As we begin our investing portion of the Personal Finance for the Business Owner series, I thought that it would be wise to, first, do a small business retirement plans comparison. Being prepared for our retirement is so vitally important, but there’s another reason for digging into this subject matter before we go much deeper into investing. When you are ready to begin investing, you need to know where to purchase those investments. Retirement accounts offer so many benefits and options in helping us to maximize our dollar and minimize our taxation, especially for business owners. With that said, get comfy because this is a lengthy post, but it is an extremely valuable one comparing retirement plans.
Small Business Retirement Plans Compared
As business owners, there are a few types of retirement accounts available to us that may not be available to the general public. There are also several that overlap and those are useful to us, as well. As we wade deeper into the comparison, you will learn about each of these retirement accounts and their provisions:
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- Traditional and Roth IRA
- SIMPLE IRA
- SEP IRA
- SIMPLE 401(k)
- Solo 401(k)
- 401(k)
- Safe Harbor Provision
- Profit-Sharing Provision
- Cash Balance Plan
I will spend some time explaining the details of the different types of accounts and how they differ from one another, as well as when you should think about using one of them. Without further ado, let’s take a look at the basic types of retirement accounts from a business owner’s perspective.
Traditional and Roth IRAs
The Individual Retirement Account (IRA) and Roth IRA are both forms of qualified accounts. They each carry valuable tax benefits with the primary difference being when the tax benefit is available to you. You contribute to the Roth — named after the senator who presented the legislature — with after-tax dollars, meaning you have already paid the taxes upfront. As such, the Roth IRA allows a month to grow TAX-FREE with TAX-FREE withdraws. With the traditional IRA, you are contributing to the account pre-tax. Therefore, your retirement benefits are subject to taxation when you begin to collect them.
As of now, if you are under the age of fifty, you can contribute up to $6,000 per year to both the traditional and the Roth IRA. If you are over the age of fifty, you’re allowed to contribute up to $7,000 in each. If you’re sitting there thinking, “But why? What’s the point?” Well, as I mentioned before, there are tax benefits. If you place $6,000 into the traditional IRA, you will receive a tax deduction. If you placed that same $6,000 into a Roth IRA, you would get no tax deduction. The reason being that you must use after-tax dollars to contribute to a Roth. The benefit of using the Roth IRA is that when you pull money from it, it’s completely tax-free.
So why wouldn’t you simply take the tax deduction that comes with a traditional IRA? Well, you have to consider that you may find yourself in a higher tax bracket when you retire. I see people with millions of dollars sitting in their IRAs all the time. That’s millions of dollars that have never been taxed and, at some point, Uncle Sam is going to want his cut. There are pros and cons to each one, but if you follow the rules, they can be powerful tools in planning for your future while also minimizing your tax bill.
The Rules for IRAs and Roth IRAs
There are restrictions and guidelines that must be followed when using IRAs and Roth’s. They regulate how much can be contributed when money can be pulled from the accounts, and who can contribute to them. Let’s begin with that last bit about who can contribute to them.
Traditional IRA Income Limits for 2019
(chart derived from information sourced from NerdWallet)
Recently, my children began working in my office. They get paid to do actual jobs within the office. As a result, they are now eligible to contribute to an IRA or a Roth IRA. One of the rules that govern who is allowed to contribute states that the contributor must be employed or have income. Now, there are some rules that apply to one but not the other. So let’s take a closer look at the rules that apply to deductions and contributions.
If you make too much money, you won’t receive deductions if you are using an IRA. With the traditional IRA, a married and filing jointly couple receives no deduction if they make more than $123,000 according to their modified adjusted gross income (MAGI). On the flip side of the coin, if you make too much money, you cannot contribute to a Roth IRA. So depending on your level of income, you may not receive any tax deductions from the IRA and you also might not be able to contribute to a Roth.
What Does This Mean To Business Owners?
In order to create diversification, one of the things I want to do is to use the tax-free income for our retirement. The Roth IRA allows me to do that because we’ve already paid the taxes on it before I ever placed it into our account. Any interest gained or account appreciation, likewise, is tax-free. Of course, I’m going to also use something like a 401(k), profit-sharing, or cash balance in order to create a large amount of wealth if my business never sells, but I also need to have the ability to set aside a little bit of tax-free income.
