Small Business Retirement Plans

Welcome to Part 2 of the FIRE small business series.

You can see the Introduction and summary of what we are talking about here.  You should also read the disclaimer:

There are 3 main types of retirement plans for small businesses:

For all of these, the contribution limits are the lower of A) 100% of the employee pay B) the plan contribution limit.  So if you only make $10k, that’s what you’re limited to.  We’ll assume you’re at least making the limits going forward.  Regardless here are types of plans:

1. SIMPLE IRA – This is super easy to set up and cheap & easy to maintain.  It’s set up to allow small businesses to set up retirement plans for their employees with minimal pain.  The limits on this are annual employee contributions of $12,500 with employer matches of 3%, or mandatory employer contributions of 2%.
2. SEP IRA – Again, fairly easy to maintain with minimal set up fees and costs and very limited paper work.  The caveat here is that the employee can not contribute.  You can have multiple employees, but the company must contribute evenly to every employee.  The limits are 25% of income of the employee or $54k** (as of 2017).
3. Solo 401(k) – More complicated to set up.  There are a variety of paperwork filing requirements, namely the 5500, if your plan has more than $250k in assets.  This is also limited to only the owner and their spouse.  The limitations are the ones that we all know and love: $18,000** per person.  The company can match up to 25% of the employee’s salary, up to a limit of $54k** total.

Any one of these plans can all be set up very easily at your major providers.  For anyone looking to do this, I’ll save you some time:

• Vanguard Small Business Plans
• Schwab Small Business Plans
• Fidelity Small Business Plans

Which one to use?

Of these three, we narrowed it down to 2 very quickly.

The SIMPLE IRA is great for folks that have employees (we didn’t) and want a cheap way to allow them to contribute on their own without having to match from the company.   But, it’s a burden if you want to do your standard Backdoor Roth Conversions (we do), as it’s considered Tax Deferred money in your IRA portfolio, and therefore subjecting you to the pro-rata rule.

Regardless, I wanted to max out the total amount that we could contribute and $12,500 just wasn’t going to cut it, so out with the SIMPLE IRA.

A couple things about this:

• I assumed we would max out our personal contributions and max out the corporate match on the 401k at 25%.
• This is assuming that you are paying all of your profit to yourself as wages.
• I also wasn’t sure how much money we would bring in.  But, I knew it would only be us, so we wouldn’t have to contribute to anyone outside the family.

What you can see is that if you are contributing the $18,000** and matching at 25%, you can tap out your 401k at ~$150k in income.  Where with a SEP IRA you can only tap it out at ~$220K in income.  You also can contribute a substantially larger sum to the 401k vs the SEP at lower income level.

How does this compare to W-2 income with a 401k?

Now that we have our company set up (an S-Corp), and we have a solo 401k.  Let’s look at how the income breaks down.

Couple assumptions:

1. Same as before: $100k in income for both a W-2 Employee or a Self Employed S-Corp Owner.
2. $40K in expenses that can be put entirely against the company.
3. Employee Contribution of $18k for both situations.
4. 100% of the pay from the S-Corp is coming as wages.
5. The S-Corp will match 25% of the wages paid.  The W-2 Employee gets a 5% match for their contributions.

So where does this shake out?

Some things to take away from this:

1. Even though the W-2 employee technically took in $5,000 more top line money ($100k + $5k 401k Match) the Business Owner took home almost the same amount ($23k vs $22k).
2. The Business Owner put more into their 401k ($29k vs $23k).  Even though $5k of the W-2 was free money from the employer.  In total the Business Owner takes home ~$5,000 more between take home pay and 401k contributions.
3. The Business Owner comes out way ahead in tax payments, simply because their expenses and company matches of the 401k are not taxed at all and $18k of their income is only subject to payroll tax ($8k vs $19k).

We’re starting to see how powerful owning a business is for retirement savings.

On the exact same income and expenses, you can:

• Add $6,000 more to your 401k
• Take home $1,000 less
• Pay Uncle Sam ~$10,000 less

Let’s compare this to our company from last time.  The same default ($100k income & $40K deductible expenses) but with no 401k.

SE Take Home + 401k ($0K personal + 0% Match):        $45,907
SE Take Home + 401K ($18K Personal + 25% Match):   $51,438

So, by opening the 401k and having your company match 25% you end up keeping ~$5,500 more dollars. Not Bad!!

What did we do?

Well, we went with the solo 401k.  I set it up through Fidelity.  It was actually pretty painless to set up.  Once into the office to sign some stuff, and the recurring stop ins to drop off checks… URGH!

We couldn’t do a Mega BackDoor Roth because these things are straight off the shelf, and they are standardized for everyone.  Most people aren’t interested in anything even remotely close to that stuff.  They didn’t even know what I meant when I asked about over contributing to it.  I actually managed to get some after tax money in there by accident, OOPS!

We did this for almost 2 years.

Once we wanted to employ someone outside of our family, this wasn’t going to cut it any more.  It worked great, we were able to put away a bunch of money through it.

But, that pesky payroll tax is still there…

What if there was a way that we could cut down on taxes even more?  What if we could “avoid” the pay roll & self employment taxes?  We’ll see about that next time!

**For the 2018 tax year the personal contributions for 401k’s have gone up to $18,500 and the total contribution limits were raised to $55k**