Planning & Investing for Early Retirement as a Small Business Owner

[MitchCraft]

Hello,

I have been casually browsing the forums trying to gain some knowledge around investing and early retirement for the past couple of years.  My discover of MMM was around the same time as starting my own business 2 years ago, and am finally to a point where I am earning enough money to invest and start my track towards (hopefully) Early Retirement. 

I am completely debt-free, and have a pretty good percentage of my income available for retirement savings and investing. 

What I cannot seem to wrap my head around is the need to have an IRA/401k instead of investing everything, what the differences are between the different types of retirement accounts, and whether or not I have advantages should I want to start an IRA/401k through my business.  I have spent the past several hours trying to research all of my questions, so the next phase of research is to just ask some actual people!

1)  I am 29 now, no debt, but no retirements account as of right now either.  If I want to retire by age 40, why even set up an IRA at all?  If I am able to make $75k+ per year and save about $50k of it, and my target amount to retire is about $650,000, that would be enough to retire early and 'safely' do the whole 4% withdrawal thing (26k is target earnings per year for ER).

2) Everybody seems to agree that having an IRA/401k/whatever is pretty much essential, because of said benefits.  But if my index investment returns are enough to give me enough money to live on forever, is it a big enough benefit to not invest that money, and instead tie it up for another 20 years  (age 40-60) until it is accessible? (thus reaching the target investment amount later)

3) If I read enough online articles that persuade me to get an IRA/401k, what's the best way to do it if I own my own business?  I was just going to open up a personal IRA account, but I recently read that being an employer allows me to contribute bookoo money to the IRA/401k ($54k/year?)  These 'maximum' amounts also seem very conflicting for standard IRAs.  Is it $5,500 per year? $12,500? $18,000?  I can't seem to get a straight answer.  I am an S-corp with 5 employees at the moment, and reading the differences it seems that a SIMPLE-IRA would be best for my business.  But, I am a pretty new business still trying to figure everything out, and currently don't offer any benefits to employees, and am not sure when/if I will be doing so.  If I do set up a SIMPLE-IRA for my business, do employees have to contribute? Do I have to let them contribute?  Can I just set it up through my business, and just contribute $54k to my own retirement account?

I am having all of these questions now, because I have decided to finally start investing for retirement, and have $15k available right now to put towards something. YAY! 

Any sage advice out there?

[maizefolk]

1 & 2) The money in your IRA/401k wouldn't be locked up until you reach traditional retirement age but, at most, for about five years. Read up a bit on the concept of a Roth Conversion Pipeline here https://forum.mrmoneymustache.com/investor-alley/how-to-withdraw-funds-from-your-ira-and-401k-without-penalty-before-age-59-5/ to see how to make it happen. The tax savings from essentially deferring paying income tax in your highest earning years and then paying little or no income tax on converting $26k/year to Roth after FIRE would allow you to hit your target number significantly earlier than you otherwise would.

3) Assuming your business is just you, what you want is a solo-401k. You can invest 18k as an employee of yourself plus about 20% of your total net income (~25% of your income less that contribution) as the employer of yourself. The limits on IRAs are completely separate and much lower, but depending on your income you may well be able to do both.  If you have employees you can still do the 18k, but employer contributions get more complex.

Hope this helps.

[MitchCraft]

1 & 2) The money in your IRA/401k wouldn't be locked up until you reach traditional retirement age but, at most, for about five years. Read up a bit on the concept of a Roth Conversion Pipeline here https://forum.mrmoneymustache.com/investor-alley/how-to-withdraw-funds-from-your-ira-and-401k-without-penalty-before-age-59-5/ to see how to make it happen. The tax savings from essentially deferring paying income tax in your highest earning years and then paying little or no income tax on converting $26k/year to Roth after FIRE would allow you to hit your target number significantly earlier than you otherwise would. 

What if I am interested in a traditional IRA instead of a Roth?  I just read the "Thirteen Word Retirement Plan" and they seem to spell out that traditional makes more sense.

3) Assuming your business is just you, what you want is a solo-401k. You can invest 18k as an employee of yourself plus about 20% of your total net income (~25% of your income less that contribution) as the employer of yourself. The limits on IRAs are completely separate and much lower, but depending on your income you may well be able to do both.  If you have employees you can still do the 18k, but employer contributions get more complex.

I am an S-corp with 5 employees.  Vanguard's Small Plan 401(k) says the total employer plus employee contribution limit is $54k for 2017.

[maizefolk]

You contribute to a traditional IRA or a traditional 401k. After you FIRE, you are able to convert those traditional contributions to Roth contributions (this requires paying income tax, but if your total income for the year is the $26k you converted then the income tax is negligible). After the converted dollars have sat in the Roth for five years you can pull them out without paying any tax or penalty whether you're 25 or 65. The link I gave has much more detail on how this actually works.

