Tricia Bailey from Future Plan rejoins us today to talk about savings vehicles for the self-employed. We start with the various limits on SEP IRAs and various 401k plans. This can include a spouse if he or she is being paid by the business.
We spend a lot of time today on a vehicle that isn't often discussed - a cash balance plan. This is an amazing opportunity for high net-worth individuals, who wouldn't have enough savings to support their lifestyle in retirement-based contributions limits of the traditional methods. You can put $260,000 or more per year into this account depending on your age and income. It's pre-tax dollars, so it is not included in your annual income. Yes, you'll have to pay taxes upon withdrawal, but that could be at a time when you're in a lower tax bracket.
Tricia shares examples from doctors and dentists, and what they were able to accomplish with plans like these. Or, if you have a "side hustle" in addition to your 9-5 job, that "side hustle" cash could be saved similarly.
These plans can also be used to mitigate tax exposure when selling a business or dealing with succession planning. Tricia explains some of the rules around contribution limits and timeframes.
If you have additional questions, you can reach Tricia Bailey at 248-520-6372 or tricia.bailey@futureplan.com
Email Paula Christine at Paula@PaulaChristine.com. You can also learn more online at www.PaulaChristine.com.
Paula: Hi, and welcome to Beyond The Paycheck. I'm Paula Christine. A few weeks ago we had Tricia Bailey from Future Plan come on and talk to us about 401ks and 401k fees, and we started to get in the conversation of what plans were available for someone like myself or Jon who are self-employed and there are options that I don't think a lot of people are aware of.
So I've asked Tricia to come back today and talk about the options for the self-employed. So welcome back Tricia.
Tricia: Thank you so much for having me, Paula. I appreciate you guys.
Paula: So I know. Because I contribute to a SEP IRA, so I know that's one option for me as a self-employed individual. I know that I can put $66,000 away each year.
Tricia: Yes. Just know too that it's 25% of your income up to $66,000. So if you didn't quite meet the $66,000 at 25%, You would've been capped at that number.
Paula: Okay. So I know the other options we have are a simple and a traditional or Roth IRA, which are very low contributions for a self-employed person. So let's talk about the solo 401k.
I know that it's one of the best savings vehicles, I think for a self-employed person and actually can be a self-employed person, And their spouse. Correct?
Tricia: Absolutely. Yep.
Paula: So talk a little bit about what a solo 401k is.
Tricia: Yeah, for sure. So I know you pulled some of the numbers, right? Like how much you can contribute or not contribute.
And you're right with the SEP, it's $66,000. But it's not a deferral, right? It's a company contribution. And so I think that's important to note. Because as a self-employed individual, it's not money coming out of say, your check. It's an employee contribution to the plan. With a simple or a 401k, you are making a contribution to yourself and then potentially giving yourself any matches, especially with the 401k.
So the simple, I can put up to $15,500. If I'm over 50, I can do an additional $3,500. That's not a lot, but it doesn't really cost anything to get one of those going. But with a 401k safe harbor, I can do up to $22,500, and then I can do a catchup contribution for $7,500. So that's me making a contribution out of my pay or my profitability.
But then I can also make an employer contribution and I can get up to the $66,000 that you get with the SEP. So you can actually get to the $66,000 by just doing a four a solo 401k. And you can do that, like you said, an owner and a spouse, without any kind of issue.
Paula: Does a spouse have to be employed with the company?
Tricia: They do. So either they have to be a partial owner or they have to receive W2 income.
Paula: And that W2 income could be a hundred percent or up to the $22,500, correct?
Tricia: Yep.
Paula: Now you can contribute up till tax day for the prior year?
Tricia: So with a SEP you can contribute up to tax day. With a 401k contribution. You have to get it in by 12/31 if you're on a 1/1 to 12/31 calendar year. So that 22,500 has to be in by 12/31, the additional profit sharing amount can go in up until you file your taxes.
Paula: Yes. Which would make sense because you have to know that your total adjusted gross income before you can determine what the company portion would be.
