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I occasionally jot down some thoughts about a post that I'd like to write. Sometimes, I lose that note. Sometimes I lose it for years. This post comes from a note I recently found. I have no idea when I wrote it or who the email came from that triggered it, but I titled the note “Questions from an Old Friend”, so that's what we'll call this post. There were apparently four questions, all of which would be helpful to discuss on the blog.
Q. Can we do an IRA? Our accountant says we can't.
A.
Your accountant is wrong. If you have earned income, you can contribute to a tax-deferred traditional IRA. However, if you wish to DEDUCT any of that contribution, one of two things must be true:
- You must either have a modified adjusted gross income (MAGI) of < $73,000 ($121,000 married) or
- You do not have access to a retirement plan like a 401(k) either at work or through your self-employed work
With regards to a tax-free Roth IRA, you can make your full $5,500 ($6,500 if 50+) contribution under two circumstances:
- You have a MAGI under $120,000 ($189,000 married) or
- You do so indirectly, by contributing first to a traditional IRA and then converting it (i.e. a Backdoor Roth IRA).
If you are married, your spouse doesn't actually have to have earned income, as long as you have as much earned income as was contributed to both of your IRAs. This “spousal” traditional IRA has slightly different rules for deducting contributions. If the working spouse has a retirement plan available at work and your MAGI is < $189,000, you can deduct the full contribution.
As you can see, your accountant is wrong if he really said what you think he said, but he probably didn't. He was probably referring to your ability to deduct your traditional IRA contribution or your ability to contribute directly to a Roth IRA.
Q. Is my S corp salary too low?
A.
The real tax benefit of an S Corporation is to save on payroll taxes, since you can split your income into salary and distributions and only owe payroll taxes (theoretically Social Security and Medicare but in reality for high earners, just the 2.9%-3.8% Medicare tax). Obviously, the less of your income you designate as salary, the less you owe in Medicare tax. However, if you set that salary too low, you also may not be able to max out your individual 401(k) or other self-employed retirement account. It can also affect the amount of the new pass-through entity deduction.
The IRS doesn't want you to set your salary too low, so it has set rules about how low you can set it. Basically, you have to pay yourself the going rate for your job. In the event of an audit, you need to be able to convince the IRS auditor that you had a good reason to use that figure. That might be a salary survey or an amount you pay an employee doc in your practice or something similar. As a general rule, The IRS rules are that the following factors should determine reasonable compensation:
- training and experience,
- duties and responsibilities,
- time and effort devoted to the business,
- dividend history,
- payments to nonshareholder employees,
- timing and manner of paying bonuses to key people,
- what comparable businesses pay for similar services,
- compensation agreements, and
- the use of a formula to determine compensation.
Sources of information on comparable compensation for services include the U.S. Department of Labor’s Bureau of Labor Statistics, employment agencies, and a market analysis.
Bottom line, as a doc working full-time, I think you'd have a very hard time justifying a salary under the amount of income subject to Social Security ($128K in 2018), much less a five figure amount. That's okay, because you'll need a salary larger than both of those amounts just to max out an individual 401(k). ($55,000 – $18,500)/25% = $146K in 2018
Q. Can I employ my spouse?
A.
Yes. You can employ anybody you like, as long as they can legally work in this country. The question, however, is SHOULD you employ your spouse. Lots of docs have this idea in their head that somehow employing a spouse gives them some huge tax deduction. In many cases, it actually COSTS them money to hire their spouse. Now, if you legitimately need someone to help you, your spouse is qualified to meet that need, and your spouse actually wants to do the work, then go ahead and hire your spouse. Remember you have to treat them like all your other employees. That means you have to pay their payroll taxes, which is where most docs realize this isn't a great idea for them. If that income was paid to the doc, it would only be subject to Medicare tax (and maybe not even that in an S Corp) but if it is paid to a previously non-earning spouse, it will be subject to Social Security tax too, which is 4 times higher than Medicare tax.
Of course, if your spouse earns money, they are able to contribute some of it to a retirement account. If things are set up properly, your spouse might even be able to put as much as $55K in there. But that's going to require you to pay a lot of payroll taxes, and the cost may not be worth the benefit. Run the numbers in your situation to see if it makes sense.
Q. Can I have a SEP-IRA and a Solo 401(k) at Vanguard?
A.
Many docs have made this mistake, and unfortunately, the solution to it is NOT to open a Vanguard Individual 401(k), because their 401(k) doesn't allow IRA rollovers. You actually need to open one at eTrade or Fidelity (which do take IRA rollovers.) Then, if you really want it at Vanguard, roll it over to a Vanguard individual 401(k).
