Self-Employed Retirement Plan Questions

[sdfire]

In March of this year I began implementing my plan to ease out of the work force by leaving a job I had for 20 years and starting my own professional services business. I hired one former associate part-time and we went back and forth on independent contractor/employee and finally settled on making him an employee. I also hired my spouse (and my child worked for me some over the summer). I am just getting to setting up a retirement plan and now I'm struggling. I read the FAQ's and they helped but didn't totally answer my dilemma. Here are the options:

1. Individual 401K (allows up to $49K), but I can't have any employees other than my spouse. I'm now regreting calling my associate an "employee" (he lives in another city and provides his own office, etc.). I suspect that I can't change this designation for 2009. But, should I try for 2010? Vanguard will create and administer this plan for free.

By the way, I maxed out my old firms 401K at $16.5K for 2009 before leaving so my contributions would be limited for 2009.

2. SEP-IRA also allows up to $49K, but I am required to pay associate up to 20% of his salary which is not part of our deal and not very attractive to me. Vanguard will create and administer this plan for free.

3. Simple-IRA allows up to $11.5K for me and my spouse (I can't tell if that includes or doesn't include 3% matching contribution from employer). My employee likely will not contribute (I know he would agree that this wasn't part of our deal and he has 401K with another part-time employer) so this would likely cost me $0 for him. Vanguard would create and administer this plan for free.

4. Create company 401K which allows up to $49K. This is attractive for the amount I can contribute. But, the costs to set up and administer are around $500 to set up, plus $1000 per year to operate, plus .75% per year to each participant on amounts in the plan. Costs stink and I'm not sure if I can contribute the full $49K for myself without contributing for employee.

I'm leaning toward Simple-IRA because it is essentially cost-free. I could use the higher deductions, but they would either require me to change my employee to a independent contractor (if that is even possible, I don't think I could do it until 2010), or 20% extra pay to employee for SEP-IRA, or huge costs to set up and administer company 401K. Any thoughts would be much appreciated!!

 

[sdfire]

I just thought of one other option. I could renegotiate my deal with my employee to pay him 20% of his salary as part of the SEP-IRA. That would allow me the full $49K per year and it would be cost free. Two problems: 1. I don't know that my employee would be happy to have 20% of his salary deferred (crazy to me, but he is young). 2. He has another part-time job with some kind of retirement plan. He works for a university so it could be something other than a 401K. Would they play well together?

Again, thanks for all thoughts!

Edited to add: The downside to the SEP-IRA is that my spouse would only be able to contribute 20% of salary. We are making that salary small to avoid extra SS and medicare taxes. The result is small retirement contribution. Whereas the Simple-IRA would allow a contribution up to $11.5K or full salary whichever is lower. Hhhmmm. Tough decision.

 

[bank5]

Is your employee W2 or 1099?

 

[ziggy29]

Is your employee W2 or 1099?

Based on the OP saying they made him an employee instead of an independent contractor, I would assume that means they're probably W-2. Which, I believe, would also make it possible to set up a defined benefit pension plan for yourself and the employee, but that might be too costly and/or overkill for the situation.

 

[sdfire]

Is your employee W2 or 1099?

w-2. We considered 1099, but elected to go with w-2.

 

[sdfire]

Based on the OP saying they made him an employee instead of an independent contractor, I would assume that means they're probably W-2. Which, I believe, would also make it possible to set up a defined benefit pension plan for yourself and the employee, but that might be too costly and/or overkill for the situation.

Yes, w-2.

I had a DB plan at my old firm. My recollection is that my old firm said that you could only make DB contributions for a total of 10 years. Is that correct? I think I made DB contributions for 9 years or so.

By the way, I rolled over my 401K into an IRA and I rolled over my DB plan into a different IRA. I presume I can't add anything to either plan, right?

 

[eridanus]

Simple this year and a solo 401k next year. Roll over the Simple assets to the 401k or a traditional IRA.

There are now solo DB plans. Schwab has one but the setup fees are high. You'll also need to contribute $80k annually.

 

[bank5]

w-2. We considered 1099, but elected to go with w-2.

I agree with you then, I think a simple IRA would be your best bet. With a simple you can also contribute to a Roth correct? So if you're eligible for a roth, you and your spouse could contribute a combined $33k / year.

