Now let’s talk about the fourth mistake: choosing the wrong retirement plan.
The amount you can contribute at any income level varies widely according to which type of plan you have. If you make $90,000, for example, you can contribute $22,500 to a simplified employee pension (SEP), $14,700 to a SIMPLE IRA, and $40,000 to a 401(k). (And that’s before any catch-up contributions you can start making at age 50.) But contribution limits aren’t all you need to know. Which plan gives you the best combination of contribution, flexibility, and liquidity?
I’m not here to make you an expert on retirement plans. But I can help you decide pretty quickly if the plan you have is right for you – or if you should be looking for something more suited for your specific needs.
We’ll assume for the purposes of this discussion that you’ve already decided you want to save more than the $5,500 you can save in an IRA. We’ll also assume that you want a “traditional” arrangement, where you deduct the contributions you make now and pay tax on withdrawals. (We’ll address alternatives, including Roth arrangements and life insurance, towards the end of the chapter.)
The Simplified Employee Pension, or “SEP,” is the easiest plan to set up because it’s just a turbocharged IRA:
- If you’re self-employed, you can contribute and deduct up to 25% of your “net self-employment income.”
- If your business is incorporated and you’re salaried, you can contribute 25% of your “covered compensation,” which essentially means your salary.
- The maximum contribution for any single employee 2017 is $54,000.
- If you’ve got employees, you’ll have to contribute for them, too. You generally have to contribute the same percentage for your employees as you do for yourself. However, if your income is significantly higher than that of your employees, you can use what’s called an “integrated” formula to make extra contributions for higher incomes.
- The money goes straight into regular IRA accounts you set up for yourself and your employees. There’s no annual administration or paperwork required.
- SEP assets accumulate tax-deferred over time. You’ll pay tax at ordinary income rates when you withdraw them in retirement. There are penalties for early withdrawals before age 59½, and for failing to take required minimum distributions beginning at age 70½.
The SEP is easy to adopt, easy to maintain, and flexible. If there’s no money to contribute, you just don’t contribute. But remember, the contribution is limited to a percentage of your covered compensation. So, for example, if you set up an S corporation to limit your self-employment tax, you’ll also limit your SEP contribution because it’s based on that lower salary amount.
The next step up the retirement plan ladder is the SIMPLE IRA. This is another “turbocharged” IRA that lets you contribute more than the usual $5,500 limit:
- You and your employees can “defer” and deduct 100% of your income up to $12,500. If your income is under $50,000, that may be more than you could sock away with a SEP.
- If you’re 50 or older you can make an extra $3,000 “catch up” contribution.
- But – you have to match everyone’s deferral or make profit-sharing contributions. You can match employee contributions dollar-for-dollar up to 3% of their pay, or contribute 2% of everyone’s pay whether they choose to defer or not. If you choose the match, you can reduce it as low as 1% for two years out of five.
- The money goes straight into employee IRAs. You can designate a single financial institution to hold the money, or let your employees choose where to hold their accounts.
- There’s no set-up charge or annual administration fee.
- SIMPLE assets accumulate tax-deferred over time. You’ll pay tax at ordinary income rates when you withdraw them in retirement. There are penalties for early withdrawals before age 59½, and failing to take required minimum distributions beginning at age 70½.
The SIMPLE IRA may be best for part-time or sideline businesses earning less than $50,000, because the flat $12,500 contribution is higher than the 25% SEP contribution for incomes up to $50,000.
The next step up the retirement plan ladder is the 401(k). Most people think of 401(k)s as retirement plans for bigger businesses. But you can set up a 401(k) for any size business. In fact, you can even set up what’s called a “solo” or “individual” 401(k) just for yourself.
The 401(k) is a true “qualified” plan. This means you’ll set up a trust, adopt a written plan agreement, and choose a trustee. But the 401(k) lets you contribute far more money, far more flexibly, than either the SEP or the SIMPLE.