I like to use what I call the “tax triangle” to illustrate the goal we are trying to achieve. On each of the three corners of the triangle, there is a different tax category. The first corner’s category is designated taxable. If I put a $100,000 CD into the bank at 2% interest, or $2,000 per year, that $2,000 is going to be recorded on my tax return in the year I earn the interest as taxable interest. I will pay taxes on it every year. That’s the first corner of the triangle.
The second corner of the tax triangle is tax deferred-taxable. You don’t pay taxes on tax-deferred money. A great example of a tax-deferred plan is your standard 401(k). The same is true of an IRA. You place the contribution into the IRA and you earn a tax deduction for that amount. However, when you pull the money out of your IRA, it is then subject to the appropriate taxation. Hence, tax deferred-taxable. You may not owe taxes on the front end of the investment but it does become taxable in the future.
The third and final corner of the triangle is my favorite category. There is nothing better than tax-free money, as long as it’s legal. That’s where a Roth IRA comes into play. It allows us to grow our money tax-free. Likewise, 529s and HSAs allow us to grow our money tax-free for particular purposes. So when you think of the triangle, look at it from your business perspective.
You have a lot of revenue that is taxable. You want to decrease the amount of taxable income, so you begin looking at tax deferrable options. However, it is so important not to overlook the tax-free corner of the triangle. This is why I am such a strong supporter of the ROTH IRA.
The Backdoor Roth
One of my goals, with each of my clients, is to double their net worth every 3-5 years. It’s not always possible, but often times it is. So if I’m doubling their net worth every 3-5 years, it’s not going to take long for them to have exceeded that $123,000 threshold that prevents them from receiving deductions from a traditional IRA or contributing to a Roth. What can we do if we find ourselves beyond that threshold?
We can place money into a Roth in three different ways. There’s the front door which is the standard way. That means you make less than $123,000 per year. The second approach is what I call the side-door. Basically, you would convert (aka conversion) some of your IRA holdings into Roth holdings. You will pay some taxes when you make the conversion, but it allows you to contribute even if you don’t have an active income.
The final method of contribution to your Roth is the backdoor. If you’re beyond the income threshold and ineligible for the deduction given by contributing to your traditional IRA, you can still make a contribution using after-tax dollars. Once you’ve placed the money into your IRA, you may then convert it into your Roth account. For more information on the backdoor Roth, follow this link.
IRAs And Roth’s — Which Is Better?
Now that you have a greater understanding of the basic concepts of traditional IRAs and Roth’s, you’re probably asking, “Which one is better?” Well, the answer to that question is “yes”! Both of these qualified accounts have the same goal in mind, to allow you to build wealth while paying the smallest tax bill allowed by law.
I ran a couple of scenarios in one of the most popular calculators available. The first scenario is that of a married 29-year old person that earns around $40,000 per year. They live in a state with a high tax rate so they’re paying roughly 25% in taxes each year. However, when they retire, their tax burden should drop to approximately 15%. Upon retirement, they have $919,902 in a traditional IRA. Meanwhile, their Roth IRA will have a balance of around $903,000. They have $16,902 more in the traditional account but it’s all subject to taxation. The Roth is 100% tax-free. After the 15% tax on the traditional IRA, they have $767,000.
Just for fun, I ran a slightly different calculation. In this version, I am 29-years old and making $110,000 per year. I am in a 50% tax bracket but that will drop to a 25% tax bracket at retirement. In this scenario, the traditional IRA had $16,500 less than the Roth IRA. You see, just a small change in the current situation made the long-term results less favorable. This can also work in the reverse, where you are in a higher tax bracket in the future — which I believe is highly likely — and that’s why the Roth IRA is a slam dunk in most cases.
However, things can become tricky when looking at the pre-tax/post-tax cost. If you contribute $6,000 to a traditional IRA, you’re just dropping $6,000 because it hasn’t been taxed. On the other hand, if you want to contribute $6,000 to your Roth, you would have needed to earn around $7,400 in order to pay the taxes before your contribution. Another way of doing this would be to simply contribute less to your Roth.
Let’s say you contribute $5,000 of the $6,000 you wanted to contribute, in order to cover the taxes. Over thirty years at 7%, the ROTH would actually have $110,000 less than the traditional IRA. However, when you take the taxes out of the traditional IRA, it ends up yielding around $800 less income than the Roth does, each year.
Which is better? They both have their uses. If you use them correctly and to their full potential, IRAs and Roths are extremely valuable tools. They’re different and neither one is better.
