When an older client goes into business for themselves, he or she will likely experience lean times at the beginning. But there are steps advisors can take to lessen the financial impact for the newly self-employed client.
1. Take Social Security sooner.
On paper anyway, the majority of eligible clients are better off delaying Social Security payments as long as possible, and getting a bigger check a little later. But cash-strapped self-employed clients are in a different situation, and should consider initiating payments as soon as they are eligible—especially if the burgeoning business is running in the red.
Those reliable Social Security checks will serve as a welcome financial and psychological bridge between the paychecks the client once received, and the profits he one day hopes to reap.
The monthly payments will also allow the client to keep cash in the business for current and future expenses and expansion. Every Social Security dollar received means another one stays in the client’s long-term assets left with you.
2. Don’t work or make too much.
If your client is under “normal retirement age” (NRA) and initiates Social Security, he or she may want to keep her earnings below the benefit-reduction limits imposed by the Social Security Administration.
For 2014 that figure is $15,480, meaning that for every $2 over that amount earned by the client in a given year, her Social Security benefits for that year will be reduced by $1.
But that figure only counts the recipient’s earnings into the formula. Spousal earnings and benefits, interest, capital gains, and pension income are not included. In addition, the extra earnings (and Social Security taxes paid) may increase the recipient’s earnings history, and the benefits he or she receives over their lifetime.
Also, any Social Security benefits reduced by earnings before normal retirement age will eventually be returned once the recipient passes that age.
The SSA has a special method of calculating whether or not a self-employed person is “retired.” If the recipient works more than 45 hours per month, he or she is not considered to be retired. But if she works less than 15 hours per month at her business, she can be designated as being “retired”. If the recipient works between 15 and 45 hours per month, the self-employment will count as working only if it requires a “substantial skill” or involves running a “sizable business.”
3. Sell securities with large capital gains.
Assuming the first few years of the client’s business will have more expenses than revenues, you can work with him and his CPA to make the best of the unfortunate financial situation.
Start by selling any securities with large inherent capital gains that are held outside of tax-sheltered retirement accounts, preferably in a tax year after the client stops working as an employee. As long as the client remains in the 15 percent federal income tax bracket, he will pay no federal taxes on those gains.
You can then redirect the proceeds to more conservative investment options, preserving the assets for future business or personal needs.
4. Use losses to cut future taxes.
Another way to turn business losses into greater tax savings is to convert IRAs to Roth IRAs during the years that losses are incurred. Specifically, convert amounts that allow the client to still remain at or below the top of the aforementioned 15 percent federal income tax bracket.
For 2014, the figure determining the client’s federal income tax bracket is found on Line 43 of the client’s 1040. Anything below $73,800 for married couples filing jointly ($36,900 for singles) will be taxed at 15 percent or less. Anything on Line 43 that exceeds that amount will be taxed by the federal government at 25 percent and beyond.
If you convert some IRA funds to Roth IRAs and then discover that the converted amount would be taxed at a rate higher than what the client would prefer, you can “undo” the conversion by the April 15 filing deadline the following year (or Oct. 15, if the client files an extension).
5. Use a Roth IRA, at first.
If the client is only pulling a modest amount of income out of the business in the beginning, he should use Roth IRAs to save for retirement. Unfortunately, he won’t get a tax deduction on the deposit. But by definition, his tax bracket will be so low that losing the tax break is inconsequential.
If he needs that money for his business or personal expenses, he can always withdraw the contributions at any time for any reason, with no penalties whatsoever. And once he’s past age 59 ½ and the Roth IRAs meet the “five-year rule,” the earnings can be withdrawn free of taxes and penalties, too.
If the client is married and has enough earned income, don’t forget to make a spousal Roth IRA contribution, too—even if the spouse doesn’t have any earnings.
6. Plan for better times.
Hopefully, the client’s self-employment will eventually turn from a money-losing proposition into one that provides a healthy profit and income (as well as a bigger tax bill). If and when that day comes, you should certainly encourage the client to switch to tax-deductible savings vehicles, such as traditional IRAs and Health Savings Accounts.