Roth Conversion Ladder Alternatives For Small Business Owner + Other Items

[mr_orange]

Situation:

-Income is generally around $500k; $200k or so W2 and $300k or so business income with the latter amount growing
-Business income is expected to rise going forward and W2 income is expected to largely be level and go to zero when we/I quit.  This could be stair-stepped down since my wife and I each work
-Business income from real estate could probably largely be structured as carried interest for long-term capital gains treatment if planned properly
-We're easily able to fund all tax-deferred accounts to the max, HSAs, etc. 
-We currently contribute to a Roth 401(k) through our employers at the max annually
-We currently fund our HSA maximally
-We're about 83% of the way to "W2 FIRE" and plan to continue working on our businesses afterward (yes, I am a glutton for punishment)
-I'm able to take any non-matched, tax-deferred items either through our employer or through our small business.  The former is easier mechanically and the latter gives us more flexibility about how to invest the funds
-Roth and Traditional are roughly evenly funded right now.  Each has about the same amount of cash

Assumptions:
-Businesses will be held in perpetuity
-Income from businesses expected to rise over time in perpetuity (assumed, but far from certain)

Questions:

1.  Does it make sense to convert contributions to a traditional 401(k)?  We'd get the tax benefits now, but our income is likely to continue to rise annually for the rest of our lives if our business ventures go as expected.  I don't see how the conversion ladder would work given this.  We also expect for our tax rates to be higher later on, but largely be capital gains instead of earned income

2.  What happens to the HSA dollars if we end up over-funding it and need to use it before "retirement age"?  Assume we can't use it for medical expenses and we end up needing it prior to the time when it could be withdrawn without penalty.  What is the penalty?  Would we just need to structure the rest of our portfolio to make sure these are the last dollars drawn such that the penalty isn't a risk?

3.  Should we start only contributing the minimum matched through our employer's plan and the excess through our small business plan instead?  A SoloK historically has increased our tax rate because we'd have to convert the business income to ordinary income to contribute and thus this has been a constraint.  I wonder if being able to self-direct the funds to real estate ventures from my syndicator buddies would be worth taking the small tax hit though

I am probably leaving out information you need so if you quiz me I will edit the thread and add it to this entry with information below so it is all in one place for future readers.  Thanks in advance for any help or guidance you can provide. 

[seattlecyclone]

1.  Does it make sense to convert contributions to a traditional 401(k)?  We'd get the tax benefits now, but our income is likely to continue to rise annually for the rest of our lives if our business ventures go as expected.  I don't see how the conversion ladder would work given this.  We also expect for our tax rates to be higher later on, but largely be capital gains instead of earned income

Traditional contributions make sense for the folks who plan to reduce their tax bracket in the future. The Roth ladder is the way you convert those contributions into penalty-free cash later. But if you don't believe your tax bracket will be lower later, you might as well make Roth contributions now and save yourself the hassle.

On the other hand, what if your business ventures don't go as expected? By contributing to a traditional retirement account you may end up paying a bit more tax if the business succeeds than you would have with a Roth, but in that scenario you have plenty of money anyway so it's not a catastrophic error. If the business fails, having the ability to defer some tax from a high-bracket year to a lower-bracket year could be a good hedge against a downturn in your business.

Also consider that your current income puts you right around the threshold of the highest tax bracket, depending on deductions and such. If you are over that line, the only way you lose by contributing to traditional is if you remain in the top bracket and Congress increases tax rates.

2.  What happens to the HSA dollars if we end up over-funding it and need to use it before "retirement age"?  Assume we can't use it for medical expenses and we end up needing it prior to the time when it could be withdrawn without penalty.  What is the penalty?  Would we just need to structure the rest of our portfolio to make sure these are the last dollars drawn such that the penalty isn't a risk?

Prior to age 65, you pay your tax bracket plus 20% on non-medical withdrawals. After 65, the 20% penalty goes away but you still pay your regular tax on it. The penalty is only 10% for retirement accounts so you may want to plan on making early withdrawals from those first if necessary.

