How Do You Start A 401
The simplest way to start a 401 plan is through your employer. Many companies offer 401 plans and some will match part of an employee’s contributions. In this case, your 401 paperwork and payments will be handled by the company during onboarding. If you are self-employed or run a small business with your spouse, you may be eligible for a solo 401 plan, also known as an independent 401.
These retirement plans allow freelancers and independent contractors to fund their own retirement, even though they are not employed by another company. A solo 401 can be created through most online brokers.
Traditional Or Roth Iras
Traditional IRAs andRoth IRAs arent exclusively for the self-employed, but people who work independently or who own their own business can contribute to these plans. Traditional IRAs allow you to make tax-deductible contributions, and Roth IRAs allow for after-tax contributions, with money growing tax-free. There is low administrative burden, you contribute to the accounts as an individual rather than as your own employer, and theres a combined contribution limit for traditional and Roth IRAs of $6,000 in both 2021 and 2022. If youre 50 or over, youre eligible for an additional $1,000 catch-up contribution, bringing your total contribution limit to $7,000.
If you or your spouse has access to another workplace retirement plan, there are income limits. If you exceed them, you will not be eligible to contribute to a Roth IRA at all, or to make tax-deductible contributions to a traditional IRA.
S Corp Retirement Contributions
When it comes to S Corp contributions for retirement, there are a few questions you may have. After all, things can work very differently with 401 contributions if youre both the owner and employee of your S corporation. Not to mention, rules for S Corp 401s can vary in general.
To ensure you fully understand S Corp retirement plan contributions before establishing a plan for your company, check out these handy S Corp 401 questions and answers for IRAs.
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Advantages Of A Small Business Retirement Plan
While there are some disadvantages to the cost of having an S Corp retirement plan for your employees, there are some significant benefits, including:
- An S Corp retirement plan helps secure your businesss future, as well as your employees futures.
- Offering a retirement plan for employees gives you a competitive edge over other companies that might not offer a retirement plan.
- There are some tax benefits to having a retirement plan, as plan contributions are deductive business expenses.
Roll Your 401 Into An Ira
The IRS has relatively strict rules on rollovers and how they need to be accomplished, and running afoul of them is costly. Typically, the financial institution that is in line to receive the money will be more than happy to help with the process and avoid any missteps.
Funds withdrawn from your 401 must be rolled over to another retirement account within 60 days to avoid taxes and penalties.
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Key Definitions And Terminology
We aim to provide a limited discussion on each of these with links to specific articles and how each of these will work for you as an S-corp owner. Before we dive in, lets ensure that we define the key terminology well be referencing whenever we discuss these plans.
Employee elective deferralsA fancy way of saying employee contributions out of their wages
Pre-tax contributionYour contributions are deductible on either your business or personal tax return. Money in your account can grow tax-deferred without paying taxes on interest, dividends, capital gains, and appreciation every year. The money is taxable when you withdraw it from your account typically after age 59 1/2.
After-tax contributionYour contributions are NOT deductible. Money in your account can grow tax-deferred without paying taxes on interest, dividends, capital gains, and appreciation every year. The appreciation is taxable when you withdraw it from your account typically after age 59 1/2.
Roth contributionYour contributions are NOT deductible. Money in your account will grow tax-free without paying taxes on interest, dividends, capital gains, and appreciation every year. You do not pay taxes on anything when you withdraw it from your account typically after age 59 1/2.
Backdoor Roth IRA contributionA way to navigate around the Roth income limits to fund a Roth IRA. Make an after-tax contribution and immediately convert the funds into a Roth.
Communication About Nature Of Comp Is Key
For 2017, the maximum retirement plan compensation that may be considered for plan benefits is $270,000. An individual might make $1 million per year, but any pay above $270,000 has to be disregarded for purposes of the plan. The limit is indexed annually for cost of living. Business owners will often set their compensation right at $270,000 in order get maximum benefits from the plan without paying themselves more salary than they need.
Heres where communication is important. An advisor might come to us looking for help in designing a plan for his client. He says the owner of the business makes $400,000 per year and has plenty of money to put into a plan. Great, wed say. Were happy to help. So we would design a plan with the understanding that the owner receives more than the maximum countable pay of $270,000, and off wed go.
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Below Is A Graph Depicting The Scenario Above
3. Loss of Social Security. Although we think of Social Security contributions as a tax, in reality, the more we contribute the more we will eventually get back. In the example of the orthodontist, by keeping her salary high she would qualify for the maximum Social Security benefit of $32,244 in 2018 at age 66. By only contributing an inflation-adjusted amount equivalent to $50,000 a year in todays dollars, over the course of her career she would only receive about $17,100 at age 66. To purchase an inflation-adjusted annuity equivalent to the lost $15,144 in annual income, it would cost a 66-year-old female around $320,000. Social Security also offers spousal and survivor benefits that might benefit her family further.