Tricia: Correct. That's exactly right. Because you don't know what you made until the end of the year or whatever.
Paula: You don't know what you make really till your taxes are done. At least I don't cuz I'm gonna take out all expenses. So let's say that I'm fortunate enough to make. $300,000 and in that $300,000 based on the solo 401k, I don't even know what the number is, but let's just say it's only $66,000 that I could put away. But what if I wanna put away more?
Tricia: Yeah. So that's where you can add in or tie in an additional cash balance account, and that matches up with age as well. So again, if you're married and your spouse is also in it, you can increase their W2 income if they're not an owner to accommodate that. If you are making $300,000 and let's just go with $330,000, because that's what we can actually factor in for our calculations, okay?
If you're somebody that makes $330,000 and you're 50 years old just with a 401k, you can do $39,900. That's including the catch up. If you do a 401k profit sharing and safe harbor at $73,500 if you're at age 50. But if you want that cash balance account, you can contribute up to $261,500. If you're older than 50, That $260,000 number goes up to $300,000, $30,000. It just keeps increasing it the older that you get because it is a defined benefit plan. And so they're saying, hey, the closer you are to retirement, you don't have as many years to fund this. So they allow you to contribute more at that time.
Paula: Okay. Let me make sure I understand this. I make $330,000. After expenses. I could put away $261,000.
Tricia: Yes. So that's the maximum number that I can calculate for. We're only factoring in for $330,000. So if you are independently wealthy and you don't need any of that money, great. Or if you're making actually $700,000, $500,000, you're making a larger number. You would be able to put in, $300,000. If you're age 60, the number is $382,500. That's the amount that you can get up to.
Paula: That's crazy.
Tricia: The tax savings on that is $172,000. So if you are making $330,000, $700,000. You're like, what do I do? How do I save extra dollars and taxes and that sort of thing. This is a way for you to say, all right, let me sink this into my retirement account.
It's still my money. I'm taking it, like I said, from my left pocket to my right pocket. I'm just relabeling this, these dollars that came in as retirement money, and now I'm reducing my tax liability for that year. Now remember, everything's treated on a pre-tax basis. So eventually, when you go to pull it out, you'll pay taxes at that time, but you'll probably be in a lower tax bracket when you go to pull it out.
And that's why it's always good to work with a good financial advisor to help you make your decisions on those things. Like one to pull it out and what have you.
Paula: So let me ask this question. Let's say that I have a regular job, a 9-5, 40-hour week, contribute to my 401k there. But let's say I have a side hustle. Can I use that side hustle to do something like this?
Tricia: Say you're employed somewhere else and you get a company match and you're making the full contribution amount to yourself there, right? You're putting in that $22,500. What you can't do is double up on that, but what you can do is, do a cash balance plan.
So for example, we have some doctors, right? They work for the hospital, they make great money working at the hospital, and they also go in and they teach courses, they give seminars, they're presenting, they're doing all kinds of speaking engagements, and they're getting compensated for those. That's 1099 income.
Now, they can't make an employee contribution any greater than the $22,500. But what they can do is they can take everything that they made, say they made $330,000 in speaking engagements, they can sink that whole amount into this cash balance plan and alleviate their tax liability for that.
Paula: So the $330,000 is really dependent on your age though, right?
Tricia: It is. It does. So not everybody can do $300 and not everybody can do that. Yeah.
Paula: Let's just make sure that everybody knows that. But still, if you think about somebody who has a side hustle and maybe who potentially wants to retire early, and then the tax savings on that money this could be huge.
Tricia: Absolutely. If you have somebody that's at age 40. Let's just say like I've got somebody that's age 40 that's out there that's hustling. They have a job where they're making a default income, they're making their contribution through that company. Again, they can't double up, but they can put an additional for $114,000, and that's gonna give them, What a $70,000 tax savings if they're in the highest tax bracket.