- You and your employees can “defer” and deduct 100% of your income up to $18,000. If you’re 50 or older, you can make an extra $6,000 “catch up” contribution.
- You can choose to match contributions, or make “profit-sharing” contributions up to 25% of everyone’s pay. (If you operate as an S corporation, you can contribute up to 25% of your salary, but not any pass-through distributions.) That’s the same percentage you can save in your SEP – on top of the $18,000 deferral.
- The maximum contribution for 2017 is $54,000 per person, plus any “catch up” contributions.
- You can offer yourself and your employees loans, hardship withdrawals, and all the bells and whistles “the big boys” offer their employees.
- You can use “cross-testing” to skew profit-sharing contributions to favored employees. “Age weighted” plans allocate more to older employees (on the theory that they have less time to save for retirement); “integrated” and “super-integrated” plans allocate more to higher-paid employees (on the theory that they get no benefit from Social Security for their income above the Social Security wage base); and “rate group” plans divide employees into groups (such as managers, administrators, and salespeople) and make different contributions for each group.
- 401(k) assets accumulate tax-deferred over time. You’ll pay tax at ordinary income rates when you withdraw them in retirement. There are penalties for early withdrawals before age 59½, and failing to take required minimum distributions beginning at age 70½.
The downside? 401(k)s are true “qualified” plans, which makes them harder to administer than SEPs or SIMPLEs.
You have to establish a qualified-plan trust to hold plan assets. The trust will have to file Form 5500, an informational return reporting contributions and assets, every year. And there are complicated anti-discrimination and “top-heavy” rules to keep you from stuffing your own account while you stiff your employees.
However, if the 401(k) really does make sense, there are three alternatives that might make administration easier:
- A “SIMPLE” 401(k) avoids nondiscrimination and top-heavy rules in exchange for guaranteed employer contributions. You and your employees can defer 25% of covered compensation up to the SIMPLE plan contribution limits. Your business has to contribute 2% of covered comp or match contributions up to 3% of covered comp. This works if you want a true 401(k), but you’re afraid your employees won’t contribute enough to let you make meaningful deferrals. You can also convert an existing 401(k) to a SIMPLE 401(k).
- A “Safe Harbor” 401(k) avoids nondiscrimination (but not top-heavy) rules in exchange for bigger employee contributions. You and your employees can defer up to the regular 401(k) limit. You can either: 1) contribute 3% of covered comp; or 2) match contributions dollar-for-dollar up to 3% of covered comp and fifty-cents-on-the-dollar for contributions between 3% and 5% of covered comp. You can even make extra profit sharing contributions on top of the required contributions.
- If you operate your business all by yourself, with no employees other than your spouse, you can establish an “individual” 401(k) with less red tape.
Finally, if you want to contribute more than the $53,000 limit for SEPs or 401(k)s, you might consider a defined benefit plan. This is your father’s retirement plan – the traditional “pension plan” that so many employers have stopped offering because they can’t afford it anymore. However, it can still be a great choice for older, highly compensated business owners with few employees.
- Defined benefit plans let you guarantee up to $210,000 in annual income (2106 limit).
- You can contribute – and deduct – as much as you need to finance that benefit. You’ll calculate those contributions according to your age, your desired retirement age, your current income, and various actuarial factors.
- A 412(i) plan (sometimes called a 412(e) plan), which is funded entirely with life insurance or annuities, lets you contribute even more.
The biggest problem with the defined benefit plan is the required annual contributions. If your business doesn’t have the money, you still have to pay. However, you can combine a defined benefit plan with a 401(k) or SEP to give yourself a little more flexibility. Let’s say you could contribute up to $100,000 to a defined benefit plan, but you’re not confident you can commit to that much every year. You might set up a defined benefit plan with a $50,000 contribution, then pair it with 401(k) for another $50,000. If business is poor in a particular year, you can choose to skip the 401(k) that year.
