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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.
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?
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?
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.SEP-IRA and a solo 401(k) at Vanguard?” and the answer to that is probably not. In fact, there are precious few reasons for most readers of this blog to have a SEP-IRA at all. The problem with SEP-IRAs, at least when compared to an individual (solo) 401(k), is that you may need more income to max them out since there is no employee contribution component (the $18,500 for those under 50 and $24,500 for those 50+) and they screw-up your Backdoor Roth IRA pro-rata calculation. (See line 6 of IRS Form 8606). And for what? Maybe you get a slightly lower ER (a Vanguard SEP-IRA is eligible for admiral shares but a Vanguard individual 401(k) is not) and slightly less hassle (don't need to spend 3 minutes getting a free EIN, don't need to fill out a few pages of paperwork, and don't need to do a Form 5500-EZ after it hits $250K).
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!