Q.
How can I tell if it will be beneficial to start a 401K/Profit-Sharing Plan for my solo practice? I have several employees. At what point am I better off investing in a taxable account instead of starting a 401K/Profit-Sharing Plan?
A.
I've been thinking about this question for months. It is an exceptional question, without a definite right answer. 401K/Profit-Sharing Plans have both costs and benefits, especially for the company owner. You have to weigh the costs against the benefits to determine what the right choice is. Remember that a 401K/Profit-Sharing Plan is a hybrid plan. It has a 401K component, which allows for employees to voluntarily defer as much as 100% of their salary up to $17,500 (plus a $5,500 “catch-up” contribution if over 50) into a tax-deferred or Roth account. It also has a Profit-Sharing Plan component, which allows for the employer to make additional contributions, up to the 2014 IRC limit of $52,000 ($57,500 if over 50). Both of these types of plans are subject to different non-discrimination tests, which ensures that the employees of the business share with the owner in the benefits of the plan.
401K/Profit-Sharing Plan Benefits
1. You get the personal benefits of a 401K/Profit-Sharing Plan
- Additional asset protection
- Easier estate planning (just have to name beneficiaries)
- Tax-protected growth
- Tax rate arbitrage between contribution and withdrawal
2. You get to offer these same benefits to employees
- Improve employee retention
- Help provide for employees' retirement
- Attract better employees
401K/Profit-Sharing Plan Costs and Downsides
- Implementation fees
- Ongoing management fees
- Possibly higher investment fees
- Money for 401K employee match/Safe Harbor contributions
- Money for Profit Sharing Plan contributions
- Employees may not value the 401K benefit as much as it costs you (they'd rather have a higher salary)
- Limited contributions ($52K at best, may be less if the owner does not make enough or if he chooses not to provide sufficient funds for contributions for his employees)
Taxable Account Benefits
- More investment options
- No implementation and management expenses (although these are paid pre-tax in a 401K/Profit-Sharing Plan)
- Minimal investment expenses
- No employee-related expenses
- Minimal compliance hassle
Taxable Account Downsides
- Higher taxes
- No asset protection
- Trickier estate planning
- No retirement plan for employees
Quantifying these factors
The difficulty ensues when you begin to try to quantify each of these factors. How much is the additional asset protection worth to you? That depends on your state, the amount of insurance you carry, your personal risk profile, your level of assets, and your own personal fear of litigation. The estate planning benefit can be quantified as the expense and hassle of using a will and trust to determine where your assets go at death, instead of just naming beneficiaries as you would in a 401K/Profit-Sharing Plan.
The expenses of the 401K/Profit Sharing Plan are relatively easy to figure out by bringing in an experienced advisor who can give you a quote for the 401K initial and ongoing expenses. If he is really good, he can keep your investment expenses no higher than they would be in a taxable account by using low-cost, passive funds in the plan. Employee Fiduciary, perhaps the lowest cost provider of 401Ks, would charge $500 for implementation of a 401K and $1,500 plus $0.08% of AUM for a small 401K. There are some additional fees required for some required actuarial testing for a profit-sharing plan. FPL and Litovsky Asset Management, two of my advertisers, also offer these services at a similar price. Konstantin Litovsky pointed out to me in an email that the fees for running the plan are actually a minor expense. The main expense associated with these plans is the contributions the owner would have to make for his employees. The fewer the employees, the younger the employees, the lower paid the employees, and the higher the employee turnover, the less this cost will be, but it can be highly variable depending on plan design and the design of your business or practice. We'll discuss more about this cost below, but plan on $2-5K per year in expenses for running the plan.
The personal tax benefits of the plan are relatively easy to calculate, although some guess work is required. The tax-protected growth factor is simply the difference between investing in a taxable account vs investing in a Roth IRA. The tax rate arbitrage, of course, depends on future, unknowable tax rates. But if you're making contributions at a marginal rate of 33%, and withdrawing the money at an effective rate of 18%, the benefit of this arbitrage can easily exceed the benefit of the tax-protected growth.
The value to the employees is perhaps the most difficult number to quantify. Each employee is different. The less they save, the less they're paid, and the less they think about retirement, the lower this benefit will be. It is quite possible that your expenses will be higher than the value your employees see in the benefit.
401K Top-Heavy/Non-Discrimination Testing
A 401K plan is generally considered top-heavy if at the end of the year more than 60% of the plan assets belong to “key employees” (i.e. the doc.) If the plan is top-heavy, then you must meet two requirements. The first is that you must meet “minimum contribution requirements” for the non-key employees. This minimum contribution is the 3% of the employee's contribution. So if you're paying a nurse $75K, a manager $75K, and receptionist $40K, and a tech $40K, and none of them contribute to the plan, then you'll need to make a total contribution of $230K*3% = $6900 if you wish to max out your own benefit. You may also match employee contributions dollar for dollar up to 4% of their salary. If your goal is to maximize your personal benefit from the plan (and thus minimize the contributions you make for employees), then you would favor the 4% rule if your employees don't contribute much, and the 3% rule if your employees use the plan heavily.
