You Don’t Have to Work for Someone Else to Get a 401(k) & Pension!

A lot of “solopreneurs” (entrepreneurs with no employees) make the mistake of relying on their business as their sole retirement plan. But that’s like investing all of your retirement money in a single stock. (Look how that turned out for the employees of Enron when that company imploded back in 2001.) Even if your business is thriving now, that’s no guarantee that it will still be thriving when you’re ready to sell it (or transfer ownership to someone else in exchange for a percentage of the business’s ongoing revenues). What if there’s no longer a market for your products/services, the profit margins have gotten too low, the regulatory environment has gotten too unfavorable, etc.? If you think none of those things could happen to you, ask yourself how many businesses twenty years ago foresaw the rise of Amazon and the way it would knock over the anthills of the brick-and-mortar world?

The good news is that, as a solopreneur, you’re entitled to set up your very own workplace retirement plans, using your business as the “workplace” (even if your office is just a corner of your home). What’s great about these workplace plans is that they potentially allow you to shelter way more money from current and/or future taxes than either a Traditional or Roth IRA, while at the same time giving you more freedom to choose how your money is invested than a workplace plan you’d get as an employee of someone else.

There are a handful of plans you can choose from (see here), but two of them stand out as particularly worthy of consideration (in my opinion). The first is a 401(k). If your business has no employees other than your spouse, you can qualify for a solo 401(k). This is basically the same as a regular 401(k), except that it isn’t subject to scrutiny by the Department of Labor (because you don’t have any employees that you need to treat fairly or whose interests you need to put ahead of your own). To a certain extent, it’s similar to another popular business-based retirement vehicle: the SEP IRA. This is an IRA that a business contributes to for the benefit of its employees (SEP stands for “simplified employee pension”). But as a solopreneur, you can open a SEP IRA for yourself. With either a solo 401(k) or a SEP IRA, you can keep contributing to the account as long as you’re working in the business, even after you turn 70½. You can’t postpone your RMDs till after you quit the business, but each year you continue working, you can offset that year’s RMD by making pretax contributions to the account (which is something you can’t do with a Traditional IRA). Also, until the year you turn 50, contributions to a solo 401(k) or SEP IRA are capped at the same amount, which for 2018 is $55,000. (Note how this is 10x the contribution limit for Traditional & Roth IRAs!) However, the solo 401(k) possesses at least four advantages over the SEP IRA. First, starting the year you turn 50, a solo 401(k) allows you to contribute as much as $6000 extra (bringing your total possible contribution up to $61,000 for 2018). Second, even without that extra $6000, a solo 401(k) potentially lets you contribute more than a SEP IRA. This is because a Solo 401(k) lets you contribute as both the business owner and as an employee. As an employee, your contributions are capped at the same limit as any employee contributing to a 401(k) at their job. For 2018, that cap is $18,500 (plus that additional $6000 starting the year you turn 50). And as the business owner, you can make a further contribution of up to 25% of your compensation (if you pay yourself as a W2 employee) or 20% of the business’s net profits. (Of course, your total combined contributions as employee and business owner can’t exceed what you actually make from the business!) With a SEP IRA, on the other hand, you only get to contribute as the business owner (again, up to either 25% of your compensation or 20% of the business’s net profits). To illustrate the difference, suppose that you pay yourself a salary of $100,000 from your business. As the business owner, you could contribute up to $25,000 (25% of $100,000), whether to a SEP IRA or a solo 401(k). But as an employee, a solo 401(k) would also let you contribute an additional $18,500 (bringing your total up to $43,500), plus another $6000 starting the year you turn 50! And, to sweeten the deal even more, those contributions as an employee can be Roth contributions! That’s the third advantage. A solo 401(k) that permits Roth contributions is like a Roth IRA that you can contribute to no matter how much you earn, and with a yearly contribution limit of $18,500 ($24,500 starting the year you turn 50)! (Your contributions as the business owner can only be pretax, because the business gets to write those contributions off as an expense.) And like a Roth IRA, you can give yourself almost unlimited investment freedom — something you’re extremely unlikely to find in a 401(k) working as someone else's employee. (For more on Roth contributions to a 401(k), see this post.) A SEP IRA, on the other hand, only allows pretax contributions — because you can only contribute to it as the business owner (which entitles you to write those contributions off as a business expense). A solo 401(k) thus gives you more flexibility by giving you the opportunity to shelter money from both current and future taxes. And the fourth advantage of a solo 401(k) is that the plan document can be written to allow loans from the plan, whereas you can’t take out a loan from a SEP IRA (or any other type of IRA, for that matter). You’re free to take money out of a SEP IRA at any time, but if you’re not yet 59½, you face an early withdrawal penalty (equal to 10% of what you withdrew). A solo 401(k) thus offers you a way to bypass the early withdrawal penalty, if necessary (although you can only borrow up to a certain amount and have to pay it back in 5 years or less).