It seems like he might be unwilling but you could ask your employee if he'd accept a raise and switch to an IC. If he's an IC you would pay 7.65%(?) of his salary less to Uncle Sam. He'd probably pay less in taxes too if he wrote off business related expenses -- car/travel, home office, sep IRA, etc. Could be a win-win for both of you.

 

[Sarah in SC]

I'd go with the Simple this year as well.
But remember that you cannot move Simple IRA assets until two years have passed since your first deferral. This is a biggie. It can only be rolled into another Simple or an IRA. It cannot be rolled into the new plan.

Next year change your employee (but check around to make sure that you're okay with this from the fed's perspective--they are pretty tricky about classifying peeps that are *really* employees as contractors) and go with the solo 401k.

Again, I urge caution about the classification. Many hours spent trying to memorize those A+B or C company rules about different employee classes and DB plans for the CFP. Get a consult with an actuary if need be.

 

[sdfire]

Thanks for all the helpful comments! I think I will explain to my employee the dilemma and ask him if he'd rather receive 20% of his pay in a retirement account (SEP-IRA) or be reclassified as an independent contractor Jan. 1. I think either option works OK.

One clarification: If I use an individual 401K, can my spouse contribute all of her earnings? I know I can contribute up to $49K. But, I can't seem to answer the question of how much my spouse can contribute. Thanks.

I suppose one downside of the SEP-IRA is that my spouse can only contribute 20% of her earnings.

 

[thefinancebuff]

With a solo 401k, it's Ok to have part-time employees who work less than 1,000 hours in any plan year. Vanguard's plan may not allow it but Fidelity's plan does allow it. If your employee and kids will never work 1,000 hours, then you are OK with a solo 401k. SEP-IRA does not allow employee contributions. All contributions come from the employer side. With a solo 401k, you have both employee deferrals and employer contributions.

 

[sdfire]

With a solo 401k, it's Ok to have part-time employees who work less than 1,000 hours in any plan year. Vanguard's plan may not allow it but Fidelity's plan does allow it. If your employee and kids will never work 1,000 hours, then you are OK with a solo 401k. SEP-IRA does not allow employee contributions. All contributions come from the employer side. With a solo 401k, you have both employee deferrals and employer contributions.

That is great news for me! My employee will be below 1,000 hours and so will my kids! Is it up to Vanguard or Fidelity or is it an IRS regulation? Is there some place I can document this? This is the best of all worlds because I can contribute the top amount for me and for my wife (I think) and not contribute anything for my employee or my kids and I don't need to change him from being an employee!! Woo Hoo!

 

[thefinancebuff]

That is great news for me! My employee will be below 1,000 hours and so will my kids! Is it up to Vanguard or Fidelity or is it an IRS regulation? Is there some place I can document this? This is the best of all worlds because I can contribute the top amount for me and for my wife (I think) and not contribute anything for my employee or my kids and I don't need to change him from being an employee!! Woo Hoo!

IRS regs allow a plan to exclude employees who work less than 1,000 hours from participating in a plan. Fidelity's plan includes this exclusion as legally allowed. My understanding is that Vanguard's plan does not include this exclusion. Here's a link to the same discussion I had with someone on the Bogleheads forum last year:

Bogleheads :: View topic - Solo 401(k) Plan

 

[sdfire]

IRS regs allow a plan to exclude employees who work less than 1,000 hours from participating in a plan. Fidelity's plan includes this exclusion as legally allowed. My understanding is that Vanguard's plan does not include this exclusion. Here's a link to the same discussion I had with someone on the Bogleheads forum last year:

Bogleheads :: View topic - Solo 401(k) Plan

Thank you so much for posting this!! I spoke with a Fidelity Rep yesterday and printed off the forms. This is the perfect plan for us! The form allows you to chose to have the plan apply immediately to the employees working on the day it starts (just me and my spouse in my case) and then have specific requirements such as 1 year of eligibility (defined as 1,000 hours in 12 months) apply to everyone else. This is perfect for us and just what I was looking for. Thanks again.

I have one more question that may be better for a new thread. But, let me ask it here because it relates to this issue. We can give any salary we want between husband and wife. So far, my thinking is that I will max out at $49K and that I will pay my spouse $16.5K and have her give all of that to the plan. Everything above $16.5K comes with only 20% able to be contributed to the plan, but with full social security and medicare taxes (at least on the first $100K or so). That doesn't seem like such a good tradeoff. Am I looking at this wrong?