3.  Should we start only contributing the minimum matched through our employer's plan and the excess through our small business plan instead?  A SoloK historically has increased our tax rate because we'd have to convert the business income to ordinary income to contribute and thus this has been a constraint.  I wonder if being able to self-direct the funds to real estate ventures from my syndicator buddies would be worth taking the small tax hit though

That would be a question for a CPA who has experience with clients with larger amounts of business income, who knows more about the tradeoffs between corporate income, personal income, or whatever the options are in your situation. You could potentially shelter quite a bit of income pre-tax with a solo 401(k), but you'll have to weigh that against whatever the difference in tax rate on the rest of the income would be.

[mr_orange]

Thanks.   This is very helpful.

The problem is that I can't predict the future ;-).  If only I could do that planning would be easier. 

Perhaps I could contribute half of the money to a Roth 401(k) and the other half to a traditional one since it seems like a toss-up.  Or....I could contribute to the Roth 401(k) up to the employer match for now and contribute the rest to a business 401(k) instead.  The main problem with funneling money to the business 401(k) is declaring the money earned income to make it eligible for contribution. 

Does an employer plan normally allow you to contribute X to Roth 401(k) and 1-X to traditional 401(k)?

[beltim]

Thanks.   This is very helpful.

The problem is that I can't predict the future ;-).  If only I could do that planning would be easier. 

Perhaps I could contribute half of the money to a Roth 401(k) and the other half to a traditional one since it seems like a toss-up.  Or....I could contribute to the Roth 401(k) up to the employer match for now and contribute the rest to a business 401(k) instead.  The main problem with funneling money to the business 401(k) is declaring the money earned income to make it eligible for contribution. 

Splitting contributions is a fine strategy to hedge your bets.  I would suggest taking into account your current balances, though – i.e. if you're 100% in Roths now, then it might make sense to contribute more to traditional accounts for a while.

Does an employer plan normally allow you to contribute X to Roth 401(k) and 1-X to traditional 401(k)?

I don't know about "normally" but plans that I've seen that allow both Roth and traditional 401k's do generally allow you to contribute like that.

[mr_orange]

Looking at my balances now the Roth and Traditional are roughly funded evenly.  I'll add this information to the first post as well. 

[beltim]

It occurs to me another consideration is whether you'll have the small business in perpetuity or whether someday you'll retire from that as well.  If someday you plan to sell, that pushes the needle to traditional accounts.

[mr_orange]

It occurs to me another consideration is whether you'll have the small business in perpetuity or whether someday you'll retire from that as well.  If someday you plan to sell, that pushes the needle to traditional accounts.

I plan to operate them in perpetuity and pass them along to my kids.  It is impossible to know how they'll do, but bias should probably be given to us having higher income in later years as our access to personal capital and capital raised via our crowdfunding company increases along with our track record. 

[beltim]

It occurs to me another consideration is whether you'll have the small business in perpetuity or whether someday you'll retire from that as well.  If someday you plan to sell, that pushes the needle to traditional accounts.

I plan to operate them in perpetuity and pass them along to my kids.  It is impossible to know how they'll do, but bias should probably be given to us having higher income in later years as our access to personal capital and capital raised via our crowdfunding company increases along with our track record.

Gotcha.  If this were me, I would make a few spreadsheets with the most probable scenarios (3 or so?) with different assumptions and see what the optimal contribution strategy is in each case.

[mr_orange]

It occurs to me another consideration is whether you'll have the small business in perpetuity or whether someday you'll retire from that as well.  If someday you plan to sell, that pushes the needle to traditional accounts.

I plan to operate them in perpetuity and pass them along to my kids.  It is impossible to know how they'll do, but bias should probably be given to us having higher income in later years as our access to personal capital and capital raised via our crowdfunding company increases along with our track record.

Gotcha.  If this were me, I would make a few spreadsheets with the most probable scenarios (3 or so?) with different assumptions and see what the optimal contribution strategy is in each case.

What are the dominant assumptions?  There are so many variables I would think the model would be subject to GIGO issues. 

My general, not-well-vetted, reasoning is that I can pay the taxes now because I have income to pay them.  Later in life I'd ideally like to structure our businesses in a way to primarily have LTCG and thus later in life we're likely to have less in ordinary income.  This assumes we'll be able to live off of the savings stuffed in our tax-advantaged accounts to have this favorable tax treatment. 