The second top-heavy requirement for a 401K plan is a vesting requirement. Employee contributions are always 100% vested, but the employer contributions (whether a simple 3% of their salary or a 4% match) must be either 100% vested after 3 years, or 20% vested after 2 years, with 20% vesting for each additional year (100% vested at 6 years). If you do not meet both of these requirements, your plan may no longer be “qualified”, meaning you will lose the tax breaks the IRS provides for 401Ks.
“Safe Harbor” 401Ks are those that make a minimum “safe harbor” contribution or each employee. The safe harbor contribution is either 3% of pay or a 4% match, but it must be vested immediately. Since any plan including a physician and her employees is almost surely going to be top-heavy, plan on making Safe Harbor contributions each year when running your numbers.
Profit-Sharing Plan Top-Heavy/Non-Discrimination Testing
If you thought that was complicated, you haven't seen anything yet. I think most physicians are capable of managing their own investment portfolio. However, I do not think most of them are capable of designing the retirement plan for their practice. The assistance of a professional (with an actuary on staff) is invaluable in this process.
There are “safe harbor” provisions for profit-sharing plans, however, they generally result in the highest required payments for your employees. The more complicated, non-safe harbor, methods of determining the match are mostly likely to minimize this expense. There are at least 6 methods for making sure your plan doesn't discriminate against your non-highly compensated employees.
Design-based Safe Harbor (Uniform Allocation) Methods
- Uniform Percentage of Pay Method (also called Salary Ratio)
- Uniform Dollar Amount Method (not common for small businesses)
- Integration Method
Non-design-based Safe Harbor Method
4. Uniform Points Method (not common for small businesses)
Non-Safe Harbor Methods
5. Age-Weighted Method
6. New Comparability Method
The Uniform Percentage of Pay Method is the easiest to understand. If you want to “profit-share” the maximum 20% of the owner's salary, you'll need to do the same for all of the employees. So if your nurse makes $60,000, you'll need to make a profit-sharing contribution of $12,000. If you have a couple of other employees making $30,000, your profit-sharing component could represent a cost of $24,000 per year! You can see why a practice owner with multiple employees might simply choose to invest in a taxable account instead of using a Profit-Sharing Plan. If your employees really value this benefit (and thus you can reduce the offered salary as a result of it), then this may be a great way to go. It is certainly straightforward.
The Integration Method is a little more complicated. Basically, this method allows you to profit-share a little lower percentage of your employees pay. So you might be able to do 20% for yourself, but only have to do 16-18% for your employees. It basically takes into account the fact that Social Security is progressive. The math is a little bit complicated. You're probably not going to want to do it without a professional's help.
The Age-Weighted Method is a great way to go if the business/practice owner is much older than all the employees. The logic behind this method is that contributions need to be comparable AT RETIREMENT AGE. So if you're 60, the retirement age in the plan is 65, and the employees are 25, then a small lump sum at 25 that is allowed to grow for 40 years is equal to a much larger lump sum at 60 that can only grow for 5 years, especially when discounted at the maximum allowed 8.5%. A really young employee may only get a profit-sharing contribution of 3 or 4% of salary where the older owner can get a 20% contribution. Beware, however, of hiring older staff with this method, even if they are not paid well. The profit-sharing contribution could be much higher than 20%!
The New Comparability Method is gaining more popularity all the time among those who wish to minimize the size of the required contributions for employees. With this one, you split employees into different groups, such as Doctors/Owners and All Other Employees. It turns out you can profit-share just 5% of salary with the “All Other Employees” group, while profit-sharing 20% of your own salary. Obviously this is going to save a whole lot of cash compared to the Uniform Percentage of Pay Method, since it cuts your required profit-sharing contributions by 75%.
401K Vs Taxable Account
So, let's compare just using a standard 401K against a Taxable account. Let's assume you have 4 employees whose combined salaries are $230,000 and you're going to use the 3% Safe Harbor mandatory contribution. If you use Employee Fiduciary, your costs are going to be less than $2,000. Your employer contributions are going to run 3% * $230K = $6900, for a total of $8900 per year (pre-tax, of course.) In return for spending this money, you get to tax-defer $17,500 per year. Let's assume you do this for 30 years. Let's also assume your current marginal tax rate is 33%, that you can withdraw your 401K contributions in retirement at an effective rate of 17%, that your investments gain 8% per year pre-tax, that you use the same investments both within and without a 401K, and that you invest in a taxable account in a very tax-efficient way but still have a 20% dividend/long-term capital gains rate. We'll ignore the value of the asset protection, estate planning, and employee relationship benefits in this analysis, all of which, of course, favor the 401K.
