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“Finding the Backdoor” - Navigating the IRA Aggregation Rule as a Small Business Owner

“Finding the Backdoor” - Navigating the IRA Aggregation Rule as a Small Business Owner

November 02, 2023

The Backdoor Roth IRA is a popular financial strategy for high-earning individuals looking to take advantage of the benefits of a Roth IRA, even if they exceed the income limits for direct contributions. Unfortunately for those seeking tax advantaged growth in their retirement accounts, these individuals often find themselves phased out of traditional IRA contributions as well. In the quest to find as much tax advantaged space as possible, a Backdoor Roth strategy might be appropriate. However, there is a major consideration to address before such a strategy is implemented.


The IRA Aggregation Rule IRC Section 408(d)(2)

If an individual has multiple IRAs, they will be aggregated as if they are one account when determining the tax consequences of any distributions. If you have a balance in preexisting traditional IRAs, this can trigger a tax liability, as a portion of the conversion will be subject to taxation determined by the “pro-rata” rule under IRC Section 72(e)(8). Early withdrawal penalties under IRC Section 72(t)(1) are also in play here. This whole thing just started sounding a lot less fun!

If you are an employee with a company 401(k) plan (that allows rollovers into the plan), you can potentially clear this up by rolling your old traditional IRA money into your company plan (but be aware of your investment limitations in that plan!).

For the small business owner and their employees, “finding the backdoor” is a little bit trickier. These individuals might have most of their retirement funds in accounts such as SEP IRAs and SIMPLE IRAs. The Secure Act 2.0 will open some flexibility for certain account types (Roth SEP IRA contributions will fall outside of aggregation rules) BUT for those business owners and employees with substantial retirement money in tax deferred SEP and SIMPLE plans, the IRA Aggregation Rule is in effect. Afterall, these accounts are simply forms of IRAs. For business owners with a staff of full-time employees, the cost of opening a 401(k) plan for your company might be worth the consideration. What about the self-employed, or business owners with no full-time employees?

 

Solo (Individual) 401(k) Has Entered the Chat

For the small business owner who does not have any full-time employees, a Solo 401(k) has many of the same benefits of SEP and SIMPLE plans, with several additional benefits not found in those plans such as higher allowable contributions for many earners and more control over investment options. Regarding the interaction between the Solo 401(k) and the Backdoor Roth strategy, the IRA aggregation rules do not apply. For 2023, this frees up an additional $6,500 ($7,500 if you are age 50 or older) of potential tax advantaged asset growth on your balance sheet per year!

 

Conclusion

The Backdoor Roth IRA strategy offers a way for high-income earners to enjoy the benefits of a Roth IRA. However, for business owners, the presence of SEP IRAs and SIMPLE IRAs, can complicate matters due to the IRA Aggregation Rule. For the self-employed, consider utilizing a Solo 401(k) in lieu of SEP IRA and SIMPLE IRA plans. Stay tuned, as we will compare the various business retirement plans in more detail in the near future.

 

-James



Please consult your tax advisor before attempting to implement any of the aforementioned concepts.

Guardian, its subsidiaries, agents and employees do not provide tax, legal, or accounting advice. Consult your tax, legal, or accounting professional regarding your individual situation. The information provided is not intended to suggest a particular course of action.  

2023-163497 Exp 11/25

This material is intended for general use. By providing this content Park Avenue Securities LLC and your financial representative are not undertaking to provide investment advice or make a recommendation for a specific individual or situation, or to otherwise act in a fiduciary capacity.