Author Topic: Creating a SEP 401k  (Read 3879 times)

ben4prez

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Creating a SEP 401k
« on: August 28, 2015, 09:32:00 AM »
Has anybody had experience setting up and contributing to a self-employed 401k?  I did the search thing, and came up with very little...but doesn't mean it hasn't been covered on this board before!

My wife has significant 1099 income (90-110k) subject to self-employment and income tax (as we understand it) as an independent contractor, and we're looking for ways to minimize our tax liability while setting up tax-deferred investment opportunities.

any help - or links to previous discussions - would be much appreciated!

Telecaster

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Re: Creating a SEP 401k
« Reply #1 on: August 28, 2015, 09:43:10 AM »
It is easy, I set one up with Fidelity a few years ago.   You can set it up online. 

https://www.fidelity.com/retirement-ira/small-business/sep-ira

A better option however is most cases would be the Self-Employed 401(k) which has much higher contribution limits.  However, you cannot set it up online (at least you wouldn't when I did it).   Also a couple more hoops to jump through when you make contributions.   


FIREby35

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Re: Creating a SEP 401k
« Reply #2 on: August 28, 2015, 09:52:38 AM »
To avoid the maximum in taxes the first step is to create an LLC and then designate part of the Gross Income as a salary (which is subject to self employment taxes) and part of the Gross Income as a distribution (which is not subject to self-employment taxes). Any competent CPA will be able to help you with the book work on this. For every $10,000 you designate as distribution rather than salary you will save $1,530 in taxes (i.e. 15.3% Self Employment Tax). So, paying a CPA a few hundred dollars is definitely worth it. With an income of $100,000 I think you could reasonably designate $70,000 (maybe more) as distribution and save $7,500+ in self-employment taxes.

The CPA should help you create the SEP/Solo 401k as well. My business is slightly bigger and I have employees so it might not be a good match for what you are doing, but I use myubiquity.com to set up a 401k for myself and my employees. I checked and they offer a "Single K" (their branding of a Solo 401k) which allows you to put up to $53,000 a year away and they charge $215 to administer it. Maybe it can be done cheaper or free somewhere (like directly through Vanguard) but it is not a bad place to start. I know they offer Vanguard funds which is one reason I chose them for my business and employees.

Seriously though, I would interview 3 or 4 CPAs. Pick the person that has the attitude that most reflects your own. Some are fast and loose. Others are overly conservative. Mine is kind of down the middle but leaning aggressive. I was able to see those differences by interviewing multiple people. Your CPA is a big part of the business and will save you a boatload of money if you let them.
« Last Edit: August 28, 2015, 10:06:56 AM by FIREby35 »

Axecleaver

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Re: Creating a SEP 401k
« Reply #3 on: August 28, 2015, 11:00:20 AM »
Quote
create an LLC and then designate part of the Gross Income as a salary
You're talking about opting for taxation as an S-corp. An LLC may opt to be taxed as an S-corp, but this is independent of the LLC structure. http://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/S-Corporations

I'm working through this scenario myself, and I find the whole situation around splitting income into salary and dividends very confusing. It's not clear what a "reasonable salary" is and what is "safe" to claim as salary. I'll be doing S-corp election starting next year (missed the election cutoff this year) and doing what I can to prepare for it.   

protostache

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Re: Creating a SEP 401k
« Reply #4 on: August 28, 2015, 04:38:47 PM »
Quote
create an LLC and then designate part of the Gross Income as a salary
You're talking about opting for taxation as an S-corp. An LLC may opt to be taxed as an S-corp, but this is independent of the LLC structure. http://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/S-Corporations

I'm working through this scenario myself, and I find the whole situation around splitting income into salary and dividends very confusing. It's not clear what a "reasonable salary" is and what is "safe" to claim as salary. I'll be doing S-corp election starting next year (missed the election cutoff this year) and doing what I can to prepare for it.

