Taxes and Retirement Questions

[readytorock]

Hey guys,

Before starting my own business, I was a teacher for a non-profit agency for eight years. I made about $25k/year. In 2008 I co-founded my own business with a good friend, and my personal income for 2010 was $138k.

I’m a bit over my head with my retirement savings/investment knowledge for this much new money, so I’d like to ask a few questions:

#1. I can no longer contribute to my Roth IRA because my income is too high. I have about $3,100 in a Roth IRA account now. I purchased my first home this year (yes, I put 20% down ). Can I close this account and pull out that money penalty-free using the “up to $10k for first home purchase” clause? I would add that money to my brokerage savings or traditional IRA.

#2. I have a traditional IRA account as well. Can I still contribute to that regardless of my income? Because I own my own business, I do not have access to an employee retirement savings plan, so I wouldn’t have to worry about income limits as far as I understand it.

#3. I hope/plan to retire early at age 45. Currently I am investing the majority of my “retirement” savings into mutual funds in a brokerage account so I will have access to that money at age 45 with no penalties. Is there a better place for that money? Or if I want access to it at age 45, will it have to remain in a taxable account?

Some other information, because I know you guys always ask for it. I am 27. I am debt-free except for my house ($95k mortgage at 5.75%) and a school loan of about $7k at 2.5%. I have a fully-funded six-month emergency fund. I’m dating, no kids. My monthly bills are about $3k including mortgage payment, the extra income on top of that goes mostly to prepaying the mortgage (I shoot for $1,500 additional to principal per month to have it paid off 4 years from now), IRA contributions, brokerage savings and music (I love music). My personal net worth is about $100k, not including my stake in the company I co-own.

Any advice on the above questions would be appreciated. Thanks!

[KTP]

look into setting up a solo 401K for your personal business (called a self employed 401K). You can contribute pre-tax $16,500, plus you can also contribute 20% of the net adjusted profits from the company pre-tax. Net adjusted profits are gross income minus business expenses minus 1/2 self employment tax. I think the totally theoretical maximum you can keep Uncle Sam's greedy hands off of is $49,000/yr. This would go a long way toward your retirement goals and would also allow you to directly contribute to a Roth because of reduced MAGI.

[jIM_Ohio]

go to IRS website and search "small business retirement plans". You might also want to check pub 590 (I think I have that right) which goes over IRA rules. SEP IRAs, for example, might be an option.

Some of the choices depend on how much you commit to putting in (meaning if you want to shelter 40k that is much different than trying to shelter only 5k from income taxes).

[kork13]

I was thinking along the same lines as KTP, so I'll just say "I agree". Another option to consider would be the SEP-IRA, which at a glance is somewhat similar to the solo 401k. You should just look into the details and determine which is best for you.

In general, I would say you should split your savings between true retirement accounts (401k/IRA) and regular non-retirement accounts. Perhaps split your savings directed for retirement at 60% to non-retirement accounts, 40% to actual retirement accounts. Doing both, you can still gain some of the tax benefits of the 401k/SEP/Roth. Those will be set aside and waiting for you once you hit 59.5 years old. Until then, you will have the non-retirement accounts to use for your expenses once you retire at 45 (good luck in making that happen btw, it's an outstanding goal!).

ETA: Don't cash out the Roth IRA, even if it's an option. Leave it where it is, because even though it's a small amount, it'll still grow tax-free until you're old enough to withdraw it. In 40 years, just that $3,100 alone will have become over $45k tax free. Plus, when you have a slow year, or are able to reduce your taxable income, you may again qualify to contribute to the Roth, which you should definitely do. So leave the Roth as it is--it'll do fine on its own.

[KTP]

The OP would actually be able to shelter more money in a solo 401K than a sep IRA. The sep IRA has a contribution limit of 25% of net profits from your business, while the solo 401K has a contribution limit of 20% of net profits plus an additional $16,500 of income. For your $138,000 income, even if all of that was net profit, the SEP IRA would only allow a pre tax contribution of $34,500, while the solo 401K would allow you to pre tax shelter $44,100. If your net profit is actually less than $138,000, the difference is even greater.

Maybe I should try and get a job as a financial planner Might be a nice way for ME to get some self employment income.

[kork13]

Yet another excellent option: Roth IRA rollovers. Contribute to a traditional IRA, then roll it over into a Roth account. I haven't paid attention to the details (I don't make nearly enough for it to matter to me), but others here can explain the particulars. Biggest thing for your consideration is that there isn't currently an income limit on doing these rollovers, so it's essentially a back door into the Roth. That would be another way to make excellent use of the Roth account you have, and as young as you are, 30-40 years of non-taxable growth can be hugely advantageous for you.