The benefits of tax-free growth on the $17.5K*0.67 = $11,725 are equal to $301,401, the difference between what $11,725 would grow to in a Roth IRA at 8% per year ($1,434,505) and what it would grow to in a taxable account at a pre-tax 8% ($1,133,104). This is the equivalent of a return that is 1.26% per year lower.
The benefit of the tax rate arbitrage (contribute at 33% marginal rate, withdraw at 17% effective rate) would add another $342,569, or about 1.10% per year higher.
So the total benefit of the 401K over just using a taxable account after 30 years (this, of course, ignores the benefit of further tax-deferred growth during retirement) is $643,970.
What is the total cost? For this particular doctor, it is $8,900 per year pre-tax, or $5,963. In a taxable account over 30 years, that would grow to $576,264. With a benefit of $67,706 plus the difficult to quantify benefits of additional asset protection, easier estate planning, continued tax-deferred growth in retirement, and employee relationship benefits, it would seem a no-brainer for this doctor to go with this low-cost 401K. However, if he had more employees, higher paid employees, a higher cost 401K, or a 401K with crappier investments, he could easily come out behind financially on this one.
Now let's repeat that exercise for a 401K/Profit-Sharing Plan for the same practice. The doctor now gets to put in $52,000 — $17,500 as a employee contribution and $34,500 as a profit-sharing contribution. We'll assume that $34,500 is 20% of his pay and that he uses a New Comparability plan where the employees get a 5% profit-share. Let's assume annual costs for the plan of $5000. He will also need to contribute 3% + 5% of all the employee salaries ($18,400) for a total of $23,400 as a pre-tax business expense.
The benefit of the tax-deferral on the $52,000*.67 = $34,840 is $895,592. The benefit of the tax-rate arbitrage is $954,298 for a total benefit of the 401K/Profit-Sharing Plan of $1,849,890. The cost of the plan ($23,400 pre-tax growing in a taxable account at 8%) comes out to $1,515,122. This doctor would come out $334,767 ahead, not including all the other benefits of the 401K/Profit-Sharing Plan.
Wrapping It All Up
Every practice and physician will need to run these numbers prior to implementing a 401K/Profit-Sharing Plan, but as long as you don't have too many highly paid employees and you stick to low cost retirement plan providers, most doctors will at least be able to break even financially while reaping the additional tax-protection, estate planning, and employee retention benefits.
What do you think? Have you implemented a retirement plan for your employees? Why or why not? What type did you choose and why? Comment below!
Actually to clarify Employee Fiduciary does all of the TPA work (including testing to ERISA plan design rules) as part of the $1,500 annual fee. EF is really a great deal.
I think if you see the money paid into employees’ accounts as purely a cost, it would rarely make sense to set up a 401k versus just investing in a regular taxable account. It would make sense if you see it as a part of your total compensation to the employees. With that in mind, going for fancy actuarial work with New Comparability benefits the vendor instead of employees. You might as well pay into the employees’ accounts. Profit sharing is a more efficient form of compensation to everyone.
Hi Harry,
Some practice owners balk at the cost of having to provide a match to the employees. I agree with you that it is much better to do that than to pay the IRS.
The TPA I work with charges the same for cross-tested plans as for a standard Safe Harbor 401k. A typical TPA (like EF) will charge $2k + 0.08% for a cross-tested plan, while my TPA charges $1200 + $20/pp, and no asset-based fees. That’s why I always recommend that practice owners do a cross-tested or a triple match design, so that owner + spouse contribution starts at about $70k.
To attract and retain employees, a solo practitioner needs to provide a decent benefits package. Some employees may value health insurance benefits more than 401k. Others, who may get healthcare through a spouse, might value the 401k. If you have family members who are also employed (spouse, children, etc), the plan provides them a means to save and partake in the profit sharing.
Why is the cost 5k for a 401 plan
I pay 1100 yearly to administer my PS plan
Don’t be so sure. A lot of 401k’s use higher cost mutual funds or share classes which then kickback a portion of the inflated expense ratio to the plan administrator. This “revenue sharing” allows the plan sponsor to shift the cost of the plan onto the participants without them realizing that they’re paying for it. It is legal and even can be done with Vanguard funds by using investor-class shares (though Vanguard’s revenue sharing involves a lot fewer basis points than most companies).
If most of the money in your plan belongs to the doctors and you have large balances, it may be worthwhile to strip these fees out and pay them directly through your corp. You should then be able to select lower expense institutional share classes for your plan which could effectively be like contributing thousands of dollars extra to your account each year (and invaluable if you’re already maxing your tax-favored savings). Alternatively, some administrators will give you the option to rebate the revenue sharing back into the individual accounts if you want certain funds that don’t offer clean share classes. I’m told that the plan expenses are also tax-deductible to the corp, although the mechanics and benefit of that may depend on your particular corporate structure.