Retirement Account Options For The S
One of the goals you should have as a business owner is to save for your future retirement. Because you are drawing a salary through your business as an S-Corp owner, you have the distinct advantage of being both the employer and the employee, which, with the right account set up, may allow you to maximize overall contributions.
As an S-Corporation owner, there are several different retirement account options available including the traditional IRA, ROTH IRA, SEP-IRA, SIMPLE IRA, and the SOLO 401. Each type of account has various tax implications and specific contribution limitations and requirements. Your customer success team at Formations can go over all the options with you and help you choose the account structure that will allow you to maximize your retirement savings.
We can show you the overall benefits of contributing before the April 15th tax filing deadline to maximize contributions while also reducing your tax liability.
- The Traditional IRA
The SOLO 401
Now that you have a better understanding of the various retirement accounts available to you as an S-Corp owner, lets talk about funding the account and maximizing tax savings.
S-Corp Owners Wages vs. Distributions
Deadlines to Open and Fund Accounts
Deadlines to Fund Accounts for Prior Year Tax Benefits
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If I Offer A 401 To My Employees Are There Compliance Regulations I Must Follow Or Can The Retirement Plan Provider Help With These
Certain employers who offer 401 and other retirement plans must abide by the Employee Retirement Income Security Act of 1974, as amended, which helps ensure that plans are operated correctly and participants rights are protected. In addition, a 401 plan must pass non-discrimination tests to prevent the plan from disproportionately favoring highly compensated employees over others. The plan fiduciary is usually responsible for helping comply with these measures.
This information is intended to be used as a starting point in analyzing employer-sponsored 401 plans and is not a comprehensive resource of all requirements. It offers practical information concerning the subject matter and is provided with the understanding that ADP is not rendering legal or tax advice or other professional services. For specific details about any 401 they may be considering, employers should consult a financial advisor or tax consultant.
Unless otherwise agreed in writing with a client, ADP, Inc. and its affiliates do not endorse or recommend specific investment companies or products, financial advisors or service providers engage or compensate any financial advisor or firm for the provision of advice offer financial, investment, tax or legal advice or management services or serve in a fiduciary capacity with respect to retirement plans. All ADP companies identified are affiliated companies.
Plans Get Expensive Once You Add Employees
Many people know how 401 plans work. The employee, including a shareholder-employee, contributes up to $18,000 out of her wages. The employer matches some portion of these savings according to a formula. For example, one common formula for safe-harbor 401 plans matches employee contributions dollar for dollar up to 4% of an employee’s wages. And matching percentages can actually go as high as 25% of wages.
Example: If a shareholder-employee earns $40,000 as an employee, he or she can contribute up to $18,000 out of wages. Then, as an employer the S corporation can do a 25%, or $10,000, employer match. That’s a pretty big pension fund contribution–around $30,000 a year. Over thirty years and assuming average rates of return, someone might be able to end up with roughly $2,000,000 by running such a retirement savings program.
A 401 plan can work great for a one -person or husband-and-wife business operated as an S corporation. One-person and husband-and-wife 401 plans let the S corporation pay very large pension fund contributions on modest wages. The matching piece doesn’t directly trigger additional payroll taxes because the match comes directly from the S corporation and not out of the employee’s wages. Furthermore, one-person and husband-and-wife 401 plans often don’t saddle the small business with expensive administration or pricey fiduciary insurance.
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Who Should Choose A Sep Ira Instead Of A Solo 401
When a newly minted entrepreneur or gig worker lands at Henrys door and asks whether to open an SEP IRA or a solo 401, he asks one question: Do you have any plans to hire an employee, even in the future? If the answer is maybe, he steers them toward an SEP IRA, which can be used to fund employee retirements.
Remember: Hiring just one employee for your business in the futurebeyond your spousewould eliminate the solo 401 as an option. And switching from a solo 401 to an SEP IRA at some future date can be a big hassle, Henry warns.
Entrepreneurs who go with an SEP IRA because of potential future hires have another important consideration: All employee contributions must be the same percentage of compensation. For instance, an entrepreneur who wants to put 10% of their net income into their SEP IRA must put 10% of worker pay into their SEP IRA, too.
But even in some cases where hiring employees simply isnt in the cards, Henry sometimes advises the self-employed to choose a SEP IRA. Simplified is in the plans name for a reason: They can be easier to set up than solo 401 plans, according to Henry, and theyre more widely available.
Every situation is different, and an individual should assess the option that is best for their financial goals, but there is some truth to the fact that a SEP is easier to open, says Cherill. In fact, most taxpayers can simply open a SEP account online with their brokerage firm and manage it themselves.
Current Year Defined Benefit Deductions May Be Higher
Because the owners Plan compensation in an S Corporation is W-2 and may be set without regard to net income, a higher Defined Benefit Plan deduction may be possible.
