Part 3: 401k’s The government has afforded several tax-advantaged options for business owners to save for retirement. The purpose of this series is to educate doctors, including small practice owners, about the most commonly-used plans for Independent Contractor (“IC”) income. (As your practice volume grows and you age, you may eventually supplement your 401k with a Defined Contribution plan, but the purpose of this series is for basic plans.) Choosing which type to use can vary from year to year, depending upon timing and other goals. In this 3-part series, we will examine the advantages and disadvantages of each.
What is a 401k and when should I use one?
A 401k is quite different from SIMPLE and SEP IRAs. It is strictly an employer account. Until becoming vested, the only ownership employees have in their 401k’s is what they have contributed themselves. Vesting indicates the percentage of ownership the employee has in the contributions the employer has made to the 401k account.
401k’s afford employers far more flexibility than do SIMPLE and SEP IRAs. The employer may contribute matching contributions to employee accounts, may elect “profit sharing” or both. Employees will be vested using a “graded” or “cliff” vesting schedule. A 401k plan can allow employees to borrow up to the lesser of 50% or $50k of their account balances. 401k’s can allow employee Roth contributions and also “after tax” contributions. The plan may or may not accept rollovers from other retirement accounts.
401k’s have other attributes, but the purpose of this post is not to explore 401k’s in depth. Flexibility comes at a price as 401k’s (with the exception of SOLO-401k’s) are more expensive to set up and maintain than low-cost SIMPLE and SEP plans. You will probably get a free analysis of your situation and needs but, after that, you will pay for a plan design and set up, along with annual fees for calculations, maintenance, and filing government reports. The payoff is that employees can contribute $18k per year ($24k if age 50+) and the employee’s 401k can receive up to $54k/$60k annually if the employer:
- matches employee contributions, and/or
- adds a profit-sharing component to the plan, and/or
- allows for after-tax contributions by employees.
If you also contribute to a personal IRA and are age 50+, your total potential retirement contribution is $60k to a 401k + $6,500 to an IRA, for a total of $66,500.
What you need to know:
- A 401k must be established by 12/31 of the year for which it is to take effect.
- You have a variety of choices to make when putting together your “Plan Document”, which is the rulebook for your 401k plan.
- Employers cannot disallow participation for employees who:
- Are age 21 and
- Have been employed for at least 1 year (2 years if the employee is then 100% vested)
- You can set up a “Safe-Harbor” 401k plan to avoid being subject to “Top Heavy” plan rules.
- If you and your spouse are the only qualified employees of your business, you can establish a SOLO-401k which will require no compliance measures until the plan balance reaches $250k on any 12/31.
- You can have a second 401k for your privately-owned business or IC income even if you participate in a 401k at work. You are limited to $18k/$24k total employee contributions across all plans, but each plan account can receive a total $54/$60k per year.
When to use a 401k:
- When you want to contribute more than you can to a SIMPLE plan
- When you want to contribute more to a Roth IRA than the personal limitation of $5,500/$6,500
- When you are making back-door Roth contributions
- When you have multiple employees and don’t want to match the 25% SEP maximum contribution for each employee
- When you have side IC income and want to contribute beyond the limits of your employer plan
- When you have side IC income and want to set up a retirement account to receive rollovers from other employer plans (allowing you to maintain control over your retirement account while continuing to fund a back-door Roth IRA)
- When your business has grown to the point that the administration costs are a reasonable trade-off for a valuable employee benefit.
SOLO 401ks are most often used by:
- Doctors with some moonlighting income, usually to set up a “receptacle account” for future 401k/403b rollovers;
- Doctors who are IC attendings, but who don’t have employees, as a way to put $54k/$60k into retirement savings annually;
- Doctors who want to hire a nonworking spouse so the spouse can contribute $18k annually.
401k’s are more complex than either SIMPLE or SEP IRAs but they afford you more tax-advantaged retirement space. And, until your plan balance reaches $250k, a SOLO-k is as simple to manage as either a SEP or a SIMPLE IRA.