If you want to see what you’re paying out of your personal account, look at the investment option data provided by your plan administrator. Next to the expense ratio, there is usually a column marked “revenue sharing” (employers have access to this, but I’m not sure if it has to be shown in the paper work sent to employees). This is the component of the expense ratio that is being kicked back to the administrator, or, the way I look at it, the amount of money you’re withdrawing from you 401k each year to cover an administrative expense that you could instead be paying with pre-tax dollars through your corp.
Hi Arthur,
1) There is absolutely NO revenue sharing done with Vanguard funds. None whatsoever. That’s exactly why I use them exclusively.
2) Using funds inside a plan for the sole purpose of offsetting plan sponsor cost, while not illegal, will get your plan sued eventually, and the plan sponsor will lose if they can’t prove that the funds are selected for the best in class status, rather than for revenue sharing purposes – this is case law, and many lawsuits are underway.
3) Actually, revenue sharing is not really disclosed. I can see it on form 5500, but even there it is often very well hidden. What you see on participant level disclosure is a total fee that YOU pay, but not the fee that the adviser is getting as a kickback. The plan sponsor should be getting this disclosure and making decisions on this basis, but that is rarely happening as it is too complex for most plan sponsors to deal with.
1. Actually, I got a proposal utilizing Vanguard last year that partially covered administrative costs by requiring investor-class shares only in the plan. It worked out to a revenue share of 9 basis points, which is certainly lower than most, but still something. You may not do it that way, but it can be done.
2. I agree and that was a second rationale we had for wanting to strip out the administrative costs. Interestingly, a lot of the DOL suits are against fairly small businesses. I think a lot of doctors believe their practice is too small to draw that kind of regulatory scrutiny, but they’re wrong.
3. I agree, again. It took a while for me to figure out the revenue sharing and I was the guy reviewing the proposals and meeting with the advisors. While it was there if you knew what to look for, none of the proposals we got highlighted it very well and the guys pitching the plans really tried to gloss over it, focusing instead on how little the group would have to pay directly. I’ve been around long enough to know that I’d be paying them somehow and when I finally figured out what was going on I made them restructure the proposals with direct payment of administrative fees and a dream line-up of institutional share-class funds. What really astounded me was that some of the companies refused to do it — one well-known investment firm flatly said revenue sharing was the only option they could provide. They did not get our business.
Looks like you are on top of things. I also didn’t like this stuff one bit, so instead I decided to offer flat-fee pricing for the plans I manage. Simply using low cost Admiral/Signal shares, independent stand-alone TPAs (not bundled anything), and a flat fee for ERISA 3(38) fiduciary (or discretionary portfolio management) services, which also include risk-managed model portfolios and individualized advice to plan participants (rarely if ever offered). Easy to understand, transparent, fees don’t increase with asset level, and probably the best pricing model considering that flat fees beat asset-based fees over the long term (which is presumably the idea – to have a retirement plan for a very long time).
Just to add to this. Vanguard Admiral and Signal shares do NOT have any revenue sharing fees. Vanguard might have a small handful of actively managed funds where they pay a share of the revenue. For a fund that costs 5 basis points to manage, 9 basis points is an awfully large number. The portfolios I construct average about 15 basis points in expenses – not really something where revenue sharing makes a lot of sense. If you are paying more than about 20 basis points for your portfolio, you are overpaying, and possibly by a lot.
This post hits on something I am trying to figure out with a job I am looking to take and was wondering if I could get some advice regarding my particular situation. This will be my first position out of residency.
The position will have me as an employee of a hospital for clinical work and a separate contract for a medical director portion for a rehab unit that is paid as a 1099 so trying to figure out the best way to do it. For a starting point I have a $225k guarantee for first year with hospital (hope to get to the 250-300k range over next few years) and the medical director pay is about $75k (paid for by a separate company that is contracted to manage the unit for the hospital).
I have pushed to keep the medical director stipend separate pay as a 1099 (other option is to have it run through the hospital with taxes taken out and forwarded on to me then). It has seemed like a good idea but when I had my attorney reviewing my contract she seemed to think it would be horrible from a tax burden standpoint (obviously she is not a financial advisor) but made me want to check and get some advice.
Here are the reasons I had for keeping it separate:
1) The medical directory money would not affect my fair market value (apparently this is huge for these hospitals and since I will be close to the 75% for specialty they may find ways to being me back into that FMV if I make too much)
2) Would allow me to write some things off as expenses related to the role
3) Would allow me to set up a solo 401k to maximize retirement contribution and investing options (I have gotten them to have a separate covering MD contract for people that cover me while on vacation so it can be billed directly through that company, essentially I would have no other employees)
My concerns with it:
1) I believe I would max out my SS tax through my regular job so would not get hit with paying employee+employer portion on this. Is this true? I know I would still have to pay the double medicare.
