Retiring early is a goal for many business owners, but it can seem out of reach. However, with careful planning and strategic use of a 401(k), it is possible to retire earlier than you think.
Let’s discuss some strategies for making the most of this essential retirement savings tool on your path to early retirement.
Establish a 401(k) Plan
As a small business owner, you can set up a 401(k) plan for yourself and your employees fairly simply. Our simplified setup process makes it possible to create a new plan in minutes, without having to make a lot of difficult decisions. These plans come with plenty of benefits, both for employers and for employees.
To determine the best plan type for your circumstances, consult with a financial advisor or talk to one of our plan consultants.
Maximize Your Contributions
As a business owner, you can contribute to your 401(k) account as both an employee and an employer. Take full advantage of the contribution limits set by the IRS. As of 2023, the employee contribution limit is $22,500, and the total combined contribution limit (employee and employer) is $66,000 for individuals under 50 years old.
By maximizing your contributions, you can benefit from tax advantages, compound growth, and potentially accumulate a significant retirement nest egg. Keep in mind that contribution limits are subject to change, so it’s essential to stay updated on the latest IRS guidelines.
Consulting with a financial advisor or retirement plan specialist can help you determine the most effective contribution strategy based on your business’s profitability, your personal financial goals, and the specific features of your 401(k) plan. They can guide you through the contribution limits, plan design options, and any additional considerations for optimizing your retirement savings as a business owner.
Consider Profit Sharing
If your business is profitable, you can use profit-sharing contributions to maximize your retirement savings. Profit-sharing contributions allow business owners to allocate a percentage of the company’s profits to their employees’ retirement accounts, including their own. This contribution is made as an employer contribution and is subject to certain limits and guidelines set by the IRS.
Implementing profit-sharing contributions can be a win-win scenario for both the business owner and employees. It allows the owner to maximize their retirement savings while providing an additional retirement benefit to employees, which can help attract and retain talented individuals.
Keep in mind that profit-sharing contributions are discretionary, meaning they can vary from year to year based on business performance and profitability. It’s important to establish a consistent approach and communicate any changes to your employees.
Explore Roth 401(k) Option
An important consideration when using a 401(k) to retire early is the tradeoffs between pre-tax (Traditional) and post-tax (Roth) contributions. On the one hand, pre-tax contributions can be a powerful way for high-earning business owners to reduce their tax liability today and benefit from potentially lower tax rates during retirement. But, post-tax or Roth contributions can be valuable for owners that are interested in locking in a low tax rate today and receiving tax-free withdrawals during retirement.
Roth 401(k) accounts are not subject to required minimum distributions (RMDs) during the account owner’s lifetime. This provides flexibility in managing your retirement income and allows you to potentially preserve the Roth funds for future generations.
Determining whether a Roth 401(k) is suitable for your retirement strategy involves considering factors such as your current and expected future tax bracket, your time horizon, and your overall financial goals.
Diversify Your Investments
Ensure your 401(k) investments are diversified to manage risk and potentially increase returns. Consider allocating your funds across different asset classes, such as stocks, bonds, and real estate investment trusts (REITs), based on your risk tolerance and retirement goals.
Regularly review and rebalance your portfolio to maintain your desired asset allocation.
Create an Early Withdrawal Strategy
Depending on how early you want to retire, you may face some complications when attempting to access your retirement funds. At a high level, business owners won’t be able to withdraw funds from their 401(k) penalty-free until age 59.5.
That said, there are some exceptions and workarounds to this issue.
- The Rule of 72(t)
For example, Rule 72(t), also known as Substantially Equal Periodic Payments, is one way that business owners can access retirement funds early penalty-free. This option allows you to create a series of payments from your retirement plan to access funds early. But, there are very specific rules and guidelines you must meet to use this strategy,
According to the IRS, Under Section 72(t)(2)(A)(iv), if payments are made as a series of substantially equal periodic payments (called “SoSEPP”), the 10% additional tax may not apply.
- The Rule of 55
Next up, the Rule of 55 states that you can access your retirement funds penalty free if you retire at or after the age of 55. The rule states that employees must separate from service with their employer. So, for a business owner, that would mean fully stepping away from your business.
- Roth 401(k) Workaround
Lastly, business owners have some unique options with Roth 401(k)s during early retirement.
While there are penalties for early distributions from a Roth 401(k), there is a workaround to access your funds early without penalty. If you retire early, you can roll over your Roth 401(k) to a Roth IRA. And importantly, the full amount of your rollover is considered to be a “contribution” for withdrawal purposes. And this is important because, with a Roth IRA, you can always withdraw your contributions tax and penalty-free, regardless of your age.
So, assuming you need to access funds before 59.5, you could do a direct rollover from your Roth 401(k) to your Roth IRA, then access the full amount of the rollover penalty-free since it is considered a “contribution.”
However, there are some additional considerations with this strategy that owners should understand. Most importantly, Roth IRAs are subject to a 5-year rule. This means that the Roth IRA has to have been open for 5 years before you can withdraw earnings penalty-free. Keep this in mind when using this strategy, and consider the possibility of working with a qualified tax or investment professional to avoid any issues.
Seek Professional Advice
Managing a 401(k) and planning for early retirement can be complex. Consider consulting with a qualified financial advisor who specializes in retirement planning and has experience working with business owners. They can help you optimize your retirement savings strategy and navigate the regulations and tax implications associated with 401(k) plans.
Remember that retirement planning is a long-term endeavor, and early retirement requires careful financial management and saving. Start early, be disciplined with your contributions, and regularly review and adjust your retirement plan as needed.
