Question: I am self-employed and report my income on Schedule C on my tax return. I earn $200,000. My spouse is also self-employed and she earns $150,000 per year. We are good savers, but it seems like so much of our income goes to taxes that we can’t get ahead and save enough for retirement. We each have SEP-IRA accounts that help a little. What options are there for us?
Answer: At your level of income, you and your spouse would both be able to save more for retirement and substantially lower your annual tax bill with individual 401(k) accounts. The new tax laws that went into effect last year will increase your taxes by cutting back your itemized deductions and phasing out your personal exemptions when your adjusted gross income (AGI) exceeds $300,000. On top of that is the new 0.9% Medicare surtax on wages and self-employment income of high-earners, starting at $250,000 of earnings for married couples.
Contributions to your retirement accounts will lower your AGI thus lowering your tax.
The SEP-IRA retirement account, like the one you have now, is a type of profit-sharing plan. SEP-IRA contributions are limited to 20% of your net profit after subtracting your self-employment tax deduction. The IRS has increased the maximum contribution from $51,000 in 2013 to $52,000 in 2014. With a SEP-IRA, you won’t reach the $52,000 contribution level until your net income reaches $260,000.
The individual 401(k) plan, which is sometimes called a “Solo 401(k),” is a combination of a profit-sharing plan like the SEP-IRA and an income deferral plan like a 401(k). This combination allows individuals with less than $260,000 of income to contribute more than they could with just a SEP-IRA. For individuals with net income levels higher than $260,000, total contributions to individual 401(k) accounts in 2014 are capped at $52,000 (under 50) or $57,500 (over 50). With an individual 401(k) you can reach the SEP’s $52,000 maximum contribution limit with less income.
As an example, a self-employed professional with net earnings of $100,000 would be able to contribute $20,000 to a SEP-IRA. If he or she had an individual 401(k) he would be able to contribute $37,500 ($43,000 if 50 or over); $20,000 to the profit-sharing part of the plan and $17,500 to the income-deferral part of the plan ($23,000 if 50 or over). An additional $17,500 contribution will save a self-employed professional in the combined 40% federal and state tax bracket $7,000 in taxes.
In summary, the key benefits of the individual 401(k) include:
- Higher contributions than a profit-sharing plan or income-deferral plan
- A larger tax deduction and more tax deferral as the assets in the plan grow
- No minimum required annual contributions
- Low cost if you use a basic plan provided by your favorite investment custodian
- Individuals over 49 years old can contribute an additional catch-up contribution, currently $5,500.
The only drawbacks to an individual 401(k) are the costs of administration, which can be minimal depending upon the custodian, and the requirement that the plan file an IRS Form 5500 or 5500-EZ annually once the account balance reaches $250,000 or more. Many mutual fund companies and broker-dealers (e.g.; Schwab, Fidelity, TD Ameritrade, etc.) have basic plans available with little or no cost.
Kenneth B. Petersen CFP®, EA, MBA, AIFA® is an investment manager and Principal of Monterey Private Wealth, Inc., a Wealth Management Firm in Monterey. He welcomes questions that you may have concerning investing, taxes, retirement, or estate planning. Send your questions to: Ken Petersen, 2340 Garden Road Suite 202, Monterey, CA 93940 or email them to firstname.lastname@example.org.