The SIMPLE IRA
According to the IRS, a SIMPLE IRA is defined as a Savings Incentive Match Plan for Employees. If you paid close attention to that sentence, you probably noticed that SIMPLE is an acronym. Essentially, it is a company-sponsored plan, in the same way, that a 401(k) is. Pretty simple stuff, right? See what I did there?
So this probably has you scratching your head and asking, “Why don’t I just use my traditional IRA?” Well, think of it this way, the traditional IRA allows you to contribute a maximum of $6,000 each year if you are under the age of fifty. However, the SIMPLE IRA allows you to contribute $13,000. That’s more than double what your traditional allowance is. Here’s the kicker. If you’re over the age of fifty, you can contribute a total of $16,000 per year by contributing to the “catch up” allowance.
There are a couple of groups that really benefit from a SIMPLE plan. Traditionally, if you have just begun to pay yourself and you’re maxing out your ROTH but you want to save a little more, the SIMPLE is a great option. Another group yet is the business owner that has a good talent group but is trying to recruit more talent to their pool. You want to attract prospects to you and your business but you’re lacking in retirement benefits. A SIMPLE IRA is an easy way to offer retirement plans to your employees without having to go the 401(k) route. On top of that, you can still contribute the same 2-3% that you would with a 401(k).
What’s The Catch with a SIMPLE IRA?
In order to establish a SIMPLE IRA, the employer must open the account and they must do this as a benefit for the employees. You, as a business owner, can’t just go and open a SIMPLE IRA for yourself. When you do set the plan up, it can be set to be effective from January 1st through October 1st, provided there was no other plan already in place. Now, there are chapters of rules and regulations in the Internal Revenue Service’s code that covers these plans, but for the sake of time, I am only covering the highlights.
One of the features of a SIMPLE IRA that I am particularly fond of is that, as the business owner, you are required to contribute to the plan every year until it is terminated. If you’re saying, “I don’t like the idea of being forced to contribute,” well, I believe it’s a good thing because it forces us to do what’s best for our long-term future regardless of our short-term problems.
Another requirement of the IRS is that, if you set up a SIMPLE plan, you must include either a 2% mandatory contribution or a 3% matching contribution. What this means is, you have to either contribute 2% of the employee’s annual salary into their account or you can set it to be a 3% matching contribution. This means that if your employees aren’t contributing, you don’t have to contribute, either. There is a stipulation, however. The employees must have earned at least $5,000 in each of the previous two calendar years in order to participate in the program.
SIMPLE IRAs Are Easily Established
One of the greatest parts of a SIMPLE IRA is just how easy it is to establish. I mean, if you’re going to call something simple it should be just that, right? You simply fill out the form, 5304 SIMPLE at the institution of your choice. As an employer, you will need to fill out the SIMPLE IRA Adoption Agreement, which outlines the rules of eligibility to participate in the plan. It really couldn’t be much easier than it is, folks!
Tax Credits And Contributions with SIMPLE IRAs
Depending on your individual situation, you may be eligible for a tax credit. SIMPLE plans allow for a 50% tax credit on necessary eligible start-up costs for up to $500 per year. You can utilize this credit for the first three years of the plan. That’s a little known perk, so keep that one rattling around in the back of your head.
Contributions to a SIMPLE IRA are able to be invested. You can use them to purchase stocks, but most plans will have ETF (exchange-traded funds), mutual funds, and target-date funds. A target-date fund is one that, as you reach the end date, the investments become more and more conservative in an effort to reduce the volatility.
There Are Cons
So for all of the pros of a SIMPLE IRA, there are some cons involved, as well. In my eyes, the largest con is the fact that you can’t save as much for retirement with a SIMPLE plan as you could with a SEP IRA — we will talk more about these in a moment — or a 401(k). It just isn’t going to give you the same yield as one of these other options.
Another con of the SIMPLE plan is that it can’t be rolled over into a traditional IRA without first going through a two-year waiting period. The imposed waiting period begins as soon as you join the plan, but again, you can’t roll your SIMPLE over until two years from your starting date. However, a correction to my misspeaking in the podcast, a law change in 2015 now allows a SIMPLE IRA to also accept transfers from traditional and SEP IRAs, as well as from employer-sponsored retirement plans, such as a 401(k), 403(b), or 457(b) plan. However, the following restrictions apply:
- SIMPLE IRAs may not accept rollovers from Roth IRAs or designated Roth accounts of employer-sponsored plans.
