Meet Carl and Mary. They are a hardworking couple in their early 50s who own their own business and juggle a busy life that includes their three kids.
Over the past 20 years, Mary and Carl have been very disciplined in setting aside money in savings and their 401(k) and have purchased a partial ownership in the building where their office is located. However, they didn’t realize they were missing out on some very basic, but quite beneficial planning strategies.
Putting the kids on the payroll // When Carl and Mary’s kids were in their early teens, they began asking about getting part-time jobs. Carl and Mary’s recruiting business had grown to the point that they could use some administrative help. However, Mary and Carl were a little hesitant about hiring their kids to assist with those office tasks. They had always kept home and work separate.
However, they soon realized the benefits. First, they would be paying their children versus bringing on a new employee to perform these various tasks.
Since Carl and Mary’s firm is a Subchapter S Corporation, they must withhold FICA (Social Security and Medicare) taxes, but their children’s wages ($6,000 each) did not create any federal income tax liability and only $90 in state tax. In addition, Mary and Carl were able to establish Roth IRAs for their children. Money was set aside that will grow tax-free for the next 50-plus years, which should provide the kids the foundation for a secure retirement.
Lastly, it exposed the children to a professional work environment and may actually result in one or two of them entering the family business. It is interesting to note that if Carl and Mary’s firm was established as a sole proprietorship, the children’s wages would not have been subject to FICA and Medicare taxes.
Maximizing the tax benefits of a 529 plan // In planning for future college expenses, we opened 529 accounts for each child, and for Carl and Mary as well. As a married couple, they contributed $6,000 to each beneficiary’s account, so they could claim the maximum deduction under Kansas law—$6,000 per 529 account.
By doing this, Carl and Mary were able to set aside a total of $30,000 annually (which can be used by any family member for college expenses) and reduce their Kansas tax liability by $1,470 under current tax rates. Originally, they had planned to only fund the children’s accounts. However, they realized that by opening accounts for themselves as well, they could obtain their goal of fully funding each child’s college education, while reducing their Kansas taxable income by an additional $12,000 and respective tax by $588 per year.
Backdoor Roth IRAs // Due to the success of their business, Carl and Mary were in the highest tax bracket, so they were not able to contribute to Roth IRAs and lost deductions that most other taxpayers counted on. They had the vast majority of their retirement funds within the firm’s 401(k) profit-sharing plan, but they also had some IRA rollover accounts as well. Under this current arrangement, they could have converted their IRA rollovers to Roth IRAs, but the tax hit would have been huge, resulting in them giving up almost one-half of the account balances to taxes. Not wise.
To address this, they amended their 401(k) plan to allow for IRA rollovers into the plan. Upon rolling each of their IRAs into their respective 401(k) accounts, Carl and Mary no longer had pre-tax money in IRAs outside of their firm’s 401(k). With these old IRAs zeroed out, they started over from scratch and began making non-deductible/after-tax contributions into them.
Within days of funding these non-deductible IRAs, they converted them to Roth IRAs. In doing so, they owed no taxes on the Roth conversions. This is the result of these non-deductible IRAs being funded with after-tax dollars, and due to the expediency of their conversions, they had no gains on their contributions.
Thus, annually, Carl and Mary are able to set aside an additional $6,500 each into tax-free Roth IRA conversion accounts. As long as they refrain from accessing their accounts for at least five years from the date of each respective conversion, then any future withdrawals up to the combined amount of their contributions will be tax-free.
Carl and Mary don’t plan to access these accounts until retirement, which won’t be until their early to mid-60s. At that time, they will be able to access these Roth IRA accounts tax-free or eventually pass them onto their children tax-free as well. Either way, it is a planning strategy that eludes most small business owners.
These strategies helped Carl and Mary, and they might work for you, too. But it’s important that you seek advice from your tax or legal professional to verify that’s the case.
