help small biz owner choosing retirement plan

[Fuzz]

Hi Mustachians,

I am hoping that other self-employed mustachians can share how they thought about their retirement plans. I am a self-employed professional and provide professional services. My business is organized as an LLC and I am on the only member. I don't take a regular salary, but make owner draws. Eventually, I would like to hire other employees, but that is at least a year off.

My understanding of my options:

Solo 401K: Contribution limits: $17,500 form after tax. 25 percent of pay pre-tax. Total can't equal more than $51,000. Assuming a hypothetical $80K in income, I could contribute $17,500 from after tax and $20,000 pre-tax. Total $37,500.

Sep-IRA: Contribution limit $51,000. Only pre-tax dollars. Limited to 25 percent of pay pretax, or 51,000. Same hypothetical 80K income limits me to a $20K contribution.

Basically, if my business made over 204K in income, then the SEP would be better since I would be able to contribute $51,000 as 25% of income, and it would be a pre-tax expense. If I want to have a gross tax-advantaged savings rate higher than 25%, and make less than $204,000, then I should choose the Solo 401K.

What other things did people consider? As far as my values, if I do hire someone, then I'm OK with funding their retirement plans and having it be more expensive. So restrictions as to eligibility are less important to me.

Links here: http://www.irs.gov/Retirement-Plans/Help-with-Choosing-a-Retirement-Plan

[forestbound]

I am also a small business owner, sole proprietorship, with no intention of ever hiring employees. I chose a SEP IRA, just because my income fluctuates wildly from year to year, and I did not see a benefit to going with a Solo 401K. All extra money over the SEP contributions goes into investments.

[dandarc]

You can shelter more of your income in a solo 401K over a Sep-IRA on incomes up to roughly 250,000, at which point you can shelter the max 52K (2014) with either of them.  If you are looking to save less than 25% of your income, the SEP is a bit easier to deal with from a paperwork perspective.  I have a Solo-401K, but my income is ~140K and it allows me to shelter about 43K as opposed to about 25K with the SEP.

However, if you are going to hire employees in the near future keep in mind that makes either of these more difficult to deal with - your individual 401K becomes a regular 401K with all that entails.  You must contribute equally (I think meaning the same percentage of salary) to your employees as you do for yourself in a SEP.  You'll want to be careful here depending on how you want to compensate your employees when that day comes.

[Phy to FI]

I am also a sole proprietor LLC with a solo 401k, and thought I'd weigh in. A s401k allows you to defer more than a SEP IRA for incomes up to $260,000. However, I don't know anything about how adding employees affects the rules.

There are a couple of numbers in your OP that, to my knowledge, are wrong. First the 25% of income only applies to employees. The self-employed have to subtract taxes first, which essentially changes the formula to 20% of gross pay. Second, the $17,500 deferral in the 401k, is also taken out before calculating the 20%.

So, for a hypothetical income of $80,000, a SEP IRA would allow a deferral of 20%, or $16,000. A s401k would allow a deferral of $17,500 + 20% x ($80,000-$17,500), or $30,000.

Also, I'm not sure what you mean by 401k being after tax. You can opt for either Roth or traditional tax treatment for the $17,500. The 20% can only be traditional, or pre-tax, but the $17,500 can be either pre- or post-tax. Also, I believe with either plan you can open an additional $5500 tIRA or Roth IRA.

[dandarc]

I am also a sole proprietor LLC with a solo 401k, and thought I'd weigh in. A s401k allows you to defer more than a SEP IRA for incomes up to $260,000. However, I don't know anything about how adding employees affects the rules.

There are a couple of numbers in your OP that, to my knowledge, are wrong. First the 25% of income only applies to employees. The self-employed have to subtract taxes first, which essentially changes the formula to 20% of gross pay. Second, the $17,500 deferral in the 401k, is also taken out before calculating the 20%.

So, for a hypothetical income of $80,000, a SEP IRA would allow a deferral of 20%, or $16,000. A s401k would allow a deferral of $17,500 + 20% x ($80,000-$17,500), or $30,000.

Also, I'm not sure what you mean by 401k being after tax. You can opt for either Roth or traditional tax treatment for the $17,500. The 20% can only be traditional, or pre-tax, but the $17,500 can be either pre- or post-tax. Also, I believe with either plan you can open an additional $5500 tIRA or Roth IRA.

Not sure this is exactly right, but the concept is spot on - the formula for the 2014 solo 401K limit for a sole-proprieter is 17,500 [Employee Deferral] + 20% * (Schedule C income - 1/2 self employment tax) [Match], assuming your business income is high enough to not fall into some more complicated situations.

The 20% equalizes between an employee and self employed (25% / 125% = 20%).  If your Schedule C income is below the SS max, then the formula above becomes roughly: 17500 + 20% * (1 - 92.35% * 7.65%) * Schedule C income.  If your situation is like mine and you have effectively no expenses, then your schedule C income = the money you receive throughout the year.  So a floor for what you can contribute to a solo 401K as a sole proprieter is 17500 + 18.587045% * Schedule C Income.  Could be higher than that if you make more than the SS maximum.

I personally just put in 18.5% of my income each month.  I am giving up a few hundred of deductible space by using 18.5% as opposed to the exact amount for me (I make a bit more than the SS max) - I suppose I should tally up the exact figure when I know my income for the year 100% and make a small contribution then.  Anything I have beyond that to invest each month goes in the following order:  Covering the 17500 - then our Roth IRAs - then paying down the mortgage (we have a very small mortgage).  Once the mortgage is payed off in a couple years, replace that with "taxable account".

If your income is lowish, then other figures may come in to play (like 100% of Schedule C income vs the 17500 deferral limit).  The worksheet in IRS Publication 560 (http://www.irs.gov/pub/irs-pdf/p560.pdf) is clear.  I just filled one out for my income, and my 17500 + 18.5% * Schedule C income formula works out to being just $300 less than the allowed amount per the worksheet. 

Remember that you have to deduct your business expenses to arrive at income before you can compute your Solo 401K limit (or SEP IRA limit for that matter) at all.  Knowing business expenses can range from trivial to quite complex, so you may not be able to know your contribution limit until the end of the year.  You have until your tax filing deadline to actually make the contributions, so this isn't that big of a problem.  I believe there is also a penalty free remedy if you send in too much throughout the year - you can withdraw the excess contributions if you catch it early enough and take care of it yourself.  So not that big of a deal, but you'll definitely want to be in the ballpark if your'e looking to maximize your deferral and make regular contributions.

[Fuzz]

Thanks everyone. My first attempt at thinking through this wasn't careful enough and I abused a lot of tax terms in the process. I have a better grasp now.