- The change applies only to rollovers made after the two-year period beginning on the date the participant first participated in their employer’s SIMPLE IRA plan.
- The new law only applies to transfers to SIMPLE IRAs made after December 18, 2015, the date of enactment.
- The one-per-year limitation that applies to IRA-to-IRA rollovers also applies to rollovers from a traditional IRA, SIMPLE IRA, or SEP-IRA into a SIMPLE IRA.
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The SEP IRA
The simplified employee pension or SEP IRA is a product that allows employers to contribute to a traditional IRA, set up by the employer, for their employees. I get the sense that a few of you are thinking, “If this is just a traditional IRA, why not just use a traditional IRA?”
Simply put, the answer is all about contribution limits. Once again, the traditional and Roth IRAs allow a person under the age of fifty to contribute just $6,000 per year. The SIMPLE IRA more than doubled that contribution, allowing $13,000 each year. The SEP, however, allows you to put up to 25% of your salary — with a maximum of $56,000 — into it each year. Up to $56,000 per year, folks!
If you have an employee that earns $100,000 per year, you could contribute up to $25,000 on their behalf. I hope you weren’t taking a drink of water as you read that last line. If you were, catch your breath, wipe off your screen, and try not to think that I’ve gone crazy as you ask, “Justin, why on earth would I ever want to do that?” The idea behind it is that the employee helped you to earn income for the business and you’re trying to share some of the wealth.
The Pros of SEP IRAs
- Unlike many other retirement benefit plans, the SEP allows an employer to skip contributions during down years. If the business isn’t doing as well for whatever reason, you aren’t bound to continuing to contribute the 1-25% that is allowed each year.
- As the business owner, it is completely at your discretion as to whether or not new employees can participate.
- Contributions to a SEP IRA are made with pre-tax dollars. This means your company’s income is lowered, leaving less to be taxed by the government.
- Employees are 100% vested in the account. When they leave the company, the account goes with them. Why is this a pro? It establishes a sense of faith and trust in your employer/employee relationship. You’re investing in them as a means of saying that you believe they are worthy of your trust.
- The contribution limit is so large that it can really impact your tax bill in a good way. Recently, I had a client who was having a bookkeeper handle his tax filing. I really don’t advise doing this, by the way. Regardless, he has a small business and only brought in an income of around $120,000 but found himself owing the IRS $38,000. That’s a crazy amount of taxes on that level of income. So he established a SEP IRA and funded it. Yes, you can do this anytime during the fiscal year, up until your taxes are filed. By doing so, he lowered his tax-bill to $12,000.
The Cons of SEP IRAs
- Contributions come solely from the employer. Employees cannot contribute to their own retirement fund when using a SEP. I am big on teaching good financial habits such as saving for retirement, so I’m not crazy about this rule.
- Unlike the SIMPLE IRA, which allows you to contribute an extra $3,000 after the age of fifty, there is no “catch up” provision in a SEP IRA. This is because it is an employer-funded plan.
- Whatever percentage — 1-25% — that you contribute to your own account, you must also contribute to each of your eligible employees. If you’re bringing home a $200,000 salary and contributing 25% to your own SEP, each of your employees have to also receive the same 25% of their salary into their own SEP accounts.
- You can’t take a loan against a SEP. 401(k)s and other retirement plans will often allow you to borrow money from your account. This is not the case with a simplified employee pension plan.
- You cannot use a Roth. This means that at some point in the future, you will have to take money out of the account and pay taxes on it because of the tax-deferred status.
- Finally, we’ve arrived at the maximum earnings limitations. Just like with the traditional and the Roth IRAs, the SEP places a cap on how much you can use it. If you earn more than $280,000, you can only contribute the $56,000 maximum.
How Do I Use A SEP?
Most of the time, SEPs are used as a means of lowering tax bills. However, there is another way. I had a client that is a dentist and he was purchasing a dental practice. Before purchasing the practice, we established a new LLC that was taxed as an S corporation, making him a paid W-2 employee of the LLC. He had no student loan debt because he served in the military and had that debt relieved.
The next thing we did was establish a SEP plan and made it immediately eligible so he could begin to save for his retirement. He purchased the practice ninety days later and suddenly employed staff. He kept the employees so he had to participate for them but he began to clean house. Every time he brought in new employees, they ended up replacing the ones that held over from the previous owner. We then changed the guidelines for his SEP to require all eligible employees to have been employed for at least one year. The next year, we changed it to two years, and finally, we changed it to three.