2) Would this really benefit me that much from a retirement standpoint? The employed position offers 401k with 100% match for first 3% and 50% match for next 7% so would likely contribute my full 17.5k there (total 28,750 with their match at current guarantee). They also offer a 457b that I can contribute up to 17.5k in (Does this count against that 52k that everyone talks about? or is it totally separate?)
3) Are there big fees/maintenance costs to having a solo 401k that would negate any benefits?
4) Am I missing something from a legal standpoint or tax standpoint that would flip anything in this situation?
Sorry for the long-winded post, trying to figure all this out has been extremely stressful and I truly appreciate any answers or thoughts.
I have been a lurker for several months now and figured I’d make my first post.
Thanks in advance!
1) I agree.
2) Yes, it would benefit you in that you could do a Solo 401(k). Remember it’s one $17.5K employee contribution no matter how many jobs and 401(k)s you have. But you could at least do employer contributions into the solo 401(k). My understanding is that 457s do not count toward the $52K limit. But your limit is going to be $28,750 anyway thanks to the way your 401(k) is set up.
3) No.
4) Not sure why your attorney thinks this set-up would be terrible from a tax standpoint. It can only help your taxes given that you will have already maxed out your Social Security tax with your employer’s help. You could pay taxes as an S Corp and reduce your Medicare tax, but this will also reduce the amount you can contribute to the Solo 401(k). It might not help them a lot, but every little bit counts.
Thanks so much for your reply! I have learned a lot from this site. I will continue to learn but this had to be decided by the time I sign next week and didn’t want to start out on the wrong foot. It really helps to have confirmation I am doing things right.
White Coat Investor has nailed it again. A solo 401k at Vanguard would have the lowest fees available (~0.15% for Admiral Shares on average). You can contribute to your solo 401k by April of the following year, so by then you’ll know exactly how much you put into your job’s 401k, so that the total is $52k.
Jim is doing an amazing job answering these questions, but he can’t be sitting there with a calculator and an excel spreadsheet optimizing contributions and doing tax planning for everyone who consults him. Your accountant would probably not do this either. The only other thing that I always recommend (and I have to disclose that I’m biased) is that you work with a flat fee adviser who can help you manage your investments as well as work with you on a continuous and ongoing basis to help you answer questions like that.
You can’t get admiral shares in a Vanguard Solo 401(k). They’re all investor shares. Kind of disappointing, but they’re still pretty good.
Yes, totally right, I always forget that. Not sure why Vanguard does it. I was kind of pissed at them for it. So basically to get an extra 0.1% it almost makes sense to got a low cost TPA for a flat fee (once your asset level goes above $2M or so). I’m actually considering Ameritrade, but managing ETF portfolios is a pain in the neck compared to managing mutual fund ones, so that’s why I still prefer Vanguard.
Thank you for this article. I am pondering how to set up my retirement plan for my solo practice, and seeing an example of taxed vs. non-taxed is exactly what I needed.
If you have a solo practice without employees, you might want to set up a solo 401k at Vanguard. The maximum contribution is $52k, and how much you can actually contribute depends on your income and how you pay yourself.
Great article as usual. Here are some comments on what was discussed:
1) While employee contribution is a cost, it is preferable to give a match to your employees than to pay this money in taxes.
2) Often, a younger dentist has older employees, so ‘new comparability’ or cross-tested plans don’t work and different designs have to be tried. Not all TPAs might know how to do it though.
3) The biggest cost many doctors/dentists will have is not the matching contributions, or even fees, which of course have to be minimized by using low cost index funds. It is actually managing their own investments inside the plan. As per DALBAR, an average investor underperforms S&P (and their own investments) by as much as 4% on average (annually) over many decades. Not everyone can (or should) manage their own investments. There is no need to pay asset-based fees for managing your plan – an ERISA 3(38) fiduciary can provide discretionary or non-discretionary advice for a flat/fixed fee.
4) A 401k plan is part of a tax diversification approach which includes after-tax investments (municipal bonds, CDs, debt repayment), qualified plans (401k, Defined Benefit/Cash Balance), and Roth IRA. How much to contribute to each type of account/strategy is an individual decision.
5) EF is an OK TPA if you are working with an experienced adviser. They are not going to be very responsive or proactive for a small plan, and you can’t count on them telling you to upgrade to a Cash Balance plan or to try to maximize your contribution to $52k. They’ll certainly not tell you about tax planning strategies such as having your spouse on the payroll. By the way, they charge an 0.08% AUM fee, which can get pretty large if your assets grow beyond $1M.