There are a few "safe" values that I've read about:

  • Figure out what someone doing your job as an employee makes and put your salary on the low end of that. Ex: A software developer in your area makes between $70k and $100k. Pay yourself $75k.
  • Pay yourself 60% of your profit as salary.
  • Pay yourself the Social Security wage max ($118,500 for 2015)

I personally do option 4: pay myself what my previous job paid me plus health insurance. That just happens to be on the high end of option 1 instead of the low end, but still less than option 3. The health insurance part is important. As a single-employee health plan for an S-corp you have to count what you or your business pays for premiums as taxable income (exempt from SS/Medicare), which makes it show up in Box 1 and Box 14 of your W2. You then get to deduct Box 14 when figuring your AGI, making it exempt from income tax.

The IRS seems to really care if your business pays you zero salary or some abnormally low percentage of profit (10%, for example). As long as you're paying a reasonably large amount of Social Security then they don't have the bandwidth to care.

iamlindoro

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Re: Creating a SEP 401k
« Reply #5 on: August 28, 2015, 05:40:57 PM »
Most likely your search ran into trouble because an SEP is an IRA, and an Individual 401k is a 401k-- Both exist, but are different in a number of ways.  We had a long discussion about it in 2013 when I was setting up mine:

http://forum.mrmoneymustache.com/investor-alley/sole-proprietorship-and-individual-401k/

I don't want to shill or give the appearance of self-promotion, but I did write an article on it this week in my blog.  You're welcome to check that out, and I'm happy to answer questions about my experience so far, here or there.  It's really simple to make contributions, I can't see how it would be thought of as more complicated than any other plan, other than putting the amounts you want to be "employer" and "employee" contributions in separate columns.  It's a snap.

iamlindoro

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Re: Creating a SEP 401k
« Reply #6 on: August 28, 2015, 07:36:26 PM »
I have set up one through Vanguard. Very easy. What I want to know is if there's a way to do after tax contributions to a solo 401k. Does anyone know?

Yes, it's possible, but unfortunately not with any of the big providers :(

http://thefinancebuff.com/after-tax-contributions-in-solo-401k.html

FIREby35

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Re: Creating a SEP 401k
« Reply #7 on: August 29, 2015, 09:06:52 AM »
Quote
create an LLC and then designate part of the Gross Income as a salary
You're talking about opting for taxation as an S-corp. An LLC may opt to be taxed as an S-corp, but this is independent of the LLC structure. http://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/S-Corporations

I'm working through this scenario myself, and I find the whole situation around splitting income into salary and dividends very confusing. It's not clear what a "reasonable salary" is and what is "safe" to claim as salary. I'll be doing S-corp election starting next year (missed the election cutoff this year) and doing what I can to prepare for it.

There are a few "safe" values that I've read about:

  • Figure out what someone doing your job as an employee makes and put your salary on the low end of that. Ex: A software developer in your area makes between $70k and $100k. Pay yourself $75k.
  • Pay yourself 60% of your profit as salary.
  • Pay yourself the Social Security wage max ($118,500 for 2015)

I personally do option 4: pay myself what my previous job paid me plus health insurance. That just happens to be on the high end of option 1 instead of the low end, but still less than option 3. The health insurance part is important. As a single-employee health plan for an S-corp you have to count what you or your business pays for premiums as taxable income (exempt from SS/Medicare), which makes it show up in Box 1 and Box 14 of your W2. You then get to deduct Box 14 when figuring your AGI, making it exempt from income tax.

The IRS seems to really care if your business pays you zero salary or some abnormally low percentage of profit (10%, for example). As long as you're paying a reasonably large amount of Social Security then they don't have the bandwidth to care.

I seriously suggest talking to a CPA. The answers from Protostache is not "wrong." However, I believe it is conservative advice and likely to cost you thousands a year in taxes. If you, or anyone else, take the time to talk with multiple CPAs and see how each of them answer the "reasonable salary" question you would see there is no magic formula. For some reason, every time this question comes up on this forum the answers includes really conservative advice that clashes with my personal experience and the information gained from talking with multiple CPAs/lawyers.