In order to hit the maximum using just employer contributions you'd need to have $270,000 in eligible income each year. If you contribution $18k as an employee, then you have $36k left in your combined limit. You can only get a tax deduction for employer contributions which are up to 25% of your eligible income, so to be able to contribute $36k on the employer side you'd need $144k in income excluding the employer contributions.

However, since you have employees you'll also have to deal with a lot of regulations that are set up to prevent employers from putting a lot of money into their accounts without also taking care of their employees these are called nondiscrimination tests (http://www.dwcconsultants.com/knowledge_center/NDT-Overview.php), so it is likely you will not be able to max out your 401k unless either your employees do as well, or you contribute to their plans on their behalf (see google "safe harbor" and 401k for more on this).

[MitchCraft]

Thank you for the help maizeman!

So, since the normal contribution limit for a traditional IRA is still $5,500,  it would still be wise to set up a retirement plan through my business, correct?  For example, a SIMPLE-IRA has employee/employer contributions set at $12,500 max per year.  This gives each employee the option to contribute or not, and I would personally be able to contribute the max of $12,500, and match a percentage (3% or so) of my compensation along with any other contributions from the other employees to their own accounts.  This would still keep everything 'fair' as far as the treatment of the employees.  So, if I matched at, say 3%, this would mean I could potentially contribute the $12,500 + 3% of my income as the employer for a total of, say $14,750 (if income was $75k). 

Is there any downside to doing all of this, other than the additional paperwork through the business?

[maizefolk]

Absolutely. $5500/year isn't a lot of money at the rate of savings early retirement requires.

You can compare a SIMPLE-IRA and the 401k options. If you're planning to match 3% or so of pay for all of your employees anyway, you might be able to set up a safe harbor compliant 401k plan, and at least be able to contribute the full employee $18k/year. But it'll obviously depend on a lot of specifics (and also how much your provider would charge for handling the paperwork on each of those types of plans) that you won't know without running the numbers on both options.

[h82goslw]

Go to bogleheads.org for in depth info and feedback on these types of investment decisions.

[SeattleCPA]

So here are some comments from the CPA who wrote the Thirteen Word Retirement Plan...

First, as Maizeman notes, you want to use a tax-deferred investment option since you're paying income taxes now but probably won't be when you retire.

Second, as Maizeman also notes, $5500 a year (or $11K if you're married) isn't really enough to retire early. The Thirteen Word Retirement Plan is a really simple formula that over the typical person's working years produces a "top ten percent" result. But that means, you're really looking at three decades or so.

Third, if you want to use a 401(k) and its higher plan limits, your S corporation will need to setup a 401(k) plan... and then you and other employees will be able to within that plan have 401(k) accounts. Answering the "should you do this" question in an online forum is tricky because we don't know all the particulars of your situation... but I would suggest caution about the 401(k) option. I think you'll find the out-of-pocket costs higher and the red tape more burdensome that you might think.

If you could make a SEP-IRA work, BTW, that's often attractive with an S corporation because the S corp pays the pension not employees and so allows you to pay yourself a lower salary and because you may be able to avoid for a couple of years at least covering employees.

I also like SIMPLE-IRAs because the costs are so low. (The question with a 401(k) plan is whether bumping the contribution limit from $12,500 to $18,000 is worth it given the costs you shoulder... )

Remember that if you're married, you can double these numbers. E.g., you and a spouse can probably do $11K and not $5500... or you and a spouse can both do SIMPLE-IRAs so $25K and not $12.5K...

Finally, note that a taxable account holding something like a US stock index fund or an International stock index fund is very tax efficient. You would not pay income taxes on the income from this investment in retirement at the income levels and wealth levels you're talking.

P.S. To anyone else reading this: We give away the Thirteen Word Retirement Plan free at the blog: http://evergreensmallbusiness.com/the-thirteen-word-retirement-plan/

[SeattleCPA]

One other thing I forgot to point out but which is really relevant to OP.

If you create a business you can sell, that'll probably take care of a LOT of your savings requirement. For example, a business that makes $100K a year is possibly worth $250K. (The typical multiple is 2.5 times cash flow.)

This possibly means you really want to do whatever you can to smartly grow your business. The return on investment you earn there will surely beat what you get in a passive investment.

http://evergreensmallbusiness.com/small-business-investment-returns/

Note: I'm not suggesting you skip the IRA or 401(k)... only that you consider a dual pronged approach here... some of your investing in an IRA or 401(k)... some into your business.