The Retirement Plan Menu of the Self-Employed…and those that work for them.

August 19, 2022
By: Director, Philip H. Clinkscales, III, CPA, CFA, CAIA, CGMA, CFP®, PFS

When a typical employee starts a job, they are usually offered a pre-set menu of retirement funding options that has been set by their employer. The choices usually involve whether to participate, which to participate in, and how much to participate. This limited choice can, in turn, limit the tax benefits available to those employees as well.

The self-employed, on the other hand, get to set their own menu. This means the options are greater for them and their employees. For those that are self-employed and solo practitioners, the menu can almost be without limits.

The number of self-employed (and their employees) makes up almost 1/3 of total employees(1) and this number has been growing since COVID-19. Below we will explore the options for this growing percentage of the labor force, the self-employed:

1. Traditional and/or ROTH Individual Retirement Accounts (IRAs)

For many just starting a business from scratch, the initial plan choice is likely an IRA. This is a very simple “plan” to establish, contribute to, and maintain. There is very little, if any, administration of the plan and very little to no overhead costs as well.

Coincidentally, this type of account (especially the Traditional version) is likely to be the final destination for most, if not all, of your other retirement plans once you are done working.

Plan Type: Individual – No ties to the employer.
Setup: Easy
Administration: Little to None
Cost to Setup & Maintain: Little to None
Annual Contribution Limit: $6,000 ($7,000 with catchup in the year you turn 50 and later)
Tax Benefits: Beneficial to make an annual decision on which type to utilize in each year.

ROTH IRA Benefit: tax free growth if distributed after age 59 ½. Here the contribution itself has income limitations and is non-deductible. All other factors equal, the ROTH IRA should be utilized in lower income years.
Traditional IRA Benefit: maximum annual tax deduction equal to the annual contribution limit but the deduction is subject to income limits. All other factors equal, the Traditional IRA should be utilized in higher income years relative to the ROTH IRA.

2. Solo 401(k)

If you still have no employees and the company income has outgrown the IRA options relative to the tax benefits provided by them, a Solo 401(k) may be worth considering. You are unable to utilize this option if you hire any employee other than your spouse (think Solo 401(k) is available to all employees on a solo joint personal tax return).

Plan Type: Employer
Setup: Easy
Administration: Little – for accounts under $250,000. Additional regulatory filings for those above that amount.
Cost to Setup & Maintain: Little to None
Annual Contribution Limit: $61,000 ($67,500 with catchup in the year you turn 50 and later) or 100% of earned income, whichever is less.

Employee Portion (Employee Deferral): $20,500 ($27,000 with catchup after age 50)
Employer Portion: 25% of compensation (or 25% of net self-employment income for single member LLCs or sole proprietors). Compensation up to $305,000 is applicable for consideration.

Tax Benefits: Current deduction for contributions and tax-deferred growth. Taxed at time of distributions beginning after age 59 ½. Much like an IRA, there is a ROTH option available.

3. Simplified Employee Pension (SEP IRA)

The Simplified Employee Pension is necessary to consider once you, as a self-employed individual, begin to hire an employee or employees (other than your spouse). Sometimes you may need more help (other than your spouse), and sometimes working with your spouse may not work out.

Plan Type: Employer but with Individual Participant IRAs
Setup: Easy
Administration: Simplified
Costs to Setup & Maintain: Little to None
Annual Contribution Limit: Contributions as a percentage of salary MUST be the same for ALL employees (owner/ employee included).

Employee Portion (Employee Deferral): None
Employer Portion: $61,000 or 25% of compensation (25% of net self-employment income for single member LLCs or sole proprietors), whichever is less. Compensation up to $305,000 is applicable for consideration.

Tax Benefits: Current deduction on contributions for the employer and tax-deferred growth. For the individual, taxed at time of distributions beginning after age 59 ½. No ROTH option available.

4. A Savings Incentive Match Plan for Employees (SIMPLE IRA)

As you grow in the number of employees and/ or the payroll dollar amounts, another option may prove useful. This option is available to employers with less than 100 employees.

Plan Type: Employer, but with Individual Participant IRAs

Setup: Easy to More Involved
Administration: Easy to More Involved
Costs to Setup & Maintain: Little
Annual Contribution Limit:

Employee Portion (Employee Deferral): $14,000 ($17,000 with catchup in the year you turn 50 and later) subject to a total of $20,500 ($27,000 with catchup after age 50) for ALL employer plans.
Employer Portion: Matching of employee contributions up to 3% of compensation OR a fixed 2% for all eligible employees. Compensation up to $305,000 is applicable for consideration.