6) The best plan for a small practice is a pooled 401k plan, for which TPA expenses are lower (no AUM fees at all), and paperwork is minimal.
7) One rule of thumb is that if you can’t max out your plan with $52k (and you have employees), the chances are that you might be better off with a SIMPLE (though a calculation might be a good idea to see if that’s indeed the case).
There’s an awfully big gap between $52K and the maximum SIMPLE contribution of $12K. It’s not like you get out of making contributions for your employees with a SIMPLE either.
You are totally correct. I find though that some docs hesitate to jump from a SIMPLE to a 401k because of the added cost (both in higher match and plan expenses), and the reason provided was because they don’t know if they can come close to the $52k (they are often maxing out the SIMPLE, but are not ready to max out the 401k).
Maybe the reason is that if someone can max out their 401k with their spouse (which can be around $70k or so), then in their mind they’ll build enough assets to justify paying for asset management. I think that this is a valid reason, though with flat fees, the ‘AUM’ equivalent fee falls very rapidly as the assets grow, they break even in a couple of years, and thereafter compounding works for them.
Then there is also income uncertainty, high debt load, etc., so I usually would want to examine their entire financial situation to understand whether a 401k is advisable, and how much they can really contribute up to $52k. They might want to stick with a SIMPLE for a year or two and pay out their loans until they can max the 401k out. It might be a better idea to keep the SIMPLE if they can only contribute $20k a year vs. the $52k, but if they can get into the $40k, then a 401k might make more sense.
Some comments on other important aspects mentioned in the article:
1) Turnover. That’s not a good thing for a plan. So we typically do a 6-year vesting schedule, 20% vested every year, so that only those employees who are around for 6 years get the full match (which for a cross-tested or a triple-match plan can be pretty high). They do get to keep the safe harbor match of 4%.
2) After-tax, my personal preference is municipal bonds. I don’t like to deal with capital gains (which by the way can go up to 20% for the 39.6% tax bracket), I want to avoid the 3.8% tax on investment income, and the portfolios that are balanced with bonds will generate a tax component (stocks only is not something I would do in any type of account because of risk/volatility). One can build an income generator with municipal bonds though, federal/state tax free so getting a 4% return is equivalent to a 8% taxable if you are in the 50% tax bracket.
Hi
I have a somewhat related/unrelated question.
I already have a 401k, 403b, 457b working for my clinic/hospital, and routinely max out my contributions.
I am setting up a Real Estate LLC.
Can I do a SEP-IRA ? Contribute to it, and deduct it from the money the Fed can take ?
Much appreciated.
sf
You can not fund a retirement plan with income from a real estate LLC – this would be passive income, unless you pay yourself a salary (which I don’t know anything about, so you might have to ask your CPA on whether that’s allowed for this type of an entity). In any case, the total contribution to your retirement plans (457b aside) is $52k, so if you already max out your 401k, and if you could make a contribution for yourself into another 401k plan (such as solo 401k for example), the total would still have to be $52k (plus a catch-up of $5,500 if over 50).
Not entirely right. You get $52K into a 401(k)/profit sharing plan for each unrelated employer you have. So you can get $52K at your regular job, then if you have another business (with earned, not passive income) you could get another $52K. You only get one $17.5K employee contribution however. See this post:
https://www.whitecoatinvestor.com/beating-the-51k-limit-friday-qa-series/
I actually ran this by a TPA, and here’s what the reply was:
“Yes it is true that the 401(k) limit (the $17,500) is an INDIVIDUAL limit – it goes with the person from job to job, but the other component of the $52,000 defined contribution maximum annual limit, the $34,500 employer component, goes from job to job, but if you own the company(ies) you will be able to put LESS, not more, because of controlled group issues. It is only with UNRELATED employers where you could potentially receive $52,000 from each employer.”
That’s my understanding as well.
Probably not because your real estate probably gives you unearned income, which can’t be contributed to a retirement plan.
Has anyone used Employee Fiduciary to set up a plan from scratch? I have 2 partners, one associate and about 20 employees. So far EF is the most reasonable as far as fees, but they were very vague about how the plan is set up. I felt like I would need to tell then how I want everything done and then they do it, whereas the other groups I contacted gave a few options for safe harbor vs. not, which employees could qualify, etc., however the fees and AUM were way to high.
Basically, I would like to use EF, but I would like to explain my goals to them and then have them give me a few options to show my partners. Has anyone used them for that?
I’ve used EF before for my clients. The client-facing people are not the ones doing the actual analysis, and the response time is mind-numbingly slow. And they are pretty straight forward about being cookie-cutter, so it does take a knowledgeable adviser to get them to customize, which again didn’t really work too well since they are not very responsive. For smaller practices I prefer a highly responsive TPAs, thus I stopped working with EF, and am now using a much better TPA for the plans I manage. Also, this allows me to offer exactly what you are describing: custom designed plans for smaller practices. My TPA would spend a lot of time explaining everything, working through various scenarios and choices, and at the end of the day you’ll have a plan that truly fits your practice.
