Retirement plans for business owners

As a business owner or self employed individual, there are options available for funding your retirement in addition to those options which are available for anyone with earned income, such as traditional and ROTH IRA accounts.  The most common types of retirement accounts for business owners are SEP-IRAs and 401K plans, which will be reviewed in detail in this article.  For information on additional options available, please see this article on defined benefit pension plans for small business owners.

SEP-IRA retirement plans

A SEP-IRA account is the same as a traditional IRA in most ways.  The only substantial difference is that with a SEP-IRA, the participant can contribute up to 25% of compensation, or $54,000 for 2017 ($60,000 for persons ages 50 or older), whichever is lesser.  This could end up being substantially more than the contribution limit for a traditional IRA account, depending on the compensation of the participant.  In order to be eligible to establish a SEP-IRA, you must own a business (this includes being self employed).  If you have any employees, they are eligible to have a SEP account as well, and must be included if they meet certain criteria (worked for the business for 3 of the previous 5 years, attained age 21, and had at least $600 in compensation.  These requirements can be made less restrictive in the SEP-IRA plan document).  SEP-IRAs have the main advantage of being easy and relatively inexpensive to administer.

401K retirement plans

A business owner, including a self employed person, has the option of establishing a 401K plan for his or her self and employees.  The participant can contribute 100% of compensation, up to the limit ($18,000 for 2017 plus a $6,000 “catch-up” contribution if age 50 or older).  The business owner can also make a non-elective contribution of up to 25% of compensation.  The rules related to the non-elective contribution are a bit more complex for a self employed individual but are in the same general range.  401K plans are in general a bit more time consuming and costly to administer than SEP-IRA plans, however they have the main advantage of having larger contribution limits than SEP-IRAs.  They also allow the participant to take loans against their 401K balance, something which is prohibited by the IRS rules pertaining to IRAs, including SEP-IRAs.

 

IRA income limits

Overview

ROTH IRA and traditional IRA account contributions are subject to income phaseout limits.  In the case of the ROTH IRA the limits are related to eligibility and in the case of a traditional IRA the limits are related to deducting the contributions.  If you exceed these limits you may want to consider alternatives for deferring taxes on your retirement savings.  There are many options available depending upon your particular situation.  In general, business owners and self employed individuals have more options available to them than do W-2 employees.  The details of the income and phaseout limits are discussed in detail below.

ROTH IRA income limits

You are typically able to make a ROTH IRA contribution if your income falls below certain levels.  If you are married filing jointly, you can make a full ROTH IRA contribution if your adjusted gross income (AGI) is less than $186,000 for the 2017 tax year.  You can make a reduced contribution if your AGI is between $186,000 and $196,000, and contributions are disallowed altogether if your AGI is greater than or equal to $196,000.

If your tax filing status is single or head of household you may make a full ROTH IRA contribution for the 2017 tax year if your AGI is less than $118,000,  a reduced contribution if your AGI is between $118,000 and $133,000, and no contribution at all if your AGI is greater than or equal to $133,000.

If you are not able to make a ROTH IRA contribution due to income restrictions, you may want to investigate whether or not your employer offers a ROTH 401K plan.  If they do not, you should consider making a request to your employer that a ROTH 401K plan be implemented.

ROTH IRA income limits for 2017 tax year
filing status income limit
Married filing jointly full contribution allowed for AGI less than $186,000; phaseout for AGI between $186,000 and $196,000, no contribution allowed for AGI greater than or equal to $196,000
Single full contribution allowed for AGI less than $118,000; phaseout for AGI between $118,000 and $133,000, no contribution for AGI greater than or equal to $133,000
Head of household full contribution allowed for AGI less than $118,000; phaseout for AGI between $118,000 and $133,000, no contribution for AGI greater than or equal to $133,000
Married filing jointly (and lived with spouse at any time during year) phaseout for AGI between $0 and $10,000, no contribution for AGI greater than or equal to $10,000

Traditional IRA income limits

There are no income restrictions related to making a contribution to a traditional IRA, however you may not be able to deduct the contributions if you or your spouse participates in a retirement plan at work.  If you or your spouse participate in a retirement plan at work, the deduction begins to phaseout at $62,000 AGI for single or head of household ($99,000 for married filing jointly) and phases out completely at $72,000 AGI ($119,000 for married filing jointly).  These numbers are for the 2017 tax year.  If you are in this situation, you should consider contributing to your retirement plan at work, such as a 401K plan, as you will be able to deduct these contributions up to their limit.

