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.
What Are The Potential Tax Benefits Of A Solo 401
One of the potential benefits of a Solo 401 is the flexibility to choose when you want to deal with your tax obligation. In a Solo 401 plan all contributions you make as the “employer” will be tax-deductible to your business with any earnings growing tax-deferred until withdrawn. But for contributions you make as an “employee” you have more flexibility. Typically, your employee “deferral” contributions reduce your personal taxable income for the year and can grow tax-deferred, with distributions in retirement taxed as ordinary income. Or you can make some or all of your employee deferral contributions as a Roth Solo 401 plan contribution. These Roth Solo 401 employee contributions do not reduce your current taxable income, but your distributions in retirement are usually tax-free. Generally speaking, there are tax penalties for withdrawals from a Solo 401 before 59 1/2 so be sure to know the specifics of your plan.
What Are The Roth Ira Requirements
To be eligible to fully contribute to a Roth IRA, you must:
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Have an earned income.
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Have whats called a modified adjusted gross income . But it has to be less than $198,000 for married couples filing jointly or $125,000 for single people.3
Now listen up, married people, because this is important. Even if you or your spouse doesnt have an earned income, you can still have two Roth IRAs between both of you with something called a spousal IRA, if your spouse has an earned income. For most folks, fully funding two Roth IRAs will be enough to reach the goal of investing 15% of their income for retirement.
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Purchasing Stock In The Business
Its not as easy as simply transferring money into the business checking account since you have to go through the process of issuing shares to the 401 account. In most cases, the percentage of ownership attributed to the 401 plan is based upon your total funding picture to start up the company. If your retirement accounts are the sole resource to fund the business, then technically your 401 plan owns 100% of the company. Its not uncommon for new business owners to use multiple funding sources including personal savings, funding from friends and family, or a home-equity loan. In these instances, a ROBS plan is still allowed but the plan will own less than 100% of the business.
I dont want to get too deep in the weeds with this point, but its usually advisable not to issue 100% of the shares of the business to your 401 plan. This could limit your ability to raise additional capital down the road because you dont have any additional shares to issue to new investors or to share equity with a new partner.
Breaking It Down: Where Do You Fit In
There are many reasons you might think this chart seems totally reasonable, or, conversely, totally unreasonable. And thats understandable. Life presents us all with different challenges. We have unexpected medical expenses, decide to go back to school, or have kids and want to pay their college tuitions. These are all perfectly valid excuses as to why you might be falling behind where this chart says you should, or could, be.
Based on this chart, you would think that most Americans should be retiring as multi-millionaires at age 65. This probably seems way off-base, and in reality, it is most people retire with very little in the way of savings and investments. The point is that this chart shows what is possible if you are disciplined and strategic about your 401k savings.
If you are on the younger end of the ages shown on the chart, you may be daunted at the prospect of contributing $8,000 per year to your 401k, not to mention $20,500. Where you live, what your first-year salary is, or what loans you may be paying can make it difficult for this contribution to seem realistic. Its crucial, however, to recognize the importance of saving as much as you can for retirement as early as you can.
So, lets determine, based on the two scenarios in the potential savings chart, whether these figures would be sufficient to support your lifestyle for the rest of your retirement.
The average life expectancy for men is around 84 years old, and 86.5 years old for women.
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Rollover Ira Tax Rules
When you roll over a retirement plan distribution, you generally dont pay tax on it until you withdraw money from your new plan, though its best to familiarize yourself with all IRA rollover tax rules to be certain.
If you dont roll over your payment, it will be taxable as ordinary income, except for any portion that was after-tax or nondeductible contributions. There also might be a 10% early distribution penalty added if youre under the age of 59½ or a penalty for making an excess contribution to an IRA, taxed at 6% per year as long as your money stays in your IRA.
Stock Your 401 With Stocks
Stocks may be the most volatile investment you can make, but theyre also your best bet if you want average annual returns of 8% .
The key is to make sure your 401 is loaded with them.
When you sign up for your 401, youll be given a worksheet or directed to go online to choose how to invest your money.
Unfortunately, many investors choose blindly.
Thats bad, because most 401 plans offer investments designed for very different purposes. Some will be aggressive stock funds geared toward maximizing long-term gains, but others will be conservative funds holding mostly bonds and cash. These funds are designed to minimize losses and, as a result, will generate a much smaller annual gain. Thats good if youre close to retirement, but not so good if you have 30 years to invest.