This is because an S Corporation simply can pay the owner the necessary W-2, as long as it is reasonable, such that the Defined Benefit Plan contribution is maximized for a given situation. On the other hand, a Sole Proprietor is constrained by net income, which is not as easily controlled.
Of course, net income can be controlled by delaying or accelerating revenue and/or expenses. However, this may be cumbersome and often inconsistent with the overall tax strategy. For example, if a Sole Proprietor wanted a higher Defined Benefit Plan deduction, they may need to increase net income by accelerating revenue or delaying the payment of expenses. And although increasing net income may support a larger Defined Benefit Plan deduction, the higher net income may offset the Defined Benefit deduction.
Additionally, recall that when determining Plan compensation for a Sole Proprietor, net income is reduced by employer-provided retirement contributions. Thus, taking a Defined Benefit Plan deduction actually reduces Plan compensation, and lower Plan compensation reduces the maximum permissible Defined Benefit deduction. Thus, Plan compensation for a Sole Proprietor is circular in nature and may result in a lower maximum deductible contribution.
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Traditional 401 Vs Roth 401
When 401 plans became available in 1978, companies and their employees had just one choice: the traditional 401. Then in 2006, Roth 401s arrived. Roths are named for former U.S. Senator William Roth of Delaware, the primary sponsor of the 1997 legislation that made the Roth IRA possible.
While Roth 401s were a little slow to catch on, many employers now offer them. So the first decision employees often have to make is between a Roth and a traditional .
As a general rule, employees who expect to be in a lower after they retire might want to opt for a traditional 401 and take advantage of the immediate tax break.
On the other hand, employees who expect to be in a higher bracket after retiring might opt for the Roth so that they can avoid taxes on their savings later. Also importantespecially if the Roth has years to growis that there is no tax on withdrawals, which means that all the money the contributions earn over decades of being in the account is tax-free.
As a practical matter, the Roth reduces your immediate spending power more than a traditional 401 plan. That matters if your budget is tight.
Since no one can predict what tax rates will be decades from now, neither type of 401 is a sure thing. For that reason, many financial advisors suggest that people hedge their bets, putting some of their money into each.
Contributing To A 401 Plan
A 401 is a defined contribution plan. The employee and employer can make contributions to the account up to the dollar limits set by the Internal Revenue Service .
A defined contribution plan is an alternative to the traditional pension, known in IRS lingo as a defined-benefit plan. With a pension, the employer is committed to providing a specific amount of money to the employee for life during retirement.
In recent decades, 401 plans have become more common, and traditional pensions have become rare as employers shifted the responsibility and risk of saving for retirement to their employees.
Employees also are responsible for choosing the specific investments within their 401 accounts from a selection their employer offers. Those offerings typically include an assortment of stock and bond mutual funds and target-date funds designed to reduce the risk of investment losses as the employee approaches retirement.
They may also include guaranteed investment contracts issued by insurance companies and sometimes the employer’s own stock.
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The Lifetime Limit May Be Increased More Easily
As mentioned, the maximum deductible Defined Benefit Plan contribution is a function of the highest three consecutive years of Plan compensation. The lifetime limit, or the maximum lump sum that may be paid out from the Plan, also is a function of this average.
As expected, S Corporations may more easily increase the lifetime limit by simply paying higher W-2s, thereby increasing the three-year consecutive average. A Sole Proprietorship, on the other hand, is restricted by net income.
Being unable to easily increase the lifetime limit, as a Sole Proprietor, especially may be an issue if Plan assets have appreciated far in excess of the lifetime limit. Although other options may be available, soaking up excess assets by simply paying a higher W-2, as the owner of an S Corporation, may be the most expedient alternative. In some instances, it may be one of the few options available to resolve an overfunded Defined Benefit Plan.
Thus, in terms of increasing the lifetime limit, an S Corporation provides much more flexibility than a Sole Proprietorship.
Leave Your 401 With The Old Employer
In many cases, employers will permit a departing employee to keep a 401 account in their old plan indefinitely, though the employee can’t make any further contributions to it. This generally applies to accounts worth at least $5,000. In the case of smaller accounts, the employer may give the employee no choice but to move the money elsewhere.
Leaving 401 money where it is can make sense if the old employer’s plan is well managed and you are satisfied with the investment choices it offers. The danger is that employees who change jobs over the course of their careers can leave a trail of old 401 plans and may forget about one or more of them. Their heirs might also be unaware of the existence of the accounts.
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What Is The Main Benefit Of A 401
A 401 plan lets you reduce your tax burden while saving for retirement. Not only are the gains tax-free but it’s also hassle-free since contributions are automatically subtracted from your paycheck. In addition, many employers will match part of their employee’s 401 contributions, effectively giving them a free boost to their retirement savings.