Assuming they're in the highest tax bracket. So even at a younger age, you're able to contribute a significant amount.
Paula: You know what, Jon? I think we need to go get a side hustle. Yeah. Really?
Jon: I'm just picturing that the cartoon money bags being held over by Wile E Coyote just handing the bag over.
Paula: Yeah. When you think about it, think of the married couple that you know, ideally if you're setting yourself up in a really good situation, you're living on one income, right? And the other person is self-employed and you could bank all that, can you imagine how wealthy you would be?
I'm like dumbfounded because you just think about the math and really, it's about the ability to do it. It's the ability to be able to put that kind of money away, and not everybody can do that, but even if you have a side small hustle, knowing that you could put all that away and it wouldn't be taxable to you.
Tricia: Absolutely. And it's nice in the way that, these have been around since 1985, so they're not new, but I will say that they're not as commonly utilized as you would think. A lot of CPAs don't talk about them or realize that they exist. So I do get out and give CPA presentations and that sort of thing.
Give CE credits. So if any of your listeners are like, oh, I wanna have some CE credits, I can help them with that sort of thing. It's underutilized, but it is such an great avenue for saving. Now granted, this is a pension, right? It's a defined benefit plan. So we're bringing back, say, a privatized pension.
It's a lot different than it used to be, but it's something that you can do through your work and save that money for you. But it has to function in a way that it's for the benefit of all, and even if you are just a single employer or it's just you and your spouse, it still has to be a very conservative investment.
So you're looking somewhere around 4.75% to 5% return on that money is what you're gonna be shooting for. So it's not going to have the ups and downs that you would see on your 401k or on your SEP or anything like that. The fluctuations that you would have in your regular stock market, this is more of your steady Eddie, right?
And we can tell you what to, the maximum you can contribute is based on your income and your profitability and that sort of thing. Once we tell you what that number is, if you're like, oh, I can't do 175,000, but I can do a hundred thousand, like I feel comfortable committing to a hundred thousand for at least the next three years.
Wonderful. Let's set you up with that. You make your contributions and you're getting that steady return on that money. And again, that's where a good financial advisor comes in cuz you're gonna be shooting to or aiming for that percentage.
Paula: So you have to contribute the same amount for three years?
Tricia: The IRS is a little fickle about it cuz they, they don't want people to set these up just as a way for you to sell your business and avoid the taxation. They don't want you to send it up for one year and forget it. Now should something happen and you have a business reason that you have to shut down, or, heck, a covid year, right? And you just don't have that money to contribute. As long as the plan is designed in a way to say, yes, I'm gonna contribute a hundred thousand dollars or X amount of profitability of my business or my side hustle.
So if you only made 40 grand that year, you're not gonna be expected to put in a hundred thousand. So it's very important that your plan design is written in a way that you would not be on the hook for that full a hundred thousand because a lot of plans are actually written that way. Because if you can't make that additional $60,000 contribution because you didn't actually earn it, and you just don't have it, you still have to make that contribution.
Paula: So make sure that you're with the right TPA, third party administrator, that sets out the document correctly. But let me ask you this question. After the third year, can you still contribute?
Tricia: After the third year, you can contribute if you're like, hey, you told me I could do $175,000. We put in the pool; we did all the things.
I wanna save more. I don't wanna just limit myself to the hundred. Can we bump it up? Absolutely. So we'll give you a minimum and a maximum and a happy number in between and say, try to make it somewhere in between. If you have a hard year and you know you're gonna have a hard year before June 1st, you can always freeze your plan by June 1st and not be stuck to those contributions to, so there are some loopholes, there are ways to get around certain things.
Paula: No, that's really cool. I think it's a great savings tool for people who are making a substantial amount of income.
Tricia: 401K is great if I'm making a regular income and I'm able to set that money aside for myself and it's gonna be very important to retire on.
