Today's guest post comes from Grant Bledsoe at 3 Oaks Capital Management, one of our highly recommended financial advisors.
I thought this post would be perfect for our readers, given many of our unique financial situations.
Adding Rocket Fuel to Your Retirement Savings: Suggestions for Using Side Income to Fund Multiple Tax Advantaged Retirement Accounts
Many of my physician and business owner clients share a common financial objective: they want to maximize all the tax advantaged savings opportunities available to them.
For most people, that starts by maxing out their 401(k) or other retirement plan at work, and then executing back door Roth IRA conversions every year.
Beyond that, the pickings are slimmer. You could always fund a health savings account, if you’re comfortable with a high deductible health plan. If you work at a company that offers them, you may also be able to participate in a 457 plan, cash balance, deferred comp, employee stock, or other benefit plans.
But for those earning side income from elsewhere, your best bet may be to establish and fund your own retirement plan.
When Peter approached me about becoming a recommended financial advisor on this blog a few months back, he suggested I write a guest post. I work mostly with medical professionals and business owners, and often help them design, structure & establish retirement plans as tax saving vehicles for their side income.
Since Peter’s blog is all about creating income from sources other than your day job, I thought a review of how this all works would make an interesting guest post.
Passive Income Does Not Equal Side-Gig Income
To get us started, the IRS allows us to contribute to individual retirement accounts (IRAs/Roth IRAs) in any year that we have earned income. This is an important concept.
If that earned income comes from self-employment, we can establish and contribute to our own retirement plan, like a SEP-IRA, 401(k), or defined benefit plan. Whereas W-2 income paid by an employer is considered “wage” compensation, 1099 or other side gig income reported on Schedule C is considered self-employment income.
Here’s the rub: passive income, including income from rental properties or stock dividends, is not considered earned. Here’s the IRS definition:
“Compensation does not include earnings and profits from property, such as rental income, interest and dividend income, or any amount received as pension or annuity income, or as deferred compensation.”
So where does this leave us? Unfortunately, side income from a couple rentals you own is not eligible to fund a retirement plan. (Of course, if you owned many properties you could form a property management company, making the income from the management company potentially eligible).
On the bright side, income from many other traditional side gigs will qualify:
- Picking up a few extra shifts at the hospital
- Medical consulting
- Teaching at a university or medical school
- Writing a book
Contribution Rules When Funding Multiple Qualified Plans
If you do have self-employment income that allows you to fund your own retirement plan, there are a few additional wrinkles to the IRS contribution limits to be aware of:
The Salary Deferral Limit
The first is that annual salary deferral limit. If you participate a 401(k) plan now, you’re probably aware that you can contribute up to $18,500 in 2018. This limit will rise to $19,000 in 2019. This is known as the “402(g) limit,” relating to corresponding section of the internal revenue code.
The point to remember here is that the 402(g) limit applies across all your 401(k) and 403(b) plans. That means that if you’re already maxing out your 401(k) employee deferrals at your day job, you’ll be restricted from making additional employee contributions to other 401(k) or 403(b) plans. You’re only allowed to defer $18,500 per year across ALL the 401(k) or 403(b) plans you may participate in.
There are nuances of this limit, of course. While the contribution limit for 457(b) plans is also $18,500 (also $19,000 in 2019), their salary deferral limits are counted separately from other plans. Same goes for SIMPLE IRAs, SIMPLE 401(k)s, SEP-IRAs, and traditional IRAs.
The Overall Defined Contribution Plan Limit
The second limit to note is the “415(c) limit”. This is the section of the code that caps total annual contributions to $55,000 in 2018 ($56,000 in 2019). This limit applies to 401(k)s, 403(b)s, SEP-IRAs, and Thrift Savings Plans.
Whereas the salary deferral limit is applied across all your 401(k) and 403(b) plans, the overall limit is counted on a per plan basis. That means that if you had multiple, unrelated businesses, you could theoretically contribute $55,000 to each.
What Type of Plan Should You Establish?