Tax Benefits: Current deduction for contributions and tax-deferred growth. Taxed at time of distributions beginning after age 59 ½. No ROTH option available.

5. 401(k)

This is the plan most W-2 employees interact with at non-self-employed employers and can be an option for those with a great number of employees.

Plan Type: Employer
Setup: Involved
Administration: Involved
Costs to Setup & Maintain: Relatively Expensive
Annual Contribution Limit: $61,000 ($67,500 with catchup in the year you turn 50 and later)

Employee Portion (Employee Deferral): $20,500 ($27,000 with catchup in the year you turn 50 and later)

Employer Portion: It can vary in forms and amounts – Matching, Qualified Matching, Profit-Sharing, Qualified Nonelective, Money Purchase.

Tax Benefits: Current deduction for contributions and tax-deferred growth. Taxed at time of distributions beginning after age 59 ½. Much like an IRA, there is a ROTH option available.

6. Defined Benefit Plan

For those self-employed individuals (especially solo practitioners employing zero to very few) with higher incomes, the below options may be particularly appealing. These can be great tools for those that would like to store away an amount of money greater than that offered by Defined Contribution plans. Unlike the above which are considered Defined Contribution plans due to the fact that the amount contributed is the known variable, the below options are considered Defined Benefit Plans. These can also be used as standalone plans or in conjunction with one of the above plans to really supercharge your retirement funding and the current tax benefits of doing so. Employees generally must be offered to participate in the plan and the employer will need to make contributions on their behalf. Often, these plan types will require the services of a separate administration firm commonly referred to as a Third-Party Administrator (TPA).

  1. Defined Benefit Pension Plan
    These are referred to as pension plans because the “known” guaranteed amount is a monthly benefit starting at retirement. This is based on a formula involving compensation and length of service.
  2. Cash Balance Plans
    These plans are much the same as pension plans but rather than a “known” monthly benefit amount, the “known” guaranteed amount is a maximum lump sum payment amount at retirement.

Plan Type: Employer
Setup: Very Involved
Administration: Very Involved
Costs to Setup & Maintain: Expensive Setup and Annual Expenses
Annual Contribution Limit: Calculated by an actuary usually with minimum, maximum, and recommended values that can be quite large.
Tax Benefits: Current deduction on contributions for the employer. The maximum deduction must be calculated by an actuary.

Conclusion

Having a retirement plan as a self-employed individual, whether solo or with employees, is important as part of your overall financial plan. By knowing all your options, you will be able to choose a plan that fits best with your situation to maximize the benefits available.

(1) Kochhar, Rakesh (2021, November 3) The self-employed are back at work in pre-COVID-19 numbers, but their businesses have smaller payrolls. Pew Research Center. https://www.pewresearch.org/fact-tank/2021/11/03/the-self-employed-are-back-at-work-in-pre-covid-19-numbers-but-their-businesses-have-smaller-payrolls/

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About Homrich Berg

Founded in 1989, Atlanta-based Homrich Berg is a national independent wealth management firm that provides fiduciary, fee-only investment management and financial planning services, serving as the leader of the financial team for our clients, including high-net-worth individuals, families, and not-for-profits. Homrich Berg manages over $9 billion for more than 2,000 family relationships nationwide.

Four Ways an HSA Can Fortify Your Retirement Savings

By: James White

01/28/2020

When it comes to retirement planning most of us think firstly of our 401k, Pension, and maybe our Roth IRA. However, many never consider saving for one of retirement’s biggest costs with the most tax-advantaged vehicle under the IRS code. Saving for healthcare costs with a Health Savings Account (HSA) can potentially be your retirement plan’s fortifying feature. Homrich Berg believes that after contributing to your 401k, up to the company match, the next best place for retirement savings could be in a HSA up to its limits for those who are eligible (more on eligibility below)… The following are four reasons your HSA can be more advantageous than other savings vehicles:

