After a bout with illness (and laziness), the hectic holiday season and a vacation to visit family, I am finally able to return for a new post.
Getting back into my routine, I have been skimming through articles on finance for some inspiration and I found one recently that highlighted one of my shortcomings, it has to do with my 401(k) and saving for retirement. I always knew I could do more but never really dove into the research of how to do it.
Before your eyes start to glaze over from the impending sense of boredom, it is worth noting that my plan here is not to stick to the normal routine of save more, spend less etc. My goal as always, is to find out and share how one can supercharge their returns and use the legal rules out there to avoid as many taxes as possible while saving as much as possible.
As explained in previous posts, I have a side income through which I partnered with a friend. We currently are in expansion mode and awaiting a license on a new adult care facility. Although the red tape and required expertise of the health care industry dissuades many people from starting a business in this industry, once up and running, the operating profits are extremely stable, predictable and of higher margins than many other industries.
However, my partner has a plan to transition from a stable municipal job with a state pension to full time managing what is soon to be the two adult care facilities. Since we are based in California, one of his primary concerns is the vesting for his state pension, which he needs about a year and a half more of work at his municipal job to receive. Giving up a pension for the uncertainty of your own company is one of the toughest personal finance decisions that any of us can make so I decided to do some research not just for my own benefit but to allay his fears and figure out how we could start our own retirement saving within the company with the added benefit of deferring some of our personal taxes until retirement.
With that in mind, I think it is worth going over all of the options that are available below in order to understand which is best based on one’s individual circumstances.
Overview – The 8 Types of Retirement Plans
The 401(k) or the 401(b) offered by large employers – Limits of $18,000 on personal contributions $24,000 if over 50. Company matching and profit sharing can lift the total cap of contributions to $54,000 for 2017.
Traditional IRA – A personal retirement fund intended for anyone but with targeted tax deductions for lower and middle class earners. Contributions are limited to $5,500 per year ($6,500 if over 50). The advantage of this account is the proceeds grow tax free and the contribution is tax deductible up to limits of $98,000 (starts to be phased out at $71,000) for single filers and $118,000 for married filing jointly (deductions starts to be phased out at $98,000) there is no income limit on the traditional IRA.
Roth IRA – A personal retirement fund intended again for working class and middle class people although the difference here from a traditional IRA is there is no tax deduction and there are income limits. Income limits are 133,000 for single filers and 196,000 for married filing jointly in 2017.
Solo 401(k) – This is a plan for someone self-employed which allows contributions of up to 54,000 with no more than 20% of W2 income going into the plan. However you can also contribute 18,000 as an employee. This option usually offers the highest limits for those that are self-employed.
SEP IRA – This works similar to a traditional IRA except that you can contribute 25% of your net earnings from self-employment up to 54,000.
SIMPLE IRA – SIMPLE IRAs also function much like traditional IRAs. Again, the primary difference is the contribution limit. If you have a SIMPLE IRA, you can make an employee contribution equal to 100% of your net earnings from self-employment, up to $12,500 for 2016 ($15,500 if you are 50 or over), plus an employer contribution equal to 3% of your net earnings from self-employment. Here however, if you have employees you have to match their contributions one for one.
Defined Benefit Pension Plan – This is a self-funded plan that has a defined payment to yourself once you enter retirement. It is usually used by high self-employed earners and allows one to contribute amounts as high as 215,000 pretax in order to fund the plan. This contribution can be combined with a SEP-IRA or a 401(k) to offer a substantial tax shield to those in the plan.
Health Savings Account – Those with certain high-deductible health insurance plans can save money tax-free in a HSA. You can contribute up to $3,350 a year for an individual or $6,650 for a family. If you’re 55 or older, you can contribute $1,000 more. You can withdraw money from your account to pay allowable medical expenses, including co-pays. If you don’t spend the money, it rolls over indefinitely. Once you’re 65, you can withdraw money for any reason without penalty, but you have to pay income taxes on money you withdraw. Or, you can use it for retiree medical expenses tax-free.
How to Maximize Retirement Savings
Since the retirement planning rules in the U.S. are a jumble of different ideas and plans, it takes some strategy in order to maximize your retirement savings and will depend on what your work situation is.
401(k) as an employee – The easiest to start with is if you work for a larger company and your company offers a 401(k )with matching. It is always recommendable to contribute at least up to your company match if your company offers one. In addition if you have the money to save, you can contribute up to 18,000 of your own contributions.
If you combine the match with profit sharing as some companies have it gets even better. The 18,000 limit only applies to your personal contributions, not the matching or the profit sharing. Some of the most generous companies offer high matching and profit sharing after you have been at the company a while and if you are lucky you will have to consider the 54,000 cap on total contributions.