The short, cop-out answer here is that it depends on your circumstances, what you’re trying to accomplish, and whether you have employees who may become eligible to participate. Different plans have pros and cons, and some will work better with employees than others. Here are the most common choices I see in my practice:
For high income professionals, a 401(k) plan is a compelling option for a couple different reasons. First, it’s appealing whether you have employees or not. If you don’t, you can establish a boilerplate solo 401(k) on the cheap, and add customization later if you like. If you do have eligible employees, a straight forward safe harbor plan can be used. While you will have to make contributions on your employees’ behalf, they’re typically lower than they otherwise would be with a SEP-IRA.
Secondarily, 401(k) plans are really convenient if you’re executing backdoor Roth IRA conversions. If you’ve deducted contributions to an IRA or SEP-IRA, rolling those balances into a 401(k) will remove them from the pro-rata calculation. I’ll save you the technicalities, but suffice it to say that this is a good thing.
If you don’t employ, or expect to employ anyone in your side gig, the SEP-IRA is a great option too. It’s free to open at any major brokerage firm, and you don’t have to make a distinction between employee deferrals or profit sharing contributions (like you do with a 401k).
If you do have eligible employees, SEP-IRAs usually become pretty expensive. You’re required to contribute the same percentage of each eligible employees’ comp to the plan that you contribute to your own.
Here’s a quick example: If you net $100k per year from your side gig, and employ an office manager at $40k, you could contribute up to $25,000 to a SEP-IRA (25% of your comp). In doing so, you’d also be required to contribute 25% of your office manager’s comp, or $10,000.
Also remember that SEP-IRAs tend to eliminate the opportunity for backdoor Roth IRA conversions, since you’d be accumulating deductible contributions. (There’s a work around here, of rolling over your SEP contributions to a 401k at your day job every single year. But that gets tedious quickly).
Defined Benefit Plan
Defined benefit plans can provide the biggest tax advantages, but come with the most strings attached. Whereas the IRS limits your contributions to 401(k)s and SEP-IRAs (hence the descriptor “defined contribution plans”), there is no contribution limit in defined benefit plans. Instead, the IRS sets a limit to the annual benefit a defined benefit plan can pay you in retirement.
On to the strings. First, your annual contributions to a defined benefit plan are mandatory. That’s because when you establish the plan, you decide what your retirement date and annual benefit amounts will be. You’re then expected to contribute enough each to have the plan fully funded by the time you hit the retirement date.
Second, you need to hire an actuary to run these calculations for you. On an annual basis, an actuary will take some assumptions published by the IRS, and determine what your contribution needs to be. If the market is up and the value in your account is higher, your required contribution won’t be as high. In years when the market falls, you’ll need to make a larger contribution to make up the difference.
The tough part about defined benefit plans is that market crashes often coincide with difficult business climates. That means that your business may be operating in a poor economy in the very same year you’re expected to make larger contributions to a defined benefit plan.
All strings aside, defined benefit plans can offer massive tax savings. They typically fit best if you’re at least 45 or 50 years old, and have at least $300k-$400k in earned income.
How to Establish a Qualified Plan for Your Side Gig
SEP-IRAs and solo 401(k) plans can be established by all the low-cost brokerage firms, including Vanguard, Schwab, TD Ameritrade, etc. They can help you open an account, and will include additional paperwork to formally establish the plan in the eyes of the IRS.
This is the route I typically go for my clients establishing a SEP-IRA. It’s not as simple for solo 401(k) plans.
Solo 401(k)’s are just like any other 401(k), but since there are no other employees, you’re not required to undergo any discrimination testing. And to offer the plan as an option to you and me, brokerage firms use a ubiquitous, boilerplate plan document. This lets them operate at scale.
While this helps save some costs, it also makes the plans inflexible. For example, Schwab’s solo 401(k)’s don’t allow Roth salary deferrals. Vanguard’s don’t allow rollovers in.
If these options are important to you, or if you want to establish a different type of plan (like a cash defined benefit plan), you’ll probably need to engage a specialist.
Regardless of the structure, there are many nuances to establishing qualified retirement plans for your practices or your side hustles. If done correctly, they can provide an excellent vehicle for tax deferred savings.
That said, it’s not hard to get in over your head if done frivolously. Make sure you’re comfortable with the long ramifications before setting anything up for yourself. Nothing about this topic is terribly complex, there’s just a lot to synthesize to do it properly.