What, then, are the advantages of a SEP IRA? Well, if you do have employees, then a SEP IRA offers you some significant advantages over a 401(k). For a business with employees, operating a 401(k) means complying with a law called ERISA (the Employee Retirement Income Security Act). This law stipulates a number of protections you have to put in place for the benefit of your employees. For example, you (the employer) have to put your employees’ contributions, as well as any contributions you make on their behalf (such as matching contributions) into a trust, so that that money can’t be touched by creditors if the business fails. And you’re held liable for how that trust is managed. Whereas with a SEP IRA, as soon as your contributions to employees arrive in their SEP accounts, your responsibility for that money comes to an end. From that point forward, you have no say about what happens to it. The employees are free at any time to transfer money from their SEP IRA to another IRA or even cash it out (at the risk of incurring an early withdrawal penalty if they aren’t yet 59½). And each year, it’s up to you whether or not to contribute to the SEP IRA; the only stipulation is that each time you do make a contribution, each employee has to receive the same percentage of their compensation (up to a maximum of 25%). Thus, if you have employees, a SEP IRA can spare you the time, effort, and expense of setting up and maintaining a 401(k). But a solo 401(k) doesn’t need to comply with ERISA, and thus doesn’t require nearly the same amount of time, effort, or expense as a “regular” 401(k). Compared to a solo 401(k), a SEP IRA might still be simpler and lower-cost, but those cost savings could be outweighed by how much more a solo 401(k) would allow you to contribute (as well as other considerations like the ability to make Roth contributions). One other advantage of a SEP IRA has to do with timing. To be able to contribute to a solo 401(k) for 2018, you need to have it set it up by the end of 2018, although your actual contribution for the year can wait until your deadline to file 2018 taxes (in other words, sometime in 2019). Whereas you can wait till your tax-filing deadline for 2018 to both set up and contribute to a SEP IRA for 2018. This means that, if your tax-filing deadline for 2017 hasn’t passed yet, you still have time to set up a SEP IRA and contribute to it for 2017, while at the same time setting up a solo 401(k) and contributing to that for 2018. (And then you can just contribute to the solo 401(k) going forward, and even roll the SEP IRA into it if you like.)

A quick note about businesses organized as a partnership: Even though there isn’t a sole owner, as long as there are no employees other than the partners and their spouses, it should be possible to set up a 401(k) for the partners (and any spouses employed by the business) and still have it qualify as a solo 401(k).

Now, if you (or your partnership) want to defer more in business taxes than a solo 401(k) would allow, consider supplementing it with a defined benefit plan — otherwise known as a “pension”. That’s right: even if you're a solopreneur, you can leverage your business to create a pension for yourself! Most retirement plans, including the solo 401(k) and SEP IRA, impose a hard upper limit on how much you can contribute each year during your working years, and the amount that’s available for you at retirement depends entirely on how much was put in and how the investments performed. There are no guarantees (unless contributions were used to fund an annuity). A defined benefit plan, on the other hand, does promise you a particular amount — starting at a predetermined "retirement age" (typically 65). And instead of imposing a hard upper limit on how much you can put into the plan each year, it imposes a hard upper limit on how much you can receive from the plan each year. For 2018, that upper limit is $220,000. (Though if your compensation was never more than, say, $100,000/year, don't expect your annual pension payout to be higher than $100,000.) Now, does this mean you can contribute an unlimited sum of money to a defined benefit plan each year? No. What it means is that your contribution each year needs to be determined by an actuary. The actuary's job is to figure out how much is needed for the plan to stay on track to meet its future obligation to you as the employee. But that still leaves you tremendous upside potential. Imagine being able to contribute $150,000 or more in a single year — all pretax! With a defined benefit plan, that’s not an unrealistic scenario, particularly as you get into your late 50s. No other retirement plan comes close in terms of the ability to defer taxes on income from a business. And no matter how large your contributions to your defined benefit plan get, you’ll still be allowed to max out your contributions to a solo 401(k)! (Note that defined benefit plans don’t allow Roth contributions. To create what’s essentially a tax-free pension, you need to fund an annuity using money rolled over from a Roth IRA or a Roth account inside a 401(k), 403(b), 457(b), or TSP. Also, as the money inside a defined benefit plan is pretax, you have until age 70½ to either start collecting your lifetime pension checks or move the money to an IRA, where RMDs will kick in.) The downside of using a defined benefit plan as a personal retirement vehicle is that contributions are mandatory each year, and you need a professional actuary to certify that you aren’t contributing too much (or too little). These requirements make defined benefit plans the most expensive type of retirement plan to set up and maintain, so you'll want to make sure the tax breaks and guaranteed future income will be worth it.

In a traditional pension plan (the type that’s famously disappearing), you’re shown your projected annual stream of income starting at your designated retirement age. But there’s another type of defined benefit plan that actually appears to be on the rise, at least among partnerships such as law firms and doctor’s offices: the cash balance plan. In a cash balance plan, you’re shown your “cash balance”, which (despite its name) isn’t the amount of money you have in your account, but is instead a projection of how much you’d get at your designated retirement age if you chose to take the money all at once. (Of course, you won’t actually be required to take it all at once; imagine the tax consequences! Instead, you can either take the money in instalments (like an annuity) or roll it over to an IRA.) As an employee of your business, your cash balance is increased every year in accordance with a formula that's laid out in the plan document. Again, it may seem like this cash balance represents the performance of investments that you hold in the plan, but what it actually represents is the amount of money the plan needs to have there waiting for you when you reach your designated retirement age. Thus, those formulaic increases in your cash balance each year aren’t increases in the plan’s assets; they're increases in the plan’s future obligation to you (as an employee). It’s up to you (as the business owner) to fund the plan adequately to keep up with that future obligation, and it’s the job of the plan’s actuary to make sure you don’t put in too much (or too little) to hit that target. Based on my research, the primary appeal of cash balance plans for business owners (whether or not they have employees) is that the future obligations are easier to meet than under a traditional pension plan. One reason for this is the fact that in a traditional pension, future obligations are heavily influenced by an employee’s compensation in their final three years on the job (when their compensation is likely at its highest), whereas in a cash balance plan, future obligations are updated each year based on the employee’s compensation that year. (The set formula for increasing your cash balance each year will factor in your compensation or net earnings from the business each year.) Thus, every year is weighted equally; there's no disproportionate influence from the final three years.