[Editor's Note: Konstantin Litovsky has written before about the merits of a “pooled 401(k) plan.” In this post, he talks about the benefits of a customized pooled plan for your individual 401(k) (also called a Solo 401(k)). You can learn more about choosing an individual 401(k) with this post published a year and a half ago. He titled this post: Turn Your Vanguard Solo 401(k) into the Perfect 401(k) for next to nothing.]
By Konstantin Litovsky, Guest Writer
Vanguard offers low cost Admiral Shares and has the best selection of index funds available. In addition, Vanguard offers a brokerage account with all of the Vanguard ETFs available commission-free. If most of your accounts are opened with Vanguard, having to open a ‘solo’ 401k at another provider can be somewhat of a burden. Unfortunately, compared with other ‘solo’ 401k plans, the one offered by Vanguard is not the best available for various reasons.
Vanguard ‘Solo’ 401(k)
Vanguard plan document for its ‘solo’ 401k plan does not allow incoming rollovers, so you can’t move an existing traditional IRA or an old 401k plan into your ‘solo’ 401k. Vanguard also limits investments in its ‘solo’ 401k to Investor Shares only, and the brokerage option is not available. Once the assets are above $250k, form 5500 has to be filled out and filed with the IRS, which is something that has to be done for all ‘solo’ 401k plans.
The Ideal ‘Solo’ 401(k)
If we had to design a ‘solo’ 401k plan from scratch, what features would we want to include? For one thing, making a Backdoor Roth contribution is a given for most physicians, so we want to be able to roll any of our existing IRAs (and old 401k/403b/457b plans) into our ‘solo’ 401k. We would also want to have the brokerage option to have the ability to purchase ETFs, especially if we want to build a multi-asset class portfolio. It takes as much as $500k to implement a 12 asset class portfolio using Admiral Shares, yet it takes as little as $10k to build a similar portfolio using low cost ETFs, and the ETF portfolio will have the same overall expense ratio (around 0.12%) as the $500k Admiral Shares portfolio. There is another feature that might prove valuable if you want to pursue the Mega Roth strategy. As of 2014, IRS allows in-plan Roth conversion of tax-deferred contributions and rollover assets regardless of how old you are, and this would be possible if outgoing transfers are allowed, so you can now have one giant Mega Roth right inside your ‘solo’ 401k. A ‘solo’ 401k account at Vanguard or at any other brokerage will use a standard plan document that cannot be changed. However, there is a way you can have all of these features enabled in your ‘solo’ 401k plan.
Turn ‘Solo’ 401(k) into the Perfect 401(k)
While many brokerages allow certain ‘solo’ 401k features that Vanguard does not allow, to get the most flexibility to make changes to your ‘solo’ 401k you will need to have full control over your plan document, regardless of which brokerages your ‘solo’ 401k is with. You can have any of the features that a regular 401k plan has for your own ‘solo’ 401k with a custom plan document. This document has to be drafted by a TPA (Third Party Administrator) who can customize the plan document to your specific needs. With a document in hand, all you need to do is open a ‘pooled’ account at Vanguard, called VRIP. To open this account, fill out the application and attach the relevant pages from your adoption agreement, as well as a letter of instruction that will tell Vanguard which assets (such as traditional and SEP IRAs and your existing ‘solo’ 401k plan account) should be moved into your new VRIP account. The TPA will provide you with all of the necessary paperwork.
Once the account is open, you can make contributions exactly the same way you’ve done it before. When your plan assets are over $250k, you will need to fill out and file form 5500-EZ, which you can try to do yourself, or you can have the TPA do it for you for a small fee. You will only need a single plan document for your plan (unless you plan to hire non-spouse employees later on), so the only ongoing cost will be the cost of filing the form 5500-EZ with the IRS.
After going through this process, you will, in fact, be opening your own ‘pooled’ 401k plan. If you ever hire employees, you will already have your own functioning 401k plan, so it will be relatively easy and cost effective to update the plan document to include a new plan design and to add participation requirements.