What do you think? Have you had any of these questions before? Do you have an S corp or a solo 401(k)? Have you employed your spouse? Comment below!
No S Corp yet, but someday when the side hustle income gets large enough I’ll probably consider doing that. Seems like a more tax efficient entity than my simple LLC pass-through income as a sole proprietor.
It continues to amaze me how many questions you get about backdoor Roths. That must be the most asked questions among all the financial questions for doctors. Maybe it’s because it sounds sneaky and cool? Not sure. Either way, I continue to get this question in person and online quite frequently despite the length at which it has been discussed.
TPP
Nope. Backdoor Roth questions aren’t even close to the pay debt or invest questions.
Haha. That’s true. That is a common one. Good point.
Awesome. These are common questions with easy to understand answers. Thanks!
I’m an employed doc and max my 403b and 457. I have a side hustle of consulting and have been maxing my SEP from the consulting income. The sep allows me to get tax breaks now plus allows me to contribute more than the $5500 of a backdoor Roth. Exploring if I should liquidate my sep, Pay taxes on the earnings and then transfer to a backdoor Roth. Do you see any advantages of one path versus the other? Thank you!!
In general an individual 401(k) is superior to a SEP-IRA because in some situations you can get your $55K in there with less income but mostly so you can do a Backdoor Roth IRA without the pro-rata rule coming into effect. Once you have a SEP, if you want to do Backdoor Roth IRAs, you have two options: Convert the SEP-IRA to a Roth IRA or roll the SEP into a 401(k) (including your new individual 401(k))
Is it worth it, then, to set up a SEP if you are not doing backdoor Roth contributions? Unfortunately I missed the boat and ended up with a lot of money in my traditional IRA, making the Roth rollover a huge tax hit.
If you are eligible for a SEP, you are eligible for an individual 401(k). If you have an individual 401(k), you can roll your IRA in there and start doing Backdoor Roth IRAs.
Thanks for the response! Makes perfect sense. Is the rollover tax-free or is there a cost associated with the rollover?
Rollovers done properly are always tax-free but can sometimes involve an account closing fee.
I already have a 401k through the corporation that owns my practice. It was recommended to me to open a SEP, however I was looking to start back-door Roth contributions instead. Would it be worth rolling the traditional IRA into the 401k that I currently have, or do you think I should open a new solo 401k solely for the purposes of the rollover? My thinking is that I would continue to max out my corporate 401k and leave the solo 401k alone once the rollover is complete, then start back-door Roth contributions.
Are you even eligible for a 401(k) or a SEP-IRA? If you’re an employee with no self-employed income, the answer is no. In that case, for someone with an IRA or SEP-IRA who wishes to do Backdoor Roth IRAs, the easy answer is to roll the traditional and SEP-IRAs into the 401(k) they have.
My income consists of W2 income from the practice and 1099 income from taking call at the hospital. The 1099 income is what I am trying to work with and why my CPA initially suggested I open up a SEP. If I open up a solo 401k, would I be able to take advantage of the 55K contribution limit? I have been reading your other posts about multiple 401ks this morning (excellent, by the way!) and trying to make sure that I understand all of the details. It would seem that there would be some benefit to having the solo 401k based on those posts, to allow me to contribute more, correct?
I see. Yea, I’d just use a solo 401k instead of a SEP-IRA, roll your SEP-IRA in there and do Backdoor Roths.
You’re going to have to take a heck of a lot of call to be able to make enough money to max out the 2019 $56K contribution limit. Assuming you’re using your $19K employee contribution in the employer plan, you would need something like $280K in call money to max it out.
solo 401k it is! Going to go with Etrade per the recommendation from another of your articles. Thank you for your prompt and wise advice!
If you want more features (and are willing to pay for them) I have a new recommendation. It’ll cost you $700 up front and $125 a year, but you’ll get a lot more support and some pretty cool features. Let me know if you’re interested, otherwise, there’ll be a blog post out in a few weeks.
Sure, I’d be interested to learn more!
I spoke to my financial advisor today and as he manages my traditional IRA, I brought up setting up a solo 401k. He told me that setting up a solo 401k would involve a TPA and administrative costs would be $1,000-$1,250 annually. I told him I am a sole proprietor and had not seen this in any of my research, and he told me to look into it further and let him know. Could he be thinking of a different retirement account or scenario? Is there anything I am missing?
If you’re talking about an individual/solo 401(k) it sounds like you need a new advisor. I personally set one up myself at Vanguard for nothing and recently got a customized one for $800 plus $125 a year with every feature you could possibly want.
If you have employees, it’s going to cost you more.