At the end of that third year, we dropped the SEP altogether and replaced it with a 401(k). That’s an example of extreme planning but it allowed him to secure his own retirement, lower his taxes, and still provide his employees with a retirement benefit in the end.
The SIMPLE 401(k)
I have to admit, I have never actually used a SIMPLE 401(k), although there have been times in my career when it probably would have made sense to do so. So what is it? In essence, it’s a mashup of the savings incentive match plan for employees and the regular 401(k). They’ve taken some key elements of both and created this hybrid type of retirement account.
In 2019, you are allowed to contribute $13,000 into a SIMPLE 401(k). That’s significantly less than the $19,000 that is allowed to go into a regular 401(k). If you’re over the age of fifty, the SIMPLE 401(k) allows you to contribute an additional $3,000 “catch-up.” Once again, falling short of the $6,000 allowed by the regular 401(k). So why would you ever choose a SIMPLE 401(k)?
The Pros of a SIMPLE 401k
In my opinion, one of the biggest pros of the SIMPLE 401(k) is that it isn’t tested. With a regular plan, you are subject to annual testing in order to ensure that you aren’t providing greater benefits to one group of employees than you are to another. The testing comes in two forms, top-heavy and non-discriminatory. They are basically acting as safeguards to keep you and your benefit structure honest. Because of the lack of testing, the cost and the administrative burden of a SIMPLE 401(k) is less than that of its traditional counterpart.
When weighing the SIMPLE 401(k) versus the SIMPLE IRA, one of the things to take into account is the fact that the 401(k) lets you use a Roth provision, as per the applicable retirement plan section 402AE1A of the revenue code. Another great pro of choosing the SIMPLE 401(k) over a SIMPLE IRA is that the 401(k) allows you to take out loans on the contributions you have made. You do have to pay interest on the loan, but at least you’re paying interest to yourself.
Furthermore, the employees receive the advantage of having their contributions — along with your contribution, matching or otherwise — immediately vested. If you contribute to their account and they leave your company tomorrow, they take the entire account with them.
The Cons of a SIMPLE 401k
The first con — for the business owner — that comes to mind, is that the contributions into the employee’s account are immediately vested. That’s right, I just listed this in both the pros and cons categories. It all comes down to perspective. It’s great for the employee but could be a potential pratfall for the employer. The traditional 401(k) gives you the freedom to set a vesting schedule for contributions. Not so with the SIMPLE 401k plan.
Not having the same contribution limits is a major disadvantage, as I see it. Being able to sock away an extra $6,000 per year plus an additional $3,000 in the “catch-up” fund is a huge benefit for the regular 401(k) that the SIMPLE 401k just can’t compete with.
When comparing to the SIMPLE IRA, the SIMPLE 401(k) comes up short in the compensation limits. Let’s say that your compensation from your company — what you take home as a salary — is $350,000. In a SIMPLE IRA, the company can contribute 3% of $350,000. However, the SIMPLE 401(k) only allows the company to contribute 3% of $280,000 because of the maximum compensation limit. That means you would have received contributions from the company for $10,500 with the IRA versus just $84,00 with the 401(k).
Lastly, you are still required to fill out form 5500. It’s still simple but it isn’t exactly as easy as the SIMPLE IRA or the SEP-IRA, in terms of paperwork.
Who Is Eligible for a SIMPLE 401k?
If you are eligible to use a traditional 401(k), then you can use a SIMPLE 401(k). If you’re an S-corp, C-corp, a partnership, or even a sole proprietorship, you should be able to use the SIMPLE 401(k) plan. Well, that’s everyone, right? Not exactly. If you have more than one hundred employees, you are ineligible for this plan. The employee cap is one of the rules from the SIMPLE IRA that they used to create the SIMPLE 401(k).
Now, if you’re sitting there thinking, “Well, I have fewer than one hundred employees, so I must be eligible,” there are a few more qualifying factors that might keep you from being able to take advantage of the SIMPLE 401(k). If your business is a charitable organization or a non-profit, you cannot use the SIMPLE 401(k). Likewise, if you’re a government institution or some form of hospital facility, you would have to have some different types of provisions.
The 401(k) participants also face some eligibility requirements. They must have earned at least $5,000 in compensation during the previous year. Participants also have to be over the age of twenty-one. Lastly, the SIMPLE 401(k) needs to be established between January 1st and October 1st.