Traditional IRA income limits for 2017 tax year
filing status no retirement plan at work retirement plan at work spouse has retirement plan at work (and you do not)
Married filing jointly no limits full deduction up to contribution limit if AGI less than $99,000, partial deduction for AGI between $99,000 and $119,000, no deduction if AGI is greater than $119,000 full deduction if AGI less than $186,000, phaseout for AGI between $186,000 and $196,000, no deduction if AGI is greater than $196,000
Single no limits full deduction up to contribution limit if AGI less than $62,000, partial deduction for AGI between $62,000 and $72,000, no deduction if AGI is greater than $72,000 N/A
Head of household no limits full deduction up to contribution limit if AGI less than $62,000, partial deduction for AGI between $62,000 and $72,000, no deduction if AGI is greater than $72,000 N/A
Married filing separately no limits partial deduction for AGI between $0 and $10,000, no deduction if AGI is greater than or equal to $10,000 partial deduction for AGI between $0 and $10,000, no deduction if AGI is greater than or equal to $10,000

ROTH IRA or traditional IRA? A comparison

Overview

Individual retirement accounts (“IRAs”)  provide an excellent option for funding your retirement due to their numerous tax advantages.  They are typically administered by a financial institution such as a bank, broker/dealer, trust company or insurance company, which acts as the trustee for the account.  There are many types of IRAs, including SEP IRAs, SIMPLE IRAs, rollover IRAs, traditional IRAs, and ROTH IRAs.  The two most common types of IRAs are ROTH IRAs and traditional IRAs, which I will review in detail here.  Each of these retirement savings vehicles has its advantages and disadvantages from a tax perspective.  Which one is more advantageous for your particular situation will depend on a variety of factors, including your age, time horizon, income (and tax bracket), investment objectives, and expected income and tax bracket in retirement.   In most cases I believe that a ROTH IRA provides a greater benefit overall however I will review in detail the advantages and disadvantages of both of these retirement savings vehicles in this article.

ROTH IRA versus traditional IRA
ROTH IRA Traditional IRA
Contributions not deductible deductible*
Withdrawals not taxable taxable
Withdrawal penalty (prior to age 59 1/2) on earnings only on total distribution
Eligibility subject to income limits  no income limits*
2016 contribution limit $5,500 per year ($6,500 if age 50 or over) $5,500 per year ($6,500 if age 50 or over)
Required minimum distribution no yes

*deduction subject to phaseout limits if you have a retirement plan at work

IRA Contributions

For both the traditional IRA and ROTH IRA an individual may contribute up to $5,500 if under the age of 50, and up to $6,500 if age 50 or over per tax year, for 2016 and 2017.  However, an individual may not contribute more than their employment income.  ROTH IRA contributions are also subject to income limits.  While traditional IRAs do not have income limits, you may not be able to deduct contributions if you or your spouse have a retirement plan, such as a 401K or 403B plan, at work.

 

Traditional IRA – take a tax deduction now, pay taxes later

As long as you are not subjected to certain income phaseout limits, IRA contributions are tax deductible in the year in which they are made.  You will, however, have to pay ordinary income taxes on the withdrawals.  You will also be subjected to a penalty tax if you make withdrawals prior to age 59 1/2 (unless you qualify for certain exceptions).  Money invested in a traditional IRA grows tax deferred, so you will not have to pay taxes related to the growth or income in the account until you start taking withdrawals from the IRA.  You can make contributions to a traditional IRA up until age 70 1/2, after which point you will need to take a required minimum distribution each year (this is true for SEP and SIMPLE IRAs as well).  The amount of the required minimum distribution which you must take increases each year based upon your age according to mortality tables which are part of the IRS code.  The required minimum distribution rule makes it difficult for the account holder to continue to grow the account after age 70 1/2 as funds must be withdrawn from the account every year, thus subjecting these funds to income taxes.

Even if you do not qualify to take a deduction for your traditional IRA contribution, you can still benefit from its tax deferral feature.  However, you may be better off making a contribution to a 401K plan instead, as you will be able to deduct your contributions there up to the limit.

ROTH IRA – no tax deduction now, withdraw tax free later

ROTH IRA contributions are not deductible in the year in which they are made.  However, ROTH IRA withdrawals are not taxed as long as the ROTH IRA has been in existence for at least five years and are taken after age 59 1/2 (if either of these criteria are not met, the earnings on the ROTH IRA are subject to a 10% penalty tax).  ROTH IRA contributions can be made at any age, and there are no required minimum distributions as there are with a traditional IRA.  These features make the ROTH IRA a very attractive choice for retirement because the account holder is able to keep the funds in the account for extended period of time, where they can continue to grow and compound tax free.  The account holder has the option to withdraw portions of the ROTH IRA assets to fund retirement, and is able to do so tax free, but is not required to.