As to your comment about the whole issue being confusing, that is because it is new. This is the exact topic you should be asking CPAs about. Listen carefully to how each one answers and compare them mentally. Then choose the person who fits your personality. Eventually, you should have enough information to have a strong opinion on the matter.

I know there is this fear of paying a CPA - we are mustachians after all :) But, if you pay a CPA to do all the extra paperwork so your books are impeccable and unassailable in the unlikely event you were ever audited, you will pay a few hundred dollars per year. On the other hand, you will save thousands in taxes. This is a place where you have to think rationally about "money saved" that is illusory v. actual money spent. Money actually spent feels more real than the theoretical tax savings. But the tax savings are very real.

To the above point, how much time and effort do mustachians spend trying to trim expenses by a few hundred dollars per year on energy efficiency, cable, insurance, etc? This is a big decision on the order of a car purchase or home purchase. It is worth thousands of dollars per year. A overly conservative decision based on a lack of reliable information will cost as much money as leasing a car because "you want to avoid costly repairs." You really have to get in the weeds and understand the decision - it is worth lots of money every single year.

Also, if you have a CPA you can talk with him/her about what kinds of expenses are tax deductible. Your home internet, phone, health insurance, etcetera can all be paid for out of your business with pre-tax dollars. If you are doing it right, your Solo 401k and deductions can turn 100k in Gross income into 20k of taxable income (solo 401k is up to 53k in tax deferments + 27k in pre-tax business expenses is totally doable!). Then the 20k in taxable income can be split between salary/distribution. Again, a good CPA is worth their weight in gold.

I make the same suggestion to Protostache because I think you might be paying way more in taxes than is necessary. I'm not saying that to be confrontational, just helpful. Get a CPA!!! :)


« Last Edit: August 29, 2015, 09:12:55 AM by FIREby35 »

iamlindoro

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Re: Creating a SEP 401k
« Reply #8 on: August 29, 2015, 09:54:13 AM »
If you are doing it right, your Solo 401k and deductions can turn 100k in Gross income into 20k of taxable income (solo 401k is up to 53k in tax deferments + 27k in pre-tax business expenses is totally doable!). Then the 20k in taxable income can be split between salary/distribution. Again, a good CPA is worth their weight in gold.

For the record, I don't disagree with your premise. I am a big fan of seeking help when appropriate.  I do want to point out that 53K in tax deferrals on 100K in gross income isn't actually possible with a Solo 401k.  You need to earn ~140-180K depending on your company structure to be able to max out the 53K, based on the "25% of net profits" rule.
« Last Edit: August 29, 2015, 09:56:10 AM by iamlindoro »

protostache

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Re: Creating a SEP 401k
« Reply #9 on: August 29, 2015, 10:00:13 AM »

(lots of great stuff about CPAs snipped)

I make the same suggestion to Protostache because I think you might be paying way more in taxes than is necessary. I'm not saying that to be confrontational, just helpful. Get a CPA!!! :)

I did say "safe" at least once :)

I have a CPA and we've talked about this a lot. Yes, I could be more aggressive on saving SS taxes, but at this point the business is bringing in $200k and I want to try to max out the employer portion of my solo 401K, which is capped at 25% of salary. I pay myself $87k in salary + $10k in health insurance which feels like a fair split.

Maybe I'm being too conservative. I'll email my accountant and ask :)

TomTX

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Re: Creating a SEP 401k
« Reply #10 on: August 29, 2015, 10:02:00 AM »
Vanguard's Solo 401k costs all of $20/year* for administration, and that gets waived once you hit $50k.

NOTE: "Solo" or "Individual" 401k is a misnomer. Any company that is comprised of owners/partners and their spouses can use it. The trigger for a full-blown 401k (and 10x the paperwork/expenses...) is having non-owner (stockholder) non-spouse employees. If everyone has a piece of the business (or is married to someone who does) you can keep costs and administration very low.

*Per fund. So just pick one. You can get plenty of diversity from a single fund if you don't even have $50k invested. $50k should be easy - set up the 401k to take in rollovers.