When choosing investments in your 401, Amy Merrill, a principal with TrueWealth Management in Atlanta, suggests holding onto US stock funds, international stock funds, and real estate stock funds. Look at your fund choices and try to find a fund that is more like a stock index for the category.
Does picking investments feel overwhelming?
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Convert To An Ira To Keep Contributing
You cannot contribute to a 401 after you leave your job, so if you want to continue adding money to your retirement funds, youll need to roll over your account into an IRA. Previously, you could contribute to a Roth IRA indefinitely but could not contribute to a traditional IRA after age 70½. However, under the new Setting Every Community Up for Retirement Enhancement Act, you can now contribute to a traditional IRA for as long as you like.
Keep in mind that you can only contribute earned income, not gross income, to either type of IRA, so this strategy will only work if you have not retired completely and still earn taxable compensation, such as wages, salaries, commissions, tips, bonuses, or net income from self-employment, as the IRS puts it. You cant contribute money earned from either investments or your Social Security check, though certain types of alimony payments may qualify.
To execute a rollover of your 401, you can ask your plan administrator to distribute your savings directly to a new or existing IRA. Alternatively, you can elect to take the distribution yourself. However, in this case, you must deposit the funds into your IRA within 60 days to avoid paying taxes on the income.
Traditional 401 accounts can be rolled over into either a traditional IRA or a Roth IRA, whereas designated Roth 401 accounts must be rolled over into a Roth IRA.
Benefits To You And Your Employees
Investments in the plan grow tax-free after contributions are made, and no tax is paid on investment gains until employees take out the money. Contributions to the plan can reduce taxable income for the year.
Employees can make contributions through payroll deductions, and move the assets in their plan to another employers plan when they change jobs.
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Using The Capital To Grow Your Business
Once the share purchase is complete, the cash will be transferred from your retirement account into the business checking account allowing use those funds to start growing the business.
There is a very important rule when it comes to what you can use these funds for within the new business. First and foremost, you cannot use these funds to pay yourself compensation as the business owner. This is probably the biggest no-no associated with these types of plans. The IRS does not want you circumnavigating income taxes and penalties just to pay yourself under a ROBS plan. In order to pay yourself as the business owner, you have to be able to generate revenue from the business. The assets from the stock purchase can be used to pay all of your expenses but before youre able to take any money out of the business to pay yourself compensation you have to be showing revenue.
Once new business owners hear this, its often disheartening. Its great that they have access to capital to build their business, but how do they pay their bills while theyre building up the revenue stream? Luckily, I have good news on this front. We have additional strategies that we can implement using your retirement accounts outside of the ROBS plan that will allow you to pay yourself compensation as the owner and it can work out better tax wise than paying yourself as a W2 income through the C-corp.
Withdrawing Funds Between Ages 55 And 59 1/2
Most 401 plans allow for penalty-free withdrawals starting at age 55. You must have left your job no earlier than the year in which you turn age 55 to use this option. You must leave your funds in the 401 plan to access them penalty-free, but there are a few exceptions to this rule. This option makes funds accessible as early as age 50 for many police officers, firefighters, and EMTs.
Make sure to understand the rules around the age requirement for penalty-free withdrawals. For example, the age 55 rule won’t apply if you retire in the year before you reach age 55, and your withdrawal would be subject to a 10% early withdrawal penalty tax in that case.
The age-55-and-up retirement rule won’t apply if you roll your 401 plan over to an IRA. The earliest age to withdraw funds from a traditional IRA account without a penalty tax is 59 1/2.
You might retire at age 54, thinking that you can access funds penalty-free in one year, but doesn’t work that way. You must wait one more year to retire for this age rule to take effect.
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Why Saving Is Hard For The Self
The reasons for not saving toward retirement wont be a surprise to any self-employed person. The most common include:
- Lack of steady income
- Education expenses
- Costs of running the business
Setting up a retirement plan is a do-it-yourself job, just like everything else an entrepreneur undertakes. No human resources staffer is going to walk you through the company-sponsored 401 plan application. There are no matching contributions, no shares of company stock, and no automatic payroll deductions.
Youll have to be highly disciplined in contributing to the plan and, because the amount you can put in your retirement accounts depends on how much you earn, you wont know until the end of the year how much you can contribute.
Still, if freelancers have unique challenges when saving for retirement, they have unique opportunities, too. Funding your retirement account can be considered part of your business expenses, as is any time or money you spend on establishing and administering the plan. Even more important, a retirement account allows you to make pretax contributions, which lowers your taxable income.
