings in a tax-efficient manner.

A cash balance plan is a type of defined benefit retirement plan that has characteristics of both traditional pension plans and defined contribution plans. Each plan participant has a hypothetical account that grows annually through company contributions and interest credits.

Upon retirement, participants receive the balance in their account, which can be taken as a lump sum or converted into an annuity. In the meantime, funds grow tax-deferred within the plan until the participant is ready to take distributions.

One of the advantages of a cash balance plan is that they allow for significantly higher contributions compared to traditional 401(k) plans, especially for older employees. This benefit makes it a powerful tool for small business owners nearing retirement to accelerate savings over a short period.

In addition, any contributions the business makes to the plan are tax-deductible, providing substantial tax savings. This can be particularly beneficial for high-income business owners looking to reduce their taxable income.

It’s important to note that cash balance plans are subject to regulatory requirements and must meet certain funding standards. Moreover, these plans can be more complex and costly to administer than defined contribution plans.

Lastly, as a business owner, you must commit to making annual contributions to the plan, which can be substantial. Be sure to consult with a financial advisor like Milestone Asset Management Group to determine if a cash balance plan is suitable for your financial situation and goals.

#4: Health Savings Account (HSA)

A Health Savings Account (HSA) is a tax-advantaged savings account designed for individuals with qualifying high-deductible health plans (HDHPs). For small business owners nearing retirement, an HSA can be an excellent tool for boosting savings and preparing for future healthcare costs in a tax-efficient manner.

HSAs offer the unique benefit of triple tax savings: deductions when you contribute, tax-free growth, and tax-free withdrawals for medical expenses. This includes a wide range of costs, from prescriptions and doctor’s visits to dental and vision care.

As healthcare costs often increase with age, an HSA provides an efficient way to save specifically for these expenses. Plus, after age 65, you can withdraw HSA funds for any purpose without the 20% penalty.

Like a traditional IRA, withdrawals for non-medical expenses are subject to ordinary income tax. However, unlike traditional retirement accounts, HSAs don’t have RMDs, allowing funds to grow tax-free indefinitely.

#5: Roth Conversion

A Roth conversion can be a strategic move for small business owners nearing retirement, especially those who expect higher tax rates in the future or want to leverage the tax-free growth and withdrawal benefits of a Roth IRA. This strategy involves transferring funds from a traditional IRA or other tax-deferred retirement account into a Roth IRA.

With a Roth conversion, the amount you convert increases your taxable income for that year. Therefore, you’ll need to have free cash available to pay the taxes due on the conversion without dipping into your retirement funds.

The main advantage of this strategy is that earnings and distributions from a Roth IRA are tax-free, so long as you’re at least 59½ and meet the five-year rule. This provides more flexibility in managing your income and taxes in retirement.

Furthermore, unlike traditional IRAs, Roth IRAs don’t have RMDs during the account owner’s lifetime. This can be crucial for business owners who may not need to tap into their retirement funds at a certain age and prefer to leave the money invested.

A Roth conversion can be a powerful tax planning tool for small business owners nearing retirement. However, this complex strategy may not be right for everyone. Be sure to consult with a trusted advisor to ensure a Roth conversion is in line with your financial objectives.

#6: Hiring a Spouse

Finally, hiring a spouse can be an efficient way for small business owners to boost retirement savings while providing immediate tax benefits to the business. However, you must do this carefully and in compliance with tax laws.

If your business has a qualified retirement plan like a 401(k) or profit-sharing plan, employing your spouse allows each of you to contribute to the plan up to the allowable limits. This effectively doubles the amount you can contribute each year.

In the case of a profit-sharing plan, your business can make contributions to your spouse’s retirement accounts. The contribution limits for these plans are often higher than those for individual retirement accounts, allowing for potentially significant tax-deferred savings.

By earning income from your business, your spouse may also be eligible to contribute to an individual retirement account (IRA), further increasing your collective retirement savings. Meanwhile, paying a spouse a salary can also help them accumulate Social Security credits, which could result in higher benefits upon retirement.

It’s important to note that your spouse’s compensation must be reasonable for the work they perform. In other words, you can’t inflate it just for tax purposes. Be sure to keep proper documentation of their role and duties in the business to stay compliant with tax laws.

Milestone Asset Management Group Offers Personalized Strategies for Small Business Owners Nearing Retirement

For small business owners, navigating the path to a secure retirement requires proactive and strategic planning. By leveraging tax-efficient strategies that align with your needs and objectives, you may be able to significantly boost your savings as you approach your retirement years, paving the way for a more comfortable and fulfilling retirement.

Milestone Asset Management Group specializes in the unique tax and retirement planning needs of busy professionals and small business owners. Our team of experts can help you develop a comprehensive financial plan that aligns with your financial goals. Contact us to begin your financial journey.