Cathy

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Re: Creating a SEP 401k
« Reply #11 on: August 29, 2015, 10:21:22 AM »
...Your home ... phone ... can all be paid for out of your business with pre-tax dollars ...

This particular tax position is highly questionable. For an "individual", "local telephone service with respect to the 1st telephone line provided to any residence of the taxpayer" is not deductible. 26 USC 262(b). This statute, which was enacted by PL 100647 (1988) 5073 ("Denial of Deduction for Certain Residential Telephone Service"), is clearly a bit dated and does not contemplate that in modern times, a taxpayer's only phone line might not strictly be "local telephone service", and might not literally be a "telephone line". It also applies only to an "individual". Nonetheless, the Tax Court has applied this statute to disallow telephone deductions by an S Corporation when there was no evidence that the individual taxpayer had any other phone line at his residence. Rogers v. Commissioner, TC Memo 2014-141, p 48. Although not explicitly stated by the Court, this might be justified because the shareholder of an S Corporation includes his share of the corporation's "items of ... deduction" in his own income, such that a limitation applicable to an "individual" may apply. 26 USC 1366(a)(1)(A). The Court also did not concern itself with the dated wording of the statute. Even if the statute does not literally apply to certain "home ... phone" expenses, the Court may not look at them favourably in light of the policy behind the statute.
« Last Edit: August 29, 2015, 10:32:46 AM by Cathy »

FIREby35

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Re: Creating a SEP 401k
« Reply #12 on: August 30, 2015, 07:47:56 AM »

(lots of great stuff about CPAs snipped)

I make the same suggestion to Protostache because I think you might be paying way more in taxes than is necessary. I'm not saying that to be confrontational, just helpful. Get a CPA!!! :)

I did say "safe" at least once :)

I have a CPA and we've talked about this a lot. Yes, I could be more aggressive on saving SS taxes, but at this point the business is bringing in $200k and I want to try to max out the employer portion of my solo 401K, which is capped at 25% of salary. I pay myself $87k in salary + $10k in health insurance which feels like a fair split.

Maybe I'm being too conservative. I'll email my accountant and ask :)

You got me on the profit sharing stuff. I never did put away the entire 53k and you just reminded me why!

I thought you were paying yourself your old salary on 100k like the original poster! So, that is why I thought it was too conservative. 87k on 200k isn't so bad. I have lots of extra expenses through employees so it's not apples to apples, but I pay myself a salary of 58k on approximately the same AGI. I never had a prior job where I earned a salary to compare it to. I use a public attorney with the same age and experience as myself as the benchmark. Like I said, I lean a little aggressive.

And the phone stuff, we do deduct our cell phones. We'll see if the IRS ever cares.

All together I think we gave decent advice :)

FIREby35

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Re: Creating a SEP 401k
« Reply #13 on: August 30, 2015, 08:19:04 AM »
Vanguard's Solo 401k costs all of $20/year* for administration, and that gets waived once you hit $50k.

NOTE: "Solo" or "Individual" 401k is a misnomer. Any company that is comprised of owners/partners and their spouses can use it. The trigger for a full-blown 401k (and 10x the paperwork/expenses...) is having non-owner (stockholder) non-spouse employees. If everyone has a piece of the business (or is married to someone who does) you can keep costs and administration very low.

*Per fund. So just pick one. You can get plenty of diversity from a single fund if you don't even have $50k invested. $50k should be easy - set up the 401k to take in rollovers.

Hey TomTX, about two years ago I posted a question and you gave a really good answer. I was in a similar stage as the poster in this case with a new business and I had not set up the 401k/LLC S-Corp stuff. Actually, at that time I was just confused and feeling like it was another big thing in addition to all the other stuff that goes into starting a  business. You basically told me to get it together and start my tax deferred investments asap. So, I did a lot of the work that makes up my answer in this case -interview CPAs, start a 401k, convert it once I got employees, etcetera and try and get the accounting/financial end of the business in good order. I figured I would take this opportunity to say thank you for taking the time to answer my "newby" question a couple of years ago. It helped me a lot and started me down a great path. Seriously, thank you.