In his book The Tax & Legal Playbook, CPA and attorney Mark J. Kohler targets the leading tax and legal questions facing small-business owners, and delivers clear-cut truths, thought-provoking advice, and underutilized solutions to save you time, money, and heartache. In this edited excerpt, the author explains what type of retirement accounts might work best for small-business owners and why.
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—good or bad?
- 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.
Even if you only save a few hundred dollars each month. I recommend almost everyone start with an IRA. The allowable annual contribution for the past several years has hovered around $5,000 to $6,000, depending on your age. If you want to save around $10,000, then an SEP may be a good fit based on your income and what you're 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.
The Power of the Roth IRA and Roth 401(k)
Many individuals aim for the holy grail of retirement plans: the Roth structure. 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 dividend or net profit income that comes from your K-1. Thus, your salary level in the company 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 take into account 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, with a low W-2 salary from the S corp, you may not be able to make the maximum contribution to the 401(k), but you’ll still be able to make excellent annual contributions compared to that of an IRA and not overpay SE tax in the process.
Elective salary deferral limit. In 2014, the deferral limit was $17,500 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 $17,500 to your 401(k) account. If you're 50 or older, you can make an additional $5,500 annual contribution if you increase your payroll.
Putting your spouse on payroll. 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 the money is staying in the family, so to speak. In 2014, a spouse’s salary could be adjusted to put away a $17,500 elective deferral, then an additional company match would be 25 percent of the salary. This could add up to a total contribution of $22,500, something unheard of for 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 2014 on approximately $21,000 of payroll would be $22,500. In fact, depending on the payroll level, the total contribution with matching can now be as high as $52,000. This deferral is always made with pretax dollars and cannot be Roth dollars. Remember, Roth contributions don’t give you a tax deduction because you pay the tax on the deferral amount as it’s contributed. However, the company match will be deductible. Based on the calculations above, in order to contribute the maximum of $52,000, you need a W-2 salary from the S corp of $138,000.