But if I'm a high net worth person and I'm making, higher income. Is $22,000 gonna get me to retirement? Is $39,000 when I get to, age 50 and above, gonna get me to retirement? No, is $66,000 gonna get me to retirement? Gonna be tough if I'm making $300, $500, $700,000 a year. But if you have the capacity to sink in an extra $250,000 for yourself, that's a very relevant number. That is gonna make a huge impact for you because that number's gonna keep growing, right? Correct. At about 5% every year.
Paula: And if you think about it, if you're young and you're hustling and can do something like this, just the compounding alone over, 30 or 40 years could be huge.
Tricia: Absolutely. Now, just know that you have to pay yourself a significant number. So if you are W2, you can't just say, I. I'm earning a million dollars in my business, but I only pay myself $60,000. You gotta, you're gonna bump up that number to make the math work. So there are some things, some nuances, or if you take too many deductions and you are a sole proprietor, that sort of thing, there won't be enough money to be able to sink into it, right? Those are just some watch outs, I would say, for individuals.
Paula: You have to have the money to do it. This has been really enlightening. So Jon, do you have any further questions?
Jon: No, like I said, I just keep seeing dollar signs. The more Tricia talks.
Tricia: It's such an amazing way for you to be able to save taxes, right? Like you're setting this aside for yourself. You're earning money on this, but you're also, you're not paying the huge tax bill this year, right? Like I had one dentist, I think he was paying $75,000 in quarterly taxes. And when we designed the plan for him, we were able to shrink that down to about $30,000 per quarter that he had to send in.
And he is like, how come nobody's told me about this before? So there's a need. There's definitely a need for it. It's a niche, but it's for the right client, in the right person in succession planning. As long as you plan, hey, I'm gonna buy you out within three years, maybe I'm gonna buy you out. Paula, I'm gonna buy your business. Jay, I'm gonna buy you out of this podcasting business. So I'm gonna give you $900,000 for the business. I'm sure it's worth more.
Jon: Thank you!
Tricia: Just bear with me for with my analogy. So I'm gonna give you $300,000. I'm gonna come work with you for the next three years, and I'm gonna make a contribution into the cash balance for $300,000 for the next three years.
Now, when you won't actually retire or sell it to me or whatever the case may be. However, we have it designed with our attorneys cuz there's also a selling agreement beyond the cash balance account. You're not gonna be hit with a tax bill for $900,000 written in a check that year. So you just saved a fortune.
Paula: Or even in capital gains, because depending on how the business is sold, it can either be ordinary income or capital gains.
Tricia: That's a super simplified analogy, right? Like I'm, it's definitely a little bit more complex than that, but it gives you an idea that you can use it for succession planning, I know we're talking about solo business owners right now, if you've got a child that wants to buy out their parents, something like that, this is a great way to transfer that money or transfer that business and leave that legacy behind for your children and not get killed with taxes.
Paula: No, great information. Very eye-opening for me, and now my brain is starting to work and I know Jon's seeing the money bag, so thank you. This has been fabulous, and you're right. I don't talk enough about it, and I'm sure other advisors and CPAs are not talking either. So it's something that needs to be talked about a lot more.
Tricia: Thank you for letting me talk about it. I appreciate you guys very much so.
Paula: Thank you so much. I know I learned a lot, so I do really appreciate you, Tricia. So if somebody wants to get ahold of you, how can they reach you?
Tricia: They can call my cell phone, (248) 520-6372. And they can find me at Tricia.Bailey@futureplan.com, and I can tell them the exact information that I need. Dates of birth, dates of hire, like when did you start your company and how are you taxed and asked them very basic questions. They don't even have to tell me the name of their business. They don't even have to tell me if they make more than $330,000. They wanna keep that confidential, right?
Paula: Okay. If you'd like to reach out to me, you can reach me at my email, paula@paulachristine.com or check out my website at paulachristine.com.
Thanks again, Tricia. Great information. So next episode, Tricia's coming back and we're gonna talk about some of the SECURE2.0 changes that are happening when in regards to retirement plan. Thanks again, Tricia.
Tricia: Thank you so much for having me.