03.13.24
Helping Small Business Owners Balance Financial Needs
by: Tyler De Haan
To combat inflation, the Federal Reserve (the Fed) has increased interest rates at a pace we haven’t seen since the early 1980s. Like the Fed intended, the higher interest rates make it more expensive to borrow money — leaving many large businesses to leverage their size and resources to find other means to pay for business-related costs.
However, small business owners often don’t have the same access to capital that larger businesses do, which can cause a tough dilemma: Do business owners put excess capital into their business, preserve it for potential operating costs in the future or save it for retirement? The following article provides insight on weighing the options and finding a financial balance for small business owners.
Opportunities for Roth IRAs
While many small business owners may delay saving for retirement to have readily available capital available for their businesses, this scenario may provide an opportunity for financial professionals to highlight their value to clients by discussing how a Roth IRA could help them keep excess capital on hand and save for retirement.
Roth IRAs differ from other pre-tax qualified accounts since contributions to a Roth IRA may be distributed tax- and penalty-free. A small business owner can contribute to a Roth IRA and then access the account balance for operating expenses if needed. This provides an extra layer of flexibility that a traditional IRA doesn’t allow.
However, some caveats need to be discussed before making these contributions. First, the tax-free distributions only pertain to contributions, and not earnings. This is where the five-year rule comes into play. To gain tax-and penalty-free distributions of the earnings, the account must be open for five years and the owner must be at least 59.5 years old. The second issue is high-net-worth — small business owners may not be able to contribute to a Roth IRA because of income limits. Two potential options can be considered for high-net-worth small business owners:
- Back-door Roth IRA: The owner contributes to a non-deductible IRA, and after 30 days makes a Roth conversion. This is a way for high-net-worth owners to put money into a Roth IRA. The caveat: While the conversion amount will come out tax-free, it could incur a 10% penalty if the Roth IRA five-year rule is not followed. The conversion amount starts a five-year clock — funds will not be able to be distributed penalty-free until after this period. However, this can get money into a Roth IRA and potentially provide flexibility in the future if capital is needed for a small business.
- SECURE 2.0 Act rules: SECURE 2.0 now allows for Roth SEPs and SIMPLE IRAs. This provision within the SECURE Act 2.0 became available in 2023. It’s important to note that many companies are still working on getting their systems ready to handle Roth SEPs and SIMPLE IRAs. Some companies may face delays to start handling these contributions. Speak with the financial company in advance to determine when they will be ready to coordinate Roth SEP contributions.
These new options may provide a flexible savings option for small business owners who would like to contribute to retirement, but have concerns about accessing future capital. As of today, all qualified distributions from a Roth SEP IRA are tax-free. Still, speak with a tax professional about any possible IRS rulings that may impact Roth SEPs, as they are a relatively new concept.
Distribution Ordering Rules to Consider
A distinct order of distribution is in place for Roth IRAs. In short, contributions come out first, then conversions, then earnings. This is important when you have a client who makes contributions and conversions. In addition, the five-year rule will be based on the account where the distribution originates. For example, if you have a small business owner who opened a Roth 401k 10 years ago, but then rolls that money into a new Roth IRA, the 10-year time frame does not follow. The 5-year rule applies to the newly opened Roth IRA, restarting the clock. It may be a good idea for a small business owner to open a Roth IRA and put a small contribution into it to start that 5-year time frame for any potential future rollover.
Laying Out Options for Small Business Owners to Consider
The Roth IRA is not new, but it can provide additional flexibility for clients seeking quick access to capital. While it may not be ideal to draw money from a retirement account, it does provide an extra layer of liquidity to assure small business owners that capital can be available in the future — if or when they need it.
Predicting future interest rates can be an exercise in futility; we just have no idea when they can change. However, we know that we will likely need funds to help pay for retirement expenses. We also know that saving early, often and over a longer period can help generate long-term wealth for retirement. Having access to liquidity can potentially ease the concerns of small business owners if they feel that access to capital could dry up in the future.
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