ROTH IRA conversion and recharacterization

Oftentimes it is advantageous from a tax planning standpoint to change an existing traditional IRA account to a Roth IRA account.  This is known as a Roth IRA conversion. Roth IRA accounts and traditional IRA accounts have different advantages and benefits.  As discussed previously, traditional IRA accounts provide an immediate tax benefit while Roth IRA accounts provide a tax benefit at the time of withdrawal.

A Roth IRA conversion would subject the IRA account owner to income taxes on the withdrawal from the traditional IRA account in the year that the conversion is made.  As Roth IRA withdrawals are tax free, the account owner will not have to pay any additional taxes on Roth IRA withdrawals once the taxes on the Roth IRA conversion have been paid.  A Roth IRA conversion should only be executed after careful analysis and tax planning has been done, with particular attention paid to income tax brackets in the current year as well as projected income tax brackets in future years.

In some other situations it becomes necessary to change IRA contributions which have already been made.  This would occur when the account owner wishes to change  traditional IRA contributions to Roth IRA contributions in order to take advantage of the benefits of the Roth IRA, or vice versa.  A common example of a recharacterization is when an individual subsequently becomes ineligible for a Roth IRA due to exceeding the relevant income limits, after the Roth IRA contributions have been made.  In this case, the account owner can recharacterize those contributions, and typically has until the tax filing deadline, including extensions, to do so.

Retirement plan limits and deadlines for the 2016 tax year

Below is a summary of key retirement plan information for the 2016 tax year.

 

Retirement plan deadlines and limits for the 2016 tax year
plan type  deadlines contribution limit
Traditional and ROTH IRA plan must be established and contribution must be made by the tax filing deadline, no extensions $5,500, $6,500 if age 50 or older
SEP IRA plan must be established and contribution must be made by the tax filing deadline, including extensions 25% of wage or salary compensation or $53,000, whichever is lesser
SIMPLE IRA new plan must be established by October 1 $12,500, $15,500 if age 50 or older
401K plan plan must be established by the end of the calendar year.  contribution must be made by the tax filing deadline, including extensions $18,000, $24,000 if age 50 or older for employee deferrals, $53,000 for total contributions, including employer contributions
Solo 401K plan plan must be established by the end of the calendar year.  contribution must be made by the tax filing deadline, including extensions $18,000, $24,000 if age 50 or older, plus 25% of compensation, or 20% of self employment income, up to a limit of $53,000, or $59,000 for an individual age 50 or older
Defined benefit pension plan contribution must be made by September 15 for plan with fiscal year ending December 31 of prior year benefit amount can not exceed $210,000 or average of highest 3 years of compensation.  Contribution limit is based upon actuarial computations based upon these benefit limits

 

IRA rollovers and transfers

IRA rollovers and transfers involve the tax deferred movement of funds between different retirement accounts.  Oftentimes there will be a need or desire to move funds from one retirement account to another.  This will occur, for example, after leaving an employer, or when moving your IRA from one financial institution to another.  If these movements of funds are conducted in accordance with IRS rules the account participant can avoid taxable events which normally occur when withdrawing funds from retirement accounts.

IRA rollovers

An IRA rollover is the movement of funds from an employer sponsored retirement plan, such as a 401K or 403B plan, to an individual retirement account (“IRA”).  If done in accordance with IRS rules, the rollover will not result in a taxable event for the account participant.

In rare cases it is possible to perform a direct, trustee to trustee transfer of funds from the 401K plan to the IRA.  Such transfers are typically initiated by the receiving financial institution or trustee.

In the majority of cases, however, rollovers are accomplished by having the 401K plan custodian generate a check payable to either the receiving financial institution which has custody of the receiving IRA account or directly to the 401K participant.  In order to comply with IRS rules and not have the 401K plan withdrawal be treated as a taxable event, funds must be rolled over to the receiving IRA account within 60 days.  This is true even in cases where the 401K plan custodian generates a check payable to the custodian of the receiving IRA account.

IRA transfers

An IRA transfer is a movement of funds from one IRA custodian to another.  These transactions can usually be executed by means of a direct, trustee to trustee transfer, typically initiated by the financial institution on the receiving end of the transfer.

Similar to how IRA rollovers are executed, a transfer can be accomplished by having the financial institution which has custody of the IRA generate a check payable directly to the receiving financial institution.  A transfer executed in this manner must be completed within 60 days in order to avoid having the withdrawal deemed to be a taxable event.