The Solo 401(k)
One of my absolute favorite retirement accounts is the solo 401(k). You can’t have any employees if you’re going to use this account, so if you’re a business owner and operate the company by yourself or with a partner, then this is the plan for you. The reason I think this is such a great retirement account is that, unlike the SIMPLE 401(k) or the regular 401(k), the “solo(k)” allows you to think of yourself as both an employee and an employer. That means you can make contributions as an employee and then turn around and make contributions from your business profits as a profit-sharing contribution from you, the employer.
In the solo(k), you can contribute up to $56,000 if you’re under the age of fifty, in 2019. On top of that, there is an additional “catch-up” allowance for people over age fifty, of $6,000. That’s a whopping $62,000 that you can sock away for your retirement in one year, not to mention the enormous impact that has on your taxable income. Another little known fact about the solo(k) is that your spouse is eligible to participate as long as they are not listed as an employee. What this means is that you and your spouse may each contribute $62,000 — if you’re over the age of fifty — per year, totaling $124,000 in retirement savings.
Using The Solo 401k In Tandem
One very interesting aspect of the solo(k) is that it can be used in conjunction with your regular 401(k). Let’s say you work for a company that offers a 401(k) retirement plan, but you also drive for Uber or Lyft. As a driver, you are an independent contractor, thus allowing you to open a solo(k). You are allowed to contribute to both accounts, although you can’t contribute more than $19,000 between the two.
However, the solo(k) has the profit-sharing option, remember? That wonderful little option allows you to tuck an additional 20-25% of your income from your side gig into your solo(k) as a profit-sharing contribution from your company. Pretty cool, huh? There is one little detail that you should know about, though.
As you really get the solo(k) rolling — once you have more than $250,000 in assets — the IRS is going to require that you fill out Form 5500-SF.
Staggered Contributions and Loan Provisions
Another thing that I really like about the solo(k) is that you can actually contribute to the profit-sharing or the employer’s contribution after the end of the year. However, the plan must be established before December 31st to do so. So if you set up the solo(k) right now, you could make your contributions — as the employee — all the way up until December 31st and then wait up until the deadline of your business tax filing to make your employer/profit-sharing contributions.
The solo(k) also has a loan provision, and let me tell you, folks, if I’m going to pay interest on a loan, there’s no one I would rather pay it to than myself. Now, it may not always be the wisest decision to take out a loan from your solo(k), but there are some strategies that can work out pretty well depending on your circumstance. For example, I have had several clients who have gone to the bank for a loan and the bank put a UCC1 filing or a blanket lien on their business. They used their solo(k)’s loan provision to get out from under that UCC1 filing.
Basically, you can borrow up to $50,000 or half of your account balance, whichever is less. The entire loan must be paid back, with interest, in five years or less unless you are using the funds to pay for a home. In that scenario, you can pay the loan back over fifteen years.
How Do You Open a Solo 401(k)?
Opening a solo(k) is relatively easy, but you will need an employee identification number. Most brokers are able to open the account for you. When I had my first solo(k), it actually had a mutual fund company and the entire account was administered by them. I just made my contributions and went about my day. You can buy so many things in your solo(k), too. Within the solo 401(k), you can purchase stocks, bonds, mutual funds, you can even self-direct. We’ll talk in more detail about self-directing in an upcoming article, but for now, just know that the solo 401(k) allows you a ton of freedom.
The 401(k) and Provisional Modifiers
The 401(k) is an account that most of us have heard of and probably even used at some point in our lives. But do you really understand what it is? In the most simplistic terms I can think of, a 401(k) is a qualified retirement account that allows you to save and invest money on a tax-deferred basis. The money grows within the account and is taxed when it is withdrawn. If for any reason, you withdraw your money from the account before you have reached retirement, you face heavy tax penalties.
Now, you are investing when you contribute to your 401(k) and there are some options available to you for how you invest, but you can’t pick any stock you want. It’s not an open market. The majority of the investment options are mutual funds. However, there are a few different modifiers that you can apply to a 401(k) to change its flavor, so to speak.
Ins and Outs of The 401(k)
When you’re dealing with a 401(k), there are a lot of moving parts. Therefore, there are several major players behind the scenes that are keeping it all in order. The first of these is the company that is sponsoring — or that established — the 401(k). There is generally a person within that company that is appointed the trustee and they will oversee the plan.