Combining with Traditional and Roth IRA – The Roth IRA is never taxed again once you contribute. The only reason you want this is if you think your income will be just as high or higher in retirement and you think taxes will increase. No one knows what’s going to happen in 30 years but when I was earning less I opened a Roth IRA just to hedge my bets.
The traditional IRA offers a tax deduction that gets phased out the higher your income goes as described above. However after a few hours of research online about this topic, there doesn’t seem to be a limit on contributing outside of company retirement plans which is great. This essentially creates a separate box for savings which can be added to your total. So if you combine either the Roth IRA or traditional IRA (or both as long as you don’t exceed the 5,500 limit for those under 50) your total max annual contribution increases to 23,500.
For Small Business Owners – Now here is where it can get interesting. The best plan for you is going to depend on whether you are self-employed, have employees and whether you already have a day job.
- For the Self-Employed With Less Than 250,000 in Earnings – The best options for you are going to be the solo 401(k) or the SEP IRA. If your business’s income is high and predictable then the SEP-IRA may be ideal for you. Contributions here are capped at 25% of your W-2 income up to 54,000 for 2017. This will also add the benefit of being tax deductible for what you contribute and so reduces your taxable income. The solo 401(k) is ideal if you have lower and less predictable earnings, even if you income is n the lower end you can still contribute up to the 18,000 max on a personal basis with the next cap being 20% of your W2 income up to 54,000.
- For the Self-Employed With Over 250,000 in Earnings – In this situation, depending on your age you may want to consider adding a defined benefit pension plan. This will allow you to sock away up to 215,000 annually pretax. However this plan will require higher costs and paperwork. You will need the input of an actuary and file additional forms for the IRS. Most of the large financial planners can set you up with this type of plan. You can get a broad overview here.
- For Those That Have a Corporate Day Job and Are Self Employed – I have not found a definitive answer on this and there is some controversy but if you have self employed income outside of your day job, this will enable you to set up either a separate 401(k) or SEP-IRA for yourself to contribute to apart from your company plan. The controversy here is whether the limit of 54,000 applies to all contributions from the employer plan and the self funded plan or whether they can be put in separate categories to individually subject to the 54,000 limit (therefore making the limit really 108,000). I would love any input from readers on this matter.
- For Those With a Small Business With Employees – If you want to try to offer some type of retirement plan but are not yet there in terms of size to be able to do the paperwork and record keeping of the full 401(k) you can create what is called the SIMPLE 401(k). The limits here are lower at 12,500 and you have to offer the plan to all eligible employees, plus there are minimum rules about eligibility. Your business gets a tax deduction for those contributions. In this case if you can handle the paperwork, it may be preferable to offer the full 401(k) to get you (as the owner) back up to the 54,000 limit as opposed to being limited to 12,500. You must offer the 401(k) to eligible employees but with the full 401(k) it is at your option to contribute.
- For Those That Have a Corporate Day Job and a Small Business With Employees – This is a tough balancing act but there may be some people out there that fall into this category. Maybe someone who has pay as an employee for a passive income business and has a day job or someone who has their business on autopilot and decides to go back to a desk job. Either way, if you can afford it and can handle the extra headache, the best option is likely to be to set up a full 401(k) and offer it through a vesting schedule to your employees. The good news is that many employees don’t bother to sign up for the 401(k) or they leave before they are fully vested. The individual limits remain the same and you can customize the plan to suit your needs. This would definitely need the help of a professional firm.
In order to try and summarize all the points I made above, below I have made a simplified matrix of all the different retirement options and how you can maximize your retirement contributions based on whether you are an employee, self-employed or both. I have ignored the partial contribution levels for a Roth IRA and the partial deductions phase outs for the IRA to focus on how to maximize contributions when you exceed various income limits.
On the furthest right column I have described the ways in which you could reach the limit for each scenario. For example in the second row W2 self-employed income of 144,000 and a SEP-IRA will be able to contribute 36,000 into a SEP-IRA in addition to the 18,000 contributed to the 401(k), I would like any readers who are experts in this field to advise if the 54,000 limit really does apply to distinct employment buckets and that the true limit can actually be 108,000, but for now I will assume the more conservative figure.
When income exceeds around 250,000 and especially if you are older, you can create a defined benefit pension plan for yourself which can offer large contributions in order to reduce your taxes. If you are younger this can be tricky though because the maximum that you can contribute is based off actuarial calculations required to be filed with the IRS and may limit the amount you can put away in any given year to well below the absolute maximum of 215,000.
Either way, I would love any input any readers can provide on these topics in order to improve the post and make it a great future resource for entrepreneurs and diligent retirement planners.
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