Alternatively, an indirect transfer can be accomplished by having the financial institution which has custody of the IRA generate a check payable to the account holder.  The account holder then has 60 days to roll the funds over to the new IRA account at the receiving financial institution or trustee.  Keep in mind that oftentimes when performing such an indirect transfer, taxes will be withheld by the outgoing custodian.  It is important that the full amount of the withdrawal be rolled over to the new account in order to avoid any taxable event associated with the withdrawal.

Asset location

Where assets are “located” has a significant impact from both a tax perspective and an asset protection perspective.  Assets can be placed/located in retirement accounts, taxable accounts, life insurance policies, annuities, trusts, corporations, and LLC’s.  This can be a complex subject overall.  We will briefly discuss here a comparison between ROTH retirement accounts and traditional retirement accounts, a comparison between retirement accounts and taxable accounts, as well as some discussion of life insurance policies and annuities.

Retirement accounts – ROTH accounts versus traditional accounts

Assets in retirement accounts typically accumulate and grow tax deferred (in the case of traditional 401K, 403B and IRA accounts) and in the case of ROTH 401K and ROTH IRA accounts can be withdrawn tax free.  For this reason, a case can be made for placing assets which have the capacity to generate the largest long term gains (such as small cap stocks) into ROTH accounts, while placing the assets which are lower risk and do not have the capacity to generate large long term gains (such as U.S. treasury bonds) into traditional accounts.  A careful analysis should be done of the tax bracket now and the expected tax bracket during retirement.

Taxable accounts versus retirement accounts

As taxable accounts do not have any tax deferral features, a case can be made for placing growth, non dividend paying assets into these accounts, and placing dividend paying assets into retirement accounts and reinvesting those dividends and interest.  This way, the investor can benefit from the long term capital gains taxes which are typically lower than the income taxes which are levied on dividends and interest.

Annuities versus taxable accounts

Assets in annuities grow tax deferred, with the basis determined by the amount contributed to the annuity.  For this reason, a case can be made that it is advantageous to place dividend-paying assets into annuity contracts while placing non-dividend paying, long term appreciating growth assets outside of annuity contracts.  This way, dividend generating assets can accumulate and grow tax deferred inside the annuity contract, and the investor can benefit from the lower capital gains taxes on growth assets held outside the annuity contract.

Required minimum distribution rules for retirement accounts

Certain retirement accounts are subject to required minimum distribution rules upon reaching a certain age, typically 70 1/2.  At this point, the account participant is required to withdraw a certain amount from the account(s) each year, and these withdrawals are usually subjected to income tax.  The participant may withdrawal more than the required amount and still be in compliance with the rule.  The rules apply to IRA accounts, SEP-IRA accounts, SIMPLE IRA accounts, 401K plans, 403B plans, 457 plans, and other defined contribution plans.  Note that ROTH IRAs are not subject to the rule in most cases.

The amount of the required minimum distribution is based upon age and marital status, and is determined based upon mortality tables.  The details of the calculation will not be covered here, however most account custodians will calculate the required minimum distribution for the account owner.

Exceptions to IRA early withdrawal penalty tax

In most cases, you will be subjected to a 10% penalty tax on withdrawals made from an IRA account (for a ROTH IRA, this penalty is levied on the earnings only) if the withdrawals are made prior to age 59 1/2.  Keep in mind that you will always pay regular income taxes on withdrawals from traditional IRA accounts if you were able to deduct all of your contributions and that there are no exceptions to this.  If you did not deduct all of the contributions the situation is a bit more complicated.  There are, however several exceptions which will allow you to avoid paying the 10% penalty tax.  In this article we will cover three of these exceptions:  an exception related to being a first time home buyer, an exception related to qualified higher education expenses, and an exception which relates to taking equal periodic payments from your account.

First time home buyer exception

If you are using the IRA funds for a down payment on your first home, you may withdraw up to $10,000 without paying the 10% penalty tax.  You will, however, still have to pay income taxes.  In order for the home purchase to qualify as a first time home purchase, you must not have owned a home within the previous two years.  If you are married you and your spouse may each withdraw up to $10,000 from your IRA for the purpose of making a first time home purchase.

Higher education expense exception

If you withdraw funds from your IRA to pay for qualified higher education expenses of yourself, your spouse or your child you will not have to pay the 10% early withdrawal penalty tax.  Qualified higher education expenses include tuition, books, supplies and equipment required for enrollment at an eligible higher education institution.