So, now that we’ve covered the menu of traditional employer-sponsored retirement plans, let’s throw another wrench into the mix. Do you even want or need a traditional plan? Or would you be better off with an alternative? Perhaps even giving up the current tax break?
All of the plans we’ve discussed so far assume that you’re better off taking a tax deduction for plan contributions now, as they go in the plan, then letting plan assets accumulate tax-free over time, and then paying tax on withdrawals, at ordinary income rates, when you need them for retirement.
That’s a great strategy if your tax rate is higher now than it will be in retirement. You benefit now by avoiding tax on contributions, which puts more to work for you today. And you benefit later by paying less tax on withdrawals.
But that traditional pattern doesn’t always hold true. Maybe you’re young, just starting your career, and your income is low. Maybe you’re transitioning from one career or business to another, and your income is temporarily low. Maybe you think that tax rates in general will rise. (Today’s top marginal rate may seem high at 39.6%, but that’s actually quite low by historical standards.) Sometimes, contributing to a traditional retirement plan creates a ticking tax time bomb and actually costs you money over the long run.
Here are two alternatives you might consider if standard qualified plans don’t fit the bill:
- “Roth” accounts take the traditional defer-now, pay-later arrangement and turn it on its head. The basic Roth IRA doesn’t give you any deduction for contributions you make today. But your withdrawals are generally tax-free so long as they’ve “aged” at least five years. Tax-free income sounds great, right? However, contributions are limited to $5,500 per year ($6,500 if you’re 50 or older), and you can’t contribute at all if your income is over $133,000 (single filers) or $196,000 (joint filers). (If your income is above those limits, you can still fund a Roth by contributing the maximum to a nondeductible traditional IRA, then immediately convert it to a Roth.)
If you sponsor a 401(k), you can choose to designate your salary deferrals up to $18,000 as “Roth” deferrals. You won’t get any deduction today, but your withdrawals down the road will be tax-free. (Any employer contributions will continue to be treated as deductible now and taxable later.)
If you have a SEP, you can create a backdoor “Roth SEP” by making a regular deductible SEP contribution, then immediately converting it to a Roth. Roth conversions in general are a subject for another book – I just want you to be aware that the possibility exists.
- Permanent life insurance policies that include a cash value can offer several significant tax breaks for supplemental retirement savings. There’s no deduction for premiums you pay into the contract. But policy cash values grow tax-deferred. And you can take cash from your policy, tax-free, by withdrawing your original premiums and then borrowing against remaining cash values. You’ll pay (nondeductible) interest on your loan, but earn it back on your cash value. Many insurers offer “wash loan” provisions that let you borrow against your policy with little or no out-of-pocket costs.
These advantages aren’t completely unlimited. If you stuff too much cash into the policy in the first seven years, it’s considered a “modified endowment contract” and all withdrawals are taxed as ordinary income until you exhaust your inside buildup.
Insurers offer three main types of cash-value policies with three different investment profiles to suit different investors. The key is finding a policy that matches your investment temperament:
- “Whole life” resembles a bank CD in a tax-advantaged wrapper, with required annual premiums and strong guarantees. Remember when we said the defined benefit pension was your father’s pension plan? Well, this is your father’s life insurance.
- “Universal life” generally resembles a bond fund in a tax-advantaged wrapper, with flexible premiums but less strong guarantees. Some insurers also offer “indexed universal life,” which lets you profit from equity markets but give you a guaranteed return even when those markets are down.
- “Variable life” lets you invest cash values in a series of “subaccounts” resembling mutual funds in a tax-deferred wrapper. You can choose “variable whole life” with required premiums and stronger guarantees, or “variable universal life” contracts with flexible premiums and less strong guarantees.
Once again, I’m not here to make you an expert in retirement plans or alternatives. My goal is simply to open your eyes to the wide variety of plans and options so that you can evaluate if the plan you have now is really the right plan for you.
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