You then have outside providers, such as financial advisors, custodians — the bank that holds your money — and record keepers. They each have different roles and each is important to the management of your 401(k). The financial advisors are responsible for communicating, with the business owner and their employees, the types of investments that are available within the 401(k). The record keepers do exactly what the name suggests, they keep records of whose money is invested in which investments and what type of 401(k) accounts each person has.
There are some companies out there that will actually provide each of these services in a one-stop-shop, in order to streamline the service. If you have specific advisors, custodians, and record keepers that you prefer to use on an individual basis, that’s fine too. You’ll just have a few more balls in the air that you will have to keep track of.
Third-Party Administrators
There is another behind the scenes player in the world of 401(k)s, and they are very important to you as a business owner. I’m talking about the third-party administrator or TPA. Essentially, the TPA is responsible for making sure that your plan is keeping up with compliance standards. But what does that mean?
Well, they file your plan’s tax return every year. You may not have realized that you have to file a tax return on your 401(k), but that’s one of the things the TPA will take care of for you. Beyond that, they will calculate what you can put into the account. The TPA will also run the testing on your contributions. Basically, if it’s a pain in your neck, the TPA will take care of it. Now, just like before, you can go with an independent TPA but a lot of times they are bundled with your record keeper.
What Are The Basic Options of a 401k?
There are several main options that you have, as a business owner, for establishing a 401(k). They serve a multitude of functions ranging from tax minimization to employee retention. Some of the things you want to look at, regardless of what your goals are for establishing a 401(k), are employee contribution limits, vesting schedules, what your employees can invest in, and the overall cost to you, the business owner.
As for the costs, they can be wide and varied. It really depends on the details of the plan and how you’ve chosen to bundle or unbundle your providers. If you bundle, you’re more likely to save on the costs associated with a 401(k).
Vesting Schedules
Vesting is a great way to achieve employee retention. Basically, you decide — within the plan document — when the money that you contribute to the employee’s account becomes theirs. As a business owner, you actually have some choices vesting your companies 401(k) contributions. One of the best long-term vesting schedules, in my opinion, is the six-year graded schedule. Basically, each year, the employee works for you they earn a higher percentage of the money that you’ve contributed on their behalf. So if they’ve been at your company for less than a year, they own 0% of your contributions. That number goes up to 20% after their first year, and so on and so forth until they reach the sixth year and own 100% of the contributions.
Another common type of vesting schedule is the three-year cliff. This is similar to the six-year graded insofar as the employee must work for a set number of years before being able to take ownership of your contributions. The difference is that, with the cliff, the employee owns 0% until they have worked for you for three years. At that point, they own 100% of the contributions made by you.
Investment Options
In most cases, your employees are going to be choosing from a variety of mutual funds and ETFs or exchange-traded funds. They’re not going to be able to go and purchase 20,000 shares of blue ocean stock. Typically, you’ll be provided with a list of 15-20 mutual and exchange-traded funds because the financial advisor has a fiduciary obligation to make sure that the employees are making money on the investments.
The Safe Harbor Provision
The safe harbor provision is one of my personal favorites. Basically, the IRS has given you a safe harbor or a free pass from some plan testing that you might have to do. Meaning, once per year, a third-party administrator examines your plan to see what you’ve contributed — as the business owner — versus what your employees contribute. If it is too great of a difference, you’re subject to penalties.
In order to qualify, you must contribute to your employee’s account either through a safe harbor match or a safe harbor non-elective contribution. The match means that you must contribute by matching up to 4% of your employee’s contribution. If the employee isn’t contributing to their account, then you don’t have to do so.
However, the safe harbor non-elective contribution requires that you contribute up to 3% of your employee’s salary into their account. The business owner contributes whether their employees contribute or not. The non-elective contribution is one that you — the business owner — must make to all of your employees, across the board.
Why Safe Harbor?
As the owner of a small business, the last thing you want to hear is that you’ve been found wanting after being tested and that your contributions to your retirement fund are going to be returned to you. It creates a mess, both for your retirement savings and to your tax minimization plans. So receiving that pass on the annual testing from the IRS is a huge benefit.
Now, you need to be aware that there is a maximum income cap on the safe harbor provision. If you make more than $280,000 — as of 2019 — you can only receive that 3-4% match on the $280,000. So if you’re a business owner making a million dollars a year, you can only utilize the company’s contribution matching on the first $280,000.