This probably points more to taking the deductions now thus freeing up the incremental dollars to work for years and years.   If LTCG structuring later in life works our marginal tax rate is likely to be lower too.

Thoughts?

[beltim]

It occurs to me another consideration is whether you'll have the small business in perpetuity or whether someday you'll retire from that as well.  If someday you plan to sell, that pushes the needle to traditional accounts.

I plan to operate them in perpetuity and pass them along to my kids.  It is impossible to know how they'll do, but bias should probably be given to us having higher income in later years as our access to personal capital and capital raised via our crowdfunding company increases along with our track record.

Gotcha.  If this were me, I would make a few spreadsheets with the most probable scenarios (3 or so?) with different assumptions and see what the optimal contribution strategy is in each case.

What are the dominant assumptions?  There are so many variables I would think the model would be subject to GIGO issues. 

My general, not-well-vetted, reasoning is that I can pay the taxes now because I have income to pay them.  Later in life I'd ideally like to structure our businesses in a way to primarily have LTCG and thus later in life we're likely to have less in ordinary income.  This assumes we'll be able to live off of the savings stuffed in our tax-advantaged accounts to have this favorable tax treatment. 

This probably points more to taking the deductions now thus freeing up the incremental dollars to work for years and years.   If LTCG structuring later in life works our marginal tax rate is likely to be lower too.

Thoughts?

I think you identified the dominant assumption - whether you'll be able to structure the business income as something other than ordinary income.  That falls into the class of assumptions regarding tax rates, which requires you to know or estimate business income (and taxable ordinary income from 401k distributions).  Other factors might include at what point you involve your kids, since having them draw funds from the business could substantially impact your tax situation, and the growth in business income.

That said, I agree that from the info so far, it seems likely that traditional accounts are beneficial now while you still have ordinary wage income from outside the business.  The other factors may play a larger role once that is gone.

[mr_orange]

The nature of our business income is going to be lumpy.  I am a:

1.  Real estate developer - Mostly OI due to intent to buy/sell
2.  Hard money lender - Have a fund structured in such a way that these distributions will be quarterly and largely LTCG
3.  Real estate investor - Rentals and such will be LTCG
4.  SaaS/Crowdfunding Investor - Investments through our platform will be LTCG and distributions from the SaaS business will be OI most likely
5.  Angel investor - 1 or 0 LTCG

I'd say 70% or more of our income later in life can likely be structured as LTCG, especially with a nice nest egg.  One of the things I like about the Roth contributions is that I can draw the contributions later on tax-free because I already paid taxes on them.

Any other thoughts or feedback is appreciated.  As I suspected this isn't really a straightforward analysis and I have to make a lot of assumptions to decide what to do.  I'm leaning toward just splitting them Roth 401(k) and Traditional 401(k) contributions evenly absent better information about how to proceed. 

[seattlecyclone]

Since so much of your future income will be long-term gains, I think traditional contributions make a lot of sense. You should probably contribute to traditional until you're reasonably confident you'll fill up at least the first couple of tax brackets with ordinary income during your retirement. Otherwise if you choose Roth you're paying tax at a high rate now to avoid paying tax at a low rate later.

[mr_orange]

Thanks folks.

Is there a thread or a resource I can review to see how people normally structure contributions optimally if they can ignore Roth constraints and such?  Something like:

1.  Put as much money as possible in the Roth bucket first
2.  Put as much money in the Traditional bucket next
3.  Put as much money in the HSA next

and so on?  I know that the conversion ladder may work if much of my income ends up being LTCG, but I am struggling with what proportions to aim for on each category in the ideal state. 

Any guidance?

[tonysemail]

RE: leaving business to kids
I would think there are more effective ways to leave them wealth or set them up for life (if that's your goal).
There are many, many reasons why your kids may choose to forge their own path.

reading through the thread, I have a hard time rationalizing roth 401k vs trad 401k.
If the business is run into perpetuity, then you can live off business cashflow.
If the business fails and you're tapping retirement accounts, then you need a ladder.
But in that case, you're not worried about high tax rates.