  1. Increased Tax Benefits – HSA contributions are pre-tax, meaning they reduce your taxable income, they grow tax-free, and are distributed tax-free for eligible expenses. No other savings vehicle has as many tax advantages.
  2. Medicare and Private Insurance Eligibility – your HSA can distribute assets tax-free to pay for Medicare, private healthcare insurance, and long term care insurance premiums during retirement.
  3. Funding Unexpected Medical Bills – Under a 401k, for example, all distributions in retirement are taxed at Ordinary Income rates. The combined state and federal tax rate can be over 35% for some people. An unexpected $5,000 medical bill can require a withdrawal of $7,700 including taxes. If you have a funded HSA account, these withdrawals are tax-free, thereby reducing the gross amount of savings needed for unexpected distributions.
  4. Penalty-Free Distributions Before Age 59 ½ — There are no penalties for early withdrawals in a HSA. In fact, you can contribute, receive credit for the pre-tax income deduction, and immediately distribute the contribution for an eligible healthcare cost. If 401k savings money were needed before age 59 ½ there would be a 10% penalty plus taxes.

You must be enrolled in a Qualified High Deductible Healthcare Plan in order to be eligible to make HSA contributions. In 2020, contribution maximums are $3,550 for single filers and $7,100 for those married filing jointly. If over the age of 55, you are allotted a catch-up contribution of an additional $1,000. Consult with your tax advisor or CPA regarding eligibility and appropriateness of this strategy. Some risks may include the inability to maintain tax-advantages for non-spouse beneficiaries, a 20% penalty and loss of tax advantages for non-qualified distributions, as well as limitations on investing HSA savings. Some accounts offer significantly more investment options than others, so be sure to ask your financial advisor which account is best for you.

Four Ways an HSA Can Fortify Your Retirement Savings

By: James White

01/28/2020

When it comes to retirement planning most of us think firstly of our 401k, Pension, and maybe our Roth IRA. However, many never consider saving for one of retirement’s biggest costs with the most tax-advantaged vehicle under the IRS code. Saving for healthcare costs with a Health Savings Account (HSA) can potentially be your retirement plan’s fortifying feature. Homrich Berg believes that after contributing to your 401k, up to the company match, the next best place for retirement savings could be in a HSA up to its limits for those who are eligible (more on eligibility below)… The following are four reasons your HSA can be more advantageous than other savings vehicles:

  1. Increased Tax Benefits – HSA contributions are pre-tax, meaning they reduce your taxable income, they grow tax-free, and are distributed tax-free for eligible expenses. No other savings vehicle has as many tax advantages.
  2. Medicare and Private Insurance Eligibility – your HSA can distribute assets tax-free to pay for Medicare, private healthcare insurance, and long term care insurance premiums during retirement.
  3. Funding Unexpected Medical Bills – Under a 401k, for example, all distributions in retirement are taxed at Ordinary Income rates. The combined state and federal tax rate can be over 35% for some people. An unexpected $5,000 medical bill can require a withdrawal of $7,700 including taxes. If you have a funded HSA account, these withdrawals are tax-free, thereby reducing the gross amount of savings needed for unexpected distributions.
  4. Penalty-Free Distributions Before Age 59 ½ — There are no penalties for early withdrawals in a HSA. In fact, you can contribute, receive credit for the pre-tax income deduction, and immediately distribute the contribution for an eligible healthcare cost. If 401k savings money were needed before age 59 ½ there would be a 10% penalty plus taxes.

You must be enrolled in a Qualified High Deductible Healthcare Plan in order to be eligible to make HSA contributions. In 2020, contribution maximums are $3,550 for single filers and $7,100 for those married filing jointly. If over the age of 55, you are allotted a catch-up contribution of an additional $1,000. Consult with your tax advisor or CPA regarding eligibility and appropriateness of this strategy. Some risks may include the inability to maintain tax-advantages for non-spouse beneficiaries, a 20% penalty and loss of tax advantages for non-qualified distributions, as well as limitations on investing HSA savings. Some accounts offer significantly more investment options than others, so be sure to ask your financial advisor which account is best for you.

Top 5 Ways The SECURE Act May Impact Your Retirement Accounts

By Jaime Ruff and Todd Hall

December 23, 2019

Packaged with the recent spending bill was some of the most significant retirement plan legislation to come along in years. The Setting Every Community Up for Retirement Enhancement (SECURE) Act was signed into law in Friday December 20th, and will impact businesses and consumers in a number of ways. Here are five key takeaways

  1. The End of the “Stretch IRA”… say hello to the new 10-Year Rule

Perhaps the most prominent change under the SECURE Act is that it creates a new 10-Year Rule for non-spouse beneficiaries of inherited IRAs. Most non-spouse beneficiaries who inherit a retirement account after 2019 will need to withdraw the entire account and pay any associated income taxes within 10 years, rather than over their life expectancy. This effectively ends what has colloquially become known as the “Stretch IRA”, since spreading the distributions from an inherited IRA over the life expectancy of the beneficiary potentially can defer those taxes for decades.