EF is not your retirement plan consultant. That’s not their role at all. What you need is someone who can help you come up with the best plan design and set-up, and that is not going to be EF. They will simply give you a plan (as cookie-cutter as it gets). There are also essential plan services that are necessary, including investment selection, model portfolio management and individualized advice to plan participants, if you prefer to deal with a participant-directed plan, all of which can be offered for a flat (not an asset-based) fee. Then there are non-participant directed (or pooled) plans with a single account that work great for small practices. Unfortunately, major firms worry too much about assets under management, and not enough about providing quality low cost retirement plans for small practices.
WCI, you don’t happen to have a spreadsheet, or know where there is one, for the numbers you ran in your 2 examples. I’m trying to run my options and I’m not sure if it’s because it’s late, or I’m missing something, but I don’t think mine are coming out right…
While I probably used Excel while running the numbers, I probably didn’t save them. Don’t assume that my numbers are more correct than yours. I do make mistakes. Perhaps we can help if you’re willing to throw out some assumptions.
OK, here goes. Partners could put in 88K between them, cost would be about 35K in employee match and administration fees etc. I am trying to run the numbers for 20 years, not 30 as your example. Tax rate is 35% federal and 5% state, with an estimated marginal rate of 20% at retirement.
To further complicate things, the partners do get a Traditional IRA deduction of 22k between them because there is no retirement plan offered at work. So the 401k allows an additional 66k in tax deferred accounts.
That point about the IRA is a good one, except that if the partners didn’t get the traditional IRA deduction they could still use a Backdoor Roth IRA, providing useful tax diversification in retirement.
I doubt the tax break would make up for those rather high costs, unless you can significantly reduce salaries as a result of the 401(k). The tax arbitrage is easy to calculate. You’re saving taxes at 40%, and paying them at 20%. So on $88K, you’re saving $35,200, then paying $17,600, for an actual savings of $17,600 per year. The value of the tax deferment over 20 years is a little trickier, as it requires a rate of return assumption and a capital gains/dividend rate assumption. Take your $88K-$35,200= $52,800 per year, then grow it at 8% for 20 years to $2,609,530. How much less will you have if that were in a taxable account? Let’s assume a highly tax efficient investment with an 8% return and a 2% yield, all of which is qualified/LTCGs. Assume your rate is 23.8% on those. So that reduces your return by 2%*0.238=0.476%. That gets you 2,464,434, which then must be reduced by capital gains taxes on the gains. The gains are $2,464,434-($52,800*20)= $1,408,434, so the taxes are $335,207. So your after-tax total is $2,129,227. The 401(k) cost is $35,200, but that also must be adjusted for the time value of money. So after 20 years at 8%, that cost is $1,739,687 pre-tax. Even without doing the tax adjusting, you can see you’d come out way behind. The costs of your 401(k) are just too high compared to the tax benefits for the owners. So you’ve got to figure out a way to reduce the costs to make it worth it. That might be lowering salaries, gaining value in better employees due to offering it, lowering 401(k) costs, extending the period of contributions, making the vesting period longer increasing employee turnover etc.
Hope that helps.
OK, well, I guess it may be time for my wife to get a second unrelated job with a 401k plan…..just kidding.
I totally agree about the vesting schedule – this is the way to go. I’ve developed a very general formula that calculates the breakeven percentage for after-tax vs. pre-tax investing (specifically for retirement plans), and the breakeven point (depending on assumptions) starts at about 30% of contribution going towards plan expenses.
It might better to treat 401k matching contributions as being part of the salary rather than expense. Giving them a match is basically giving them a raise. So now you might not have to offer a higher salary to new employees or you don’t have to give them raises as often.
Can you please clarify on the 5% gateway safe harbor rule for the new comparability plan. My understanding is that it is 5% not 3%+5% as used in your example. This article has been very helpful. With a top-heavy plan and over 60 employees, we are trying to determine if it is more cost effective to restructure our current 401k/profit sharing plan or consider going the route of a taxable account for HCEs.
Hi DMV,
While a New Comparability is one such design, there are several others that also work depending on the demographics. The answer is that it depends on many factors. What you need to do is to work with a high quality TPA who can help you run several plan designs for various cases. When working with medical/dental practices, I always have my TPA run multiple scenarios, because things can change, and a design has to work within a range of parameters. Even if a design might work now, it may not in the future, and in any case, anticipating changes in plan demographics and design should be part of the TPA’s job (and that is rarely if ever done by most TPAs).