Many retirement plans for the self-employed allow you, as a business owner, to contribute more money annually than you could to an individual IRA.
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The Limitations On Retirement Plans Can Prevent You From Doing What You Want
401 plans can be an effective way that workers can save toward their retirement. However, many employees dont like the investment choices that their employers 401 plans allow them to make, and they would prefer to move money out of their 401 plan accounts into an IRA in their own name. Most employer plans dont allow employees to transfer money from a 401 account to an IRA while theyre still working, but a few do offer what are known as in-service rollovers that make that option available to a limited number of workers.
The general rule: No rollover while workingWorkers generally arent allowed to take money out of their 401 plan accounts while theyre still working. Limited exceptions apply for hardship withdrawals, but workers arent allowed to take those withdrawals and roll them over into an IRA. Similarly, money ta ken out of a 401 for uses like a first-time home purchase or educational expenses might qualify for exceptions to the 10% penalty for early withdrawals, but they dont open the door to IRA rollovers.
If you do take a 401 withdrawal and deposit the proceeds into an IRA, the IRS will treat it as a taxable distribution followed by an IRA contribution. The distribution will be taxable and subject to an early withdrawal penalty if appropriate, and the contribution will be subject to normal IRA limitations. If youre not allowed to make an IRA contribution in that amount, additional penalties will apply.
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Can You Invest In Real Estate Through Your 401k
If you have a 401k plan through your employer, the answer is probably no at least not directly. I have yet to find an employer-sponsored retirement plan that allows participants to buy investment properties or participate in crowdfunded real estate investments.
The only possibility of even putting money to work in real estate indirectly in an employer-sponsored 401k would be if theres a real estate investment fund on the plans menu of investment options. For example, the Vanguard Real Estate Index Fund might be one of the funds offered by your plan.
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How Much Should An Employer Contribute To The Plan
The amount you as an employer decide to contribute is entirely up to you. As you make this decision, consider the tax savings you can receive for making employer contributions. Employer matches are tax-deductible on federal corporate income tax returns, and some administrative fees associated with managing a 401 plan are tax-deductible as well.
You can match as much as you want as long as it stays within the IRS limitations, which combine both employer and employee contributions. According to the IRS, this combined total is the lesser of 100 percent of an employee’s compensation or $61,000 for 2022, not including “catch-up” elective deferrals of $6,500 for employees age 50 or older.
Also consider factors such as the positive impact a matching contribution can have on employee morale and worker retention strategies. Given the steep costs of hiring and training new employees, an employer match offers the opportunity to truly invest in your workforce. These considerations may help guide your decisions about how much to contribute to the 401 plan.
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Choose An Account Type
Traditional 401s are standard at workplaces, but more employers are adding the Roth 401 option, too.
As with Roth IRAs versus traditional IRAs, the main difference between the two types of plans is when you get your tax break:
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The regular 401 offers it upfront since the money is automatically taken out of your paycheck before the IRS takes its cut . Youll pay income taxes down the road when you start making withdrawals in retirement.
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Contributions to a Roth 401 are made with post-tax dollars , but qualified withdrawals are tax-free
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Investment earnings within both types of 401s are not taxed
Another upside to the Roth 401 is that, unlike a Roth IRA, there are no income restrictions to limit how much you can contribute.
The IRS allows you to stash savings in both a traditional 401 and Roth 401, which can add tax diversification to your portfolio, as long as you dont exceed the annual maximum contribution limits of $20,500 in 2022 .
Employer Matching Contributions May Be Limited
Many people think they can still take full advantage of an employer match late in the year, by contributing larger sums of money in just a few months. But many 401 plans calculate matching on a per-pay-period basis. For these plans, your matching contribution is calculated based only on that pay periods contributionnot the whole year.
Lets look at an example:
Adams Apples sets up a 401 plan to start November 1, with 4 pay periods left. They provide a dollar-for-dollar match up to 5% of an employees pay. Adam makes $250,000 and contributes 5% of his pay, $12,500. It seems like Adam should get $12,500 in employer matching as well. But if its a per-pay-period match, Adam will only get a match during the pay periods he contributes. Since there are only 4 pay periods, he would only get $2,083 in matching contributions.
If you start your plan on January 1, you can generally avoid this confusion for your employees and prevent a lot of unintended miscommunication. Most employees tend to spread their contributions throughout the year to keep things manageable. Be sure to also inform your employees of how the per-pay-period match works, even if its January, so that the certain strategic employees understand not to front or backload their contributions for the full year!
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