What You Need to Know About Retirement Accounts Get ready for your retirement with these smart tips from a legal and tax expert.
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The following excerpt is from Mark J. Kohler's book The Tax and Legal Playbook. Buy it now from Amazon | Barnes & Noble | IndieBound | Entrepreneur Books
There are four primary considerations in determining which retirement plan is best for any individual or family:
- How much can you deposit each month, quarter, or year?
- What would be the tax impact of your decision—decision—need a deduction now or not?
- Do you want to self-direct your retirement plan?
- Might you need to access the money before age 591/2 for some reason?
The first question I ask a client when meeting on this topic is how much they can and want to put away into a retirement plan. The issues of tax impact, self-directing, and withdrawal strategies are all secondary to this first important question.
I recommend most everyone start with at least a traditional IRA, even if you only save a few hundred dollars each month. The allowable yearly contribution to an IRA in 2019 is $6,000 ($7,000 if age 50 or over). As you have the ability to save more, you will graduate to a Roth IRA, and then if you need a deduction of around $10,000, a SEP (for a limited time in your situation) may be a good fit based on your income and what you are trying to accomplish. When you're willing and able to put away $15,000 or more, the power of the 401(k) is unsurpassed. In fact, the advent in recent years of the Solo 401(k) for the small-business owner is absolutely amazing.
For those who are seeing incredible financial success in their business and want to put away serious dollars, I'd advise significant matching with a 401(k), adjusting salary levels, implementing profit sharing, possibly starting a pension plan, and exploring even more exotic and unique plans. I've had clients save $200,000 to $400,000 in deferred compensation plans annually. Many small-business owners are shocked at these numbers, thinking they can only save $5,000 to $10,000 at most in an IRA and perhaps $40,000 in a 401(k) each year. But the adage is true: The more money you make, the more you can save.
But remember, there is balance! I am not suggesting in any way, shape, or form that retirement plan funding, especially at significant levels, is more important than investing in real estate, building your business, or holding precious metals, just to name a few. Meet regularly with tax, legal, and financial professionals to create a wellbalanced approach to the correct retirement plan, the funding amounts and investment strategy within the plan itself.
The Power of the Roth IRA and Roth 401(k)
Many individuals aim for the holy grail of retirement plansplans—the Roth structure, and they may be correct in that assumption. For those new to retirement planning, these are built with after-tax funds, meaning you pay tax on the money before it's deposited in the account. Then the funds grow tax-free and come out tax-free. Yes, there are sometimes contribution limits based on your situation, and you can only withdraw profit from the plan after five years or age 591/2, whichever is longer. However, almost every financial model in existence shows that with the time value of money, the Roth will outperform the traditional IRA or 401(k) every time. While a Roth IRA or 401(k) costs more money to use initially because you must pay taxes on the contribution going in, rather than getting a tax deduction, it pays off significantly over time. If you can afford the initial cost of paying the taxes, I strongly encourage you to consider a Roth structure.
But there are some stark differences between a Roth IRA and a Roth 401(k):
60-Day Rollover. This provision is unique to IRAs. It allows you to withdraw money for 60 days, use it for any purpose you like, keep and pay taxes on the profit (if you make money with the withdrawal), return the original withdrawal amount before the 60 days is up, and avoid any penalty or tax for the withdrawal. Some investors will move some money out of a 401(k) to an IRA and use the 60-day rollover provision to access cash quickly for an investment or other project. This method allows them to take more than would be allowed under the rules of the 401(k).
72t Distributions. Once your money's been rolled from a 401(k) to an IRA or if the money originated in the IRA, you can make a special election/calculation based on your age and the value of the account to take regular distributions before you're 591/2. The distributions need to continue at least five years or until you're 591/2, whichever is longer. As you earn money in your 401(k), you can roll certain amounts to an IRA and make 72t distributions to avoid penalties while accessing your retirement funds well before retirement age.
401(k) Loans. Many people don't realize how affordable and easy it is to set up their own 401(k) in their business. This is sometimes referred to as a Solo 401(k), and it comes in handy with this strategy: You can borrow up to 50 percent of the balance or $50,000 of your 401(k), whichever is less, and use the funds for business or personal use. You cannot do this with an IRA. The loan term is typically more than five years; if you can't pay back the loan in that time, it's deemed an early distribution from the 401(k) that may be subject to penalties and/or taxes.
Small-Business Solo 401(k) Plan
Years ago, the cost of setting up and maintaining a 401(k) was prohibitive for a single business owner. But in recent years, the benefits and flexibility of the Solo 401(k) have become astounding. A business owner can not only employ themselves and contribute to a 401(k), but they can also include their spouse or other family members in the plan.
Here are a few provisions related to the Solo 401(k) you should keep in mind as you interview professionals to help you implement your own plan.
Only W-2 salary income can be contributed to a 401(k). You cannot make 401(k) contributions from your rental income, investments, dividends, or net profit income that comes from your K-1. Thus, your salary level in your S corp is absolutely critical in this analysis. While many S corp owners seek to minimize their W-2 salary for self-employment tax purposes, you must also carefully consider your annual planned 401(k) contributions. In other words, if you cut your salary too low, you won't be able to contribute the maximum amount to your 401(k). On the other hand, in order to make a large contribution to the 401(k), you may need to take an unnecessarily high W-2 salary from the S corp, This may not make sense for SE tax planning. There is a sweet spot and balance to this planning! Nevertheless, you'll still be able to make excellent annual contributions compared to that of an IRA.
Elective salary deferral limit. In 2019, the deferral limit is $19,000 or 100 percent of your W-2, whichever is less. Thus, if you have at least $21,000 (approximately) of payroll income from the S corp, after FICA withholdings, you can contribute $19,000 to your 401(k) account. If you are 50 or older, you can make an additional $6,000 annual contribution if you increase your payroll.
Putting your spouse on payroll. As I mentioned earlier, many small-business owners can essentially double their contributions to the 401(k) by putting their spouse on the payroll as an employee, board member, or co-owner, knowing all of the money is staying in the family, so to speak. In 2019, a spouse's salary could be adjusted to put away a $19,000 ($25,000 if age 50 or over) elective deferral, and then an additional company match would be 25 percent of the salary. This could add up to a total contribution of approximately $30,000 with only a payroll of approximately $21,000)—something unheard of in an IRA!
The "match." Another benefit of the 401(k) is the nonelective deferral of 25 percent of the payroll, otherwise referred to as the company match. Combined with the payroll deferral, in the example above, the total contribution in 2019 on approximately $21,000 of payroll would be $24,000 ($19,000 + $5000 and add another $6,000 if age 50 or over). In fact, depending on the payroll level, the total contribution with matching can now be as high as $56,000. Remember, if you make Roth contributions, you don't get a tax deduction because you pay the tax on the deferral amount as it's contributed. However, the company match will be deductible. Don't get fixated on contributing the maximum amount of $56,000. Based on the contribution equations, in order to contribute the maximum of $56,000, you need a W-2 salary from the S corp of $148,000. Also, keep in mind that if you have employees other than yourself or your spouse, you are required to implement an approved "matching" program of some sort.