Equal periodic payments exception

There is another exception to the early withdrawal penalty which involves taking equal periodic payments from the retirement account beginning at a time prior to age 59 1/2 and continuing for 5 years or until age 59 1/2, whichever is later.  The rules for using this exception are complex and we emphasize the importance of  consulting with a financial or tax adviser when using this exception.

Retirement account withdrawals

Retirement account withdrawals

How should withdrawals be taken from retirement accounts?  Factors include investment style and the amount which is withdrawn each year.  The manner in which  withdrawals are taken from retirement savings account has a significant impact on how long these assets will last.  A common practice in the financial services industry is to use Monte Carlo simulations to estimate probabilities of certain outcomes occurring with respect to how withdrawals will affect the retirement assets over time.  In this article we will illustrate how retirement account withdrawals can have different results by using two simple examples.

Can I take a loan against my 401K or IRA?

It is often tempting to take a loan or withdrawal from a retirement account to satisfy a financial need such as making a down payment on a house or paying off another debt.  Taking such loans and withdrawals is highly discouraged as it depletes retirement savings and can have significant impact on these retirement savings in the long run.  It is a serious decision which should not be taken lightly.  In cases where retirement savings must be accessed prior to retirement, a loan has an advantage over a withdrawal in that it will not result in taxable income as long as it is paid back according to its terms. However, certain retirement accounts allow loans while others do not.  This article will discuss the rules applying to different types of retirement accounts.

IRA loans – generally prohibited

Generally a loan can not be taken using an IRA.  Using an IRA as collateral for a loan is prohibited by IRS rules, and can result in the IRA becoming disqualified.  There is an IRS provision which allows 60 days to rollover or transfer an IRA to another custodian if the distribution from the IRA is paid directly to you.  Keep in mind that in this scenario the taxes are withheld from the distribution so you will need to supply additional funds to complete the rollover or transfer.

401K loans – take with caution

In many cases a 401K participant can take a loan against their 401K account balance, if the particular plan allows loans.  You can check the plan document or summary plan description, or check with your company’s HR department to see if a loan is permitted.  Taking such a loan is usually quick and easy and is not subject to any underwriting processes.  The installment payments made on the loans are usually made through payroll deduction from the participant’s paycheck.  401K loans must be paid back according to their terms in order to avoid being deemed to be a distribution and thus subject to taxes.  The loan terms are usually five years or less, unless the loan is used to purchase a primary residence, in which case it can be longer.  Keep in mind that if you are separated from service with your employer while the loan is outstanding, it must be paid back in full according to its terms, usually within 60-90 days of termination, or be deemed to be a distribution and thus be taxable.  “Interest” which is charged on the loan is typically paid back into the participant’s account as payments are made.

401K hardship withdrawal

A hardship withdrawal can be taken from a 401K plan in certain situations.  Under most circumstances it is not advised to withdraw funds from an IRA or 401K account prior to retirement.  You will be subjected to income tax on the withdrawals at both the federal and likely state and local levels, as well as a 10% penalty tax if the withdrawal is taken prior to age 59 1/2 (unless you meet certain exceptions).  Perhaps more importantly, a withdrawal prior to retirement will have the effect of depleting your retirement savings as well as the future earnings on these savings.

In the case of a hardship withdrawal, you will need to meet certain requirements related to your hardship.  You will be unable to make contributions to the plan for a period of six months subsequent to the hardship withdrawal.  If your employer makes matching contributions to the plan, these will be suspended as well.

Investing in real estate through a self directed IRA

A self directed IRA allows an investor to invest in real estate in an IRA account.  The IRS code restricts investments in IRA accounts, and certain investments are prohibited (such as art, antiques, S-corp stock, life insurance, and collectibles).  Investment real estate is allowed, however, as long as the participant is not benefiting from the real estate in any way.  In order to qualify under IRS rules the participant may not use the property in any manner, or receive rental income from the property outside of the IRA.

To invest in real estate, typically the IRA participant must designate a financial institution, in the majority of cases a trust company, as the trustee and custodian of the self directed IRA account.  The IRA participant can then direct the trustee to purchase real estate for the IRA.  All real estate expenses must be paid from the IRA account, and all income from the real estate must be paid directly back into the IRA account.

As long as the self directed IRA is set up correctly and is compliant with IRS rules, the IRA participant is able to enjoy the tax advantages of the IRA.   This includes tax deferral of both the income received from the property as well as capital gains received when the property is sold.  In the case of a ROTH IRA, the participant is also entitles to receive tax free withdrawals, assuming that the normal requirements are met.