The Profit-Sharing Provision
A profit-sharing provision is a fantastic tool for reaching the contribution limit of $56,000 per year, of the 401(k). Essentially, the company contributes to you and your employees’ accounts out of the profits earned. The simplest form of profit-sharing is pro-rata, where everyone gets the same contribution across the board. If you — the owner — receive 2%, so does each of your employees. In most cases, that 2% is based on the individual’s salary.
New comparability profit-sharing is the most common form seen today. Use the new comparability form to maximize the owner and, maybe, a few key employees. Employees still receive a share of the profits, but it isn’t like the pro-rata plan where everyone receives the same amount. With the new comparability form of profit-sharing, the business owner can take a larger slice of the pie.
A few things need to ring true in order for the new comparability form of profit-sharing to work really well. If you are older than your employees, that helps because the IRS thinks, “Well, he doesn’t have as long to save for retirement as his employees do.” Income disparity is another factor. If you give yourself a $32,000 W-2, it’s going to be much more difficult to give you a larger share of the profit-sharing than if you reported a larger income.
The Cash Balance Plans
Cash balance plans are a type of defined benefit plan. It’s similar, in concept, to your grandfather’s pension, where he would draw a monthly check from his pension. The 401(k) carries whatever balance you have contributed and earned. Conversely, the cash balance plan can net you a maximum benefit of $225,000 per year. It is a defined benefit plan, paying a set amount each year upon retirement. Usually, you use the cash balance plan in conjunction with your 401(k).
How Much Can You Save with a Cash Balance Plan?
Depending on your individual situation, you can save anywhere from $150,000 to $300,000 per year. The older you are, the closer you will be to the top end of that range. Basically, you combine your 401(k), safe harbor, and profit-sharing options with the cash balance contributions to put back massive retirement savings.
So how do you know if the cash balance plan is right for you? Well, if you want to put back $100,000 or more each year, that’s a good start. Furthermore, your business needs to be profitable and steady. If you’re doing great this year but maybe you were in the red last year, it’s probably not a good plan for you. The reason for this is that the cash balance contributions are required. On top of that, you need to contribute 5-8% for your team members. If you have a very large company, there are ways to avoid including everybody but you still need the budget to do so.
Implementing a Cash Balance Plan
Knowing what the cash balance plan is and how much money can be saved each year is all well and good, but how can it be used from a strategical sense? Depending on your individual situation, the cash balance plan can have a monumental benefit to you, as a business owner.
I had a client who contributed a total of $328,000 to the cash balance plan. He made the required 10% — for his individual situation — contribution to their employees. This came to around $50,000. Now, you can do the math here and see that he put around $280,000 back for him and his wife. That’s about 86% that he got to keep for himself. In this scenario, he could fund his retirement plan with the tax savings, alone! So the cash balance plan is an amazing tool for tax minimization and retirement savings.
Is There Wiggle Room?
As I stated before, you need stability in your bottom line because you are required to contribute to the cash balance plan. But what if something crazy happens and your business takes a hit? Well, you could rewrite the original plan document but that has costs associated with it. Another option is to actually change your W-2 compensation.
If the document says that you will contribute 78% of $218,000, you might not be able to afford it this year. However, if you change your W-2 compensation to $58,000 dollars, 78% of that is much more manageable. Similarly, you could also drop your personal deferral to the cash balance, as well as any profit-sharing. Be aware that your employee’s deferrals and profit-sharing still factor into the plan. So there are ways around the otherwise rigid structure of the cash balance plan.
Rate Of Return of a Cash Balance Plan
Unlike the 401(k), you can’t be too aggressive in your investments. If you over contribute or over earn in a cash balance, you can’t contribute as much next year. The goal is to get to the point where you receive $225,000 per year at retirement. So it isn’t quite the same strategy as a 401(k).
The final thing to consider is that the IRS likes cash balance plans to be fully funded within 5-10 years. If you’re older, the five-year plan is a great way to catch up on your retirement planning. If you’re younger, the ten-year plan lets you fully fund the plan over a longer period of time.
What does this mean for you?
I know this was a massive amount of information and I hope that you find value in it. Life is often complicated but our retirement investments don’t need to be. With this information, our retirements can at least be financially simple.
I’d like to extend a special thank you to Jennifer McConnell of July Business Services for all of her help in explaining the complexities of the 401(k).
Be sure to get the most out of investing by following along with all articles in the Personal Finance for the Business Owner series.