How do these plans described above differ from “Non-Prototype” plans ? They seem to be the same thing to me – part 401K and part profit sharing. Also, if one maxes out the $52K pretax contributions between profit-sharing and 401K, are they still eligible to convert a traditional IRA to a backdoor Roth IRA without having to deal with pro rata conversion taxes (assuming no other IRAs) ?
Yes, you can still do a Backdoor Roth IRA even if you are maxing out a 401(k)/profit-sharing plan. I’m not familiar with the term “non-prototype”. A quick google search suggests that a non-prototype plan is a pooled plan in which the investors can direct their own investments like a more standard 401(k). Fidelity’s “non-prototype” is more like an “I’m opting out of my 401(k)’s lousy funds and buying Fidelity ones instead” plan.
I am the only employed physician at a practice with 4 partners. We have a 401k that I am maxing out and my salary puts me in the highly compensated employee (HCE) category. Because of my contributions and the low rate of contributions of the rest of the staff, our plan is top heavy if they don’t do the safe harbor contributions. The partners decided to do the non elective 3% safe harbor contribution but I am told, according to the rules, they don’t have to make the contribution to HCEs and they still qualify for the safe harbor. My question is: CAN they make a safe harbor contribution for me? This could be out of the goodness of their heart or because my contract states I am supposed to get the same benefits as all employees and I raised a stink about it? Thanks
Hello
I want to ask about your profit sharing plans
I was curious if it would work in my situation.
Money maxed out into 401k (income based), transitioned in the same year to an employed position from 1099 job (locums)
Traditional ira maxed out
Can I put the money in a profit sharing plan as a sole proprietor no employees?
Besides an EIN number what else do I need? Is it better to put it in a brokerage?
Etrade is free for a profit sharing plan
Thank you
You’re just talking about opening a solo 401(k). The “profit sharing plan” is just the employer contribution to the solo 401(k).
https://www.whitecoatinvestor.com/where-to-open-your-solo-401k/
Great article…
Trying to determine if this is a better option for my particular medical office.
I am 49 yrs old, running a concierge medical practice.
I have been using a SEP-IRA but now approaching the 5th year (now am required to contribute to employees, as up until this point employees did NOT want to participate/contribute).
However, as I transitioned to a concierge model, I now only have one employee (aside from myself as the employer, i.e. 2 total in office), and this employee IS interested in a 401K option.
Thus, I am curious what TPA and 401K plan/CBP combo may be ideal for this type of very small office.
My employee is in their 30s and I intend to retire by age 65 approx (i.e. 16 years or so from now).
Also, by switching to a 401K, I would intend to roll my SEP-IRA (via vanguard) into this 401K plan, so that I can begin doing backdoor ROTH conversions too.
Thank you.
I’m not sure you’re allowed to have a SEP-IRA (or any other company retirement plan) and not give employees any money in their retirement accounts just because they tell you they don’t want it.
This isn’t a do it yourself project. These folks can help: https://www.whitecoatinvestor.com/retirementaccounts/
My apologies…
Clarification:
I have had the SEP-IRA for almost 5 years, but my current (only employee) has only been employed by me for <3 years… so my understanding is that I would not need to contribute to to their account until they have completed 3 years of employment.
You may be right on that rule; they can be complicated. Just make sure you are. You certainly can exclude employees for a while, especially if they’re part-time, and still use a SEP-IRA/Solo 401(k). But as a general rule, once you have employees, this is not longer a DIY thing.
OMG…. you just opened up a HUGE possibility (and discounted!) potential option for me!?!?!
My current employee IS considered a part-time employee as the past 2+ years, as this individual has worked <1000 hours per year (the limit per 401K rules appears to be <1000/year = part-time) and thus, I can open a solo 401K (if I so choose to do so) in a legal manner.
Am I missing something!?
Hm.
Thanks again for the responses.
Note there is a bill in Congress that could change these rules.
I might still consult with an expert on this if you have an employee.
Good point and reminder. And per the SECURE ACT:
Under the SECURE Act, 401(k) plans must also allow participation by long-term, part-time employees who work at least 500 hours in three consecutive years (and have attained age 21). Thus, part-time employees who traditionally were excluded because they have never completed a year of service (i.e., 1,000 hours) will now be eligible.
https://www.huschblackwell.com/newsandinsights/secure-act-new-part-time-eligibility-rules-for-401k-plans
So even a part-time employee working 500 hours in 3 consecutive years.
Always something new.
Thanks and happy holidays!
Once there are employees, I do not consider this a DIY project any more. While you may be able to still do a solo 401(k) for a while, be very careful here and make sure you understand all of the rules. They are surprisingly complicated. Having now set up the “world’s best 401(k)” at WCI, I am amazed at how many different experts it took to do so and to maintain the plan in order to be fully in compliance. Just remember the main point behind all these 401(k) compliance rules–it cannot just benefit the owners and highly compensated employees.