The 10-Year rule does not apply in the following situations:

  • If the beneficiary is the spouse of the original IRA owner
  • If the original IRA owner dies before January 1, 2020, in which case the beneficiaries are grandfathered under the old rules and can “stretch” the IRA over their life expectancy
  • If the beneficiary qualifies for “eligible designated beneficiary” status under the SECURE Act, including heirs that are less than 10 years younger than the decedent, chronically ill individuals, disabled individuals, and minor children. Minor children will age out of the exclusion once they hit the age of majority in their state, typically 18 to 21. At that time, the 10-year required minimum distribution period would become applicable to any remaining balance in the inherited defined contribution plan or IRA. As such, minors will still be able to stretch out distributions slightly longer than other individuals.

Example…

Joe was 65 when he died in 2020. He had an IRA worth $500,000 and his designated beneficiary was his daughter Megan, age 40.

Under prior rules, Megan would have only have been required to take out a percentage of the IRA each year based on her life expectancy. The required minimum distribution or “RMD” would start around $15,000 in the first year and the percentage to withdraw would gradually rise until Megan turned 85 when the account would have to be empty. She thus could have “stretched” those distributions over 35 years and deferred the associated income taxes.

Now, if she wants, Megan won’t have to deal with an RMD at all during those first nine years. Instead she must empty the entire IRA balance within 10 years, which could bump her into a higher tax bracket pretty quickly. Notably, she has flexibility as to when within those 10 years to take her distributions, so perhaps she can time her distributions to coincide with years when her income will otherwise be lower.

 

In light of these changes many existing estate plans should be revisited.

The loss of potential decades of tax deferral further tips the scale in favor of considering charities rather than individuals as retirement account beneficiaries.

Things like Roth IRA conversions and multi-generational trusts are tools that will be useful in managing many wealthier families’ income tax brackets.

Use of a conduit trust as an IRA beneficiary may be a problem now. Under the previous Stretch IRA rules, trust distributions could be spread over the life expectancy of the beneficiary. Now with the IRA emptied within 10 years the funds will effectively be distributed outright to the trust beneficiary, thus negating the elements of the trust that were sought after.

 

  1. Later Required Beginning Date for Retirement Distributions

On a positive note, if you were born on or after July 1, 1949 then you are not required to begin taking Required Minimum Distributions (RMDs) from your IRA until age 72, rather than 70½. If you’re already 70½ in 2019, the new rules won’t apply to you as you’ll have an RMD for 2019 that must be withdrawn by April 1, 2020. But if you were born after July 1, 1949 your required beginning date is postponed.

Those with birthdays in the first half of 2020 will benefit slightly more from this provision. For example, someone who turns 70 next spring (and 70½ next fall) won’t have to take distributions until 2022 when they turn 72 —two extra years than if the bill didn’t pass. But if someone is turning 70 next fall (and 70½ in the spring of 2021), they don’t have to take distributions until 2022 when they turn 72. That person gets just an extra year.

 

  1. Contributions to Traditional IRAs Allowed After age 70

Another positive aspect of the legislation is in recognition of the fact that many more people are now working after age 70. Under the SECURE Act workers over age 70 can start making IRA contributions up to $7,000 per year (including the $1,000 catch-up contribution for workers over age 50). A nonworking spouse whose spouse earns income also can contribute.

 

  1. Qualified Charitable Distributions Still Allowed Beginning at Age 70½

People who are 70½ or older still can make a Qualified Charitable Distribution (“QCD”) from their IRA to one or more charities, up to $100,000 in a given year. The SECURE Act does not change that popular tax break. The legislation does, however, introduce an anti-abuse provision to reduce the allowable QCD amount by any traditional IRA deduction received for that year.

 

  1. Initiatives to Increase Employer Adoption of Retirement Plans

The new law increases the tax credit for small businesses to set up new retirement plans, from $500 to $5,000. It also creates a new tax credit of up to $500 per year to defray startup costs for new 401(k) plans and SIMPLE IRA plans that include automatic enrollment. Unaffiliated small employers are now able to band together to offer a 401(k) type of plan and shift some of the administrative burden to a retirement plan administrator. And starting in 2024, 401(k) plans will be required to allow employees who work more than 500 hours for three years to contribute.