Here’s the good part. If you have a startup plan, the IRS allows you to take a $500 credit over 3 years for administrative expenses, so your plan document and subsequent administration expenses over the next 2 years will cost you next to nothing. So if you are about to open a ‘solo’ 401k, it makes sense to get a custom plan document so that you can turn your ‘solo’ 401k into the perfect 401k plan. Even if you’ve had your plan for a while, it might also make sense to upgrade your ‘solo’ 401k plan if you are contributing significant amount to your plan and want to take advantage of having a brokerage account, incoming rollovers and in-plan Roth conversions.
- Vanguard is a great place to consolidate your accounts.
- Vanguard ‘solo’ 401k does not allow ETF investing, has only Investor and not Admiral Shares, and does not allow account consolidation via rollovers. You cannot use Vanguard ‘solo’ 401k to implement the ‘backdoor’ Roth strategy or to make in-plan Roth conversions.
- With a custom plan document you can have all of the features that a regular 401k plan has (and you’ll be converting your ‘solo’ 401k into a pooled 401k), so you can have the best 401k at Vanguard with Admiral Shares, ETFs, incoming rollovers and in-plan Roth conversion available. There are two major reasons for having a customized plan document for your ‘solo’ 401k plan:
- To have full flexibility to enable plan features to allow incoming rollovers and in-plan Roth conversions. If there are any future strategies and options that become available, an off-the-shelf plan document might not have these features, so having full control over the plan document ensures that you will always be able to have the best features in your 401k plan.
- To have an actual 401k plan that can easily be upgraded by making changes to the plan document if you hire employees in the future.
- A startup plan can take advantage of a 3-year $500 credit to offset administrative cost (which includes a one-time plan document and form 5500-EZ filing if the assets are over $250k), so it might be a good idea to get a custom plan document for your plan as soon as you open it. Existing ‘solo’ 401k plan can also benefit from a custom plan document if you are contributing significant amounts to your plan and want to take advantage of having a brokerage account, incoming rollovers and in-plan Roth conversions.
[Editor's Note: I debated doing this post as a “Pro/Con” post, but was unable to come up with enough I didn't like about it to really flush out a post. However, there are a few points worth making. First, obviously Kon would love for you to hire his firm to do a customized plan document. However, it may not be clear from his post that there is a certain expense to this. While the IRS credit will help offset that expense, it will not do so completely. The credit is only up to 50% of your expenses, so it will still cost you something. So you have to determine whether the benefits are worth the additional expense and hassle. One of the benefits for me would be to get Admiral shares. But that's only worth about 0.1% per year in additional return, or $100 a year in lower expenses on a $100K individual 401(k). If the plan document costs me $775 ($388 after the credit,) then it will take me four years for the lower ongoing costs to make up for the initial cost. It's hard for me to justify the hassle for that. If your main concern is to be able to do a transfer of an old IRA in order to do Backdoor Roth IRAs, it might be easier to go to Fidelity or Etrade. Another downside of the account is that the Vanguard VRIP, at least according to the paperwork I could find, so you'll either have to do that yourself or hire a TPA to do it. I don't think you have to do that with either the regular Vanguard or the eTrade individual 401(k). At any rate, I do agree with Mr. Litovsky that this is another reasonable option for someone to use for an individual 401(k), especially if they have a large account and highly value keeping it at Vanguard with their other assets.]
[Editor's Note: Konstantin Litovsky, owner of Litovsky Asset Management, is a long-time WCI partner and an expert in designing low-cost small practice retirement plans, however, this is not a sponsored post. This article was submitted and approved according to our Guest Post Policy.]
What do you think? Would you find the benefits of a pooled individual 401(k) worth the hassle/cost? Why or why not? Where is your individual 401(k)? Are you happy with it? Comment below!