Pre-Tax and After-Tax Savings for Entrepreneurs

March 21, 2024

The Taxman: Pay Me Now or Pay Me Later

Successful entrepreneurs know that the most important thing is to make sure you pay yourself and protect your personal finances. While we all know that our multi-trillion-dollar idea is going to make our retirement years a time of bliss and harmony as we sip cocktails on our private island and reminisce of the days we struggled; it is still important to “sneak a little money away” into a tax diversified account. You never know if you might need extra funds to keep the good times rolling. A little bit of tax optionality now, as well as later in life is a good thing.

So, what is available? Let us start with the basics.

Pre-Tax vs After-Tax.

Pre-Tax gives you the ability to reduce your taxable income now. Every dollar you drop into a pre-tax bucket, is a dollar less you will have to pay taxes on.  In our country, we have a progressive tax system. This means that the more you make, the more you must share with your fellow Americans. We call these levels tax brackets. The highest bracket is currently 37% for federal plus up to approximately 9% in a handful of states. That is a whopping 46%. This means that for every dollar you plug into your pre-tax account your take-home pay is reduced by only fifty-four cents.  There is a trap though, when you pull the money out in retirement to buy that new $500K Ferrari Golf Cart to drive around your private island you will be taxed on the distribution. You may need to distribute another $300K or so to pay the taxes, $800K after-tax for that golf cart may just be too much for the future you.

Another possibility is to make after-tax contributions. We call these after-tax savings Roth contributions, named after Senator Bill Roth, who sponsored the Act in 1999 as a 5-year program, funded by a portion of the federal budget surplus (Yep, you read that right “budget surplus”). As you are aggressively growing your multi-trillion-dollar business, you may have years where your income will not yet be pushing those higher brackets. It costs Mucho-Dinero to hire an army of engineers and coders. During these times it might be a better idea to fund a Roth. Why? This is because” pre-tax contributions” do not provide a lot of tax savings if one does not have a lot of “pre-tax income.” Your Roth contributions are invested with no future tax obligations, are allowed to grow tax-free, and then can be spent without any taxes due. Suddenly, that golf cart is much more affordable, perhaps you’ll want to buy a matching one for your significant other.

In a perfect world, you should have a combination of both pre-tax and after-tax retirement savings. That way you can really mess with the IRS in your later years, allowing you to your bracket.

I could ramble on for days, but I will stop for now. I am quite sure I have lost most of you already.  Even I get “bored to tears" with this stuff. In later installments we will learn about the distinct types of retirement plans that are available to business owners. These include IRAs, Simples, SEPS and the several flavors of Employer Sponsored Qualified Plans (think 401(k)s). If you do want to know more and simply cannot stand the suspense, give us a call. We are always eager to chat about all things financial.