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[Editor's Note: This guest post is from John Lim, MD. He sent me this email:
“I'm a radiologist practicing in Newport Beach, California in a group of about 30 radiologists. I had no prior financial background and basically taught myself finance since beginning in private practice in 2002. I love finance and sometimes wonder if it was my true calling. I have no websites or books to sell or advertise. I serve as a trustee on our groups retirement plans (401k, Roth 401k, profit sharing plan, and Cash balance plan) and was a former CFO for our group. I recently lobbied to add a Roth 401k option for our group. I succeeded but met fairly stiff resistance. I wrote this to explain to our members why they might consider a Roth 401k option.”
I found it kind of sad that he met any resistance at all. There is literally no downside to adding a Roth 401(k) option to a plan, whether you use it or not. At any rate, I thought many readers would find the post useful, especially his “trick” for those who have a cash balance plan but aren't maxing it out. We have no financial relationship.]
WHY ROTH 401K?
Tax diversify your retirement savings. “Multiple buckets”
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Nobody knows what income tax rates will be in the future (upon retirement). By diversifying retirement savings into both pretax accounts (401k, IRA, Cash Balance plan) and posttax accounts (Roth 401k, Roth IRA, Health Savings accounts), you have greater flexibility at retirement to draw income in a way that is most tax efficient. For example, if income tax rates are very high for a few years, you could draw income from the Roth 401k account without paying any income taxes (or conversely if tax rates are low, draw on pretax accounts).
This issue is particularly applicable to us because we are able to put away so much money in pretax accounts. Not only does this open you up to tax rate risk, but the larger your total pretax balance, the larger your mandatory distributions will be (starting at age 70.5). This alone could raise your income tax bracket at retirement.
Here is a chart of income tax rates that might give you pause:
You are saving more for retirement in a Roth 401k. “Forced savings”
The annual contribution limits for a Roth 401k and traditional 401k are the same ($18,000 in 2015). However, $18,000 in a Roth 401k is more “valuable” than $18,000 in a 401k. Why? Because the 401k will get taxed when it comes out and the Roth 401k does not. “Wait”, you say, “but I’ve saved on my taxes by contributing to the 401k!”
That is true. But, you haven’t saved more for retirement unless you take that tax savings and set it aside and invest it for retirement. Instead you might take the taxes you’ve saved and go on a vacation, nothing wrong with that, but you just haven’t used the tax savings for retirement
Junior members benefit most from a Roth 401k. “Time is on your side”
Two reasons. First, you may be in a lower tax bracket during your early years prior to reaching full partner. So, although contributions to a Roth 401k are still taxable, you are paying lower tax rates then you will later on in your career. Second, the longer your time horizon, the longer your investments have time to grow tax deferred. And when you withdraw money from the Roth 401k, it will be tax free.
You can bequeath Roth IRA accounts to your family. “Be a Rockefeller”
Unlike traditional 401k and IRA plans, the IRS does not mandate that you withdraw
money from Roth IRA accounts. Therefore, for those so inclined, there is an easy way
to bequeath money to your children or family. Simply rollover the Roth 401k into a Roth
IRA upon retirement and then it will not be subject to required minimum distributions
(RMD). On the other hand, the IRS mandates withdrawals from IRA and 401k accounts
beginning at age 70.5.
Roth 401k tax strategy for those contributing to the Cash Balance Plan “Have your cake and eat it too”
I believe this is a compelling strategy for those who want to contribute to a Roth 401k but are not willing to give up the immediate gratification of the tax deduction they have been receiving. Two prerequisites to this strategy are:
- You are contributing to the CBP but not maxing it out (many of us are in this boat)
- You can save & invest at least $18,000 per year in regular after-tax accounts.
So, let’s say you plan on doing the following in 2015:
- Traditional 401k contributions: $18,000 (maximum) Roth 401k contributions: zero
- Profit sharing contributions: $34,500 (maximum)
- Cash Balance plan contributions: $60,000 (your maximum is $80,000)
- After tax income that is saved: $25,000 (but outside of retirement accounts)
- Total Pretax savings (tax-sheltered income): $112,500 ($18,000+$34,500+$60,000)
Instead, why not do this?
- Traditional 401k contributions: zero
- Roth 401k contributions: $18,000 (maximum)
- Profit sharing contributions: $34,500 (maximum)
- Cash Balance plan contributions: $78,000 (your maximum is $80,000)
- After tax income that is saved: $7,000 (but outside of retirement accounts)
- Pretax savings (tax-sheltered income) $112,500 ($34,500+$78,000)
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What have you really done? You’ve taken $18,000 of savings that you’ve already paid taxes on and simply put it into a Roth 401k instead. But, in order to do this, you could no longer contribute anything to your traditional 401k. To offset the loss of tax-sheltered income of $18,000, you simply increase your CBP contribution by an equal amount of $18,000. Voila! You still save the same amount of taxes and you now have $18,000 in a Roth 401k (instead of a regular taxable brokerage account). That $18,000 contribution alone in a Roth 401k can grow tax deferred over decades (e.g. into ~$123,000 in 25 years assuming an 8% annualized return), and when you take the money out, you owe Uncle Sam exactly zilch!
Of course, you could simply invest the $18,000 in a regular after-tax brokerage account or mutual fund, but every year you would pay taxes on dividends & capital gains. And at the end of 25 years, you would have less than $123,000 (because of taxes on dividends and capital gains, as would happen with any mutual fund). Let’s say because of this tax drag your annual return is only 7.5% (instead of 8%). That translates into just less than $110,000 at the end of 25 years. Not bad, until you realize you owe taxes on the capital gains of $92,000 ($110,000 – $18,000). Today that means you would owe about $18,400 in taxes. After paying Uncle Sam, you have a grand total of $91,600.
That’s a far cry from $123,000 in the Roth 401k. And that is based on a one time $18,000 contribution! (you will likely be making annual contributions for many years) Besides boring you all to tears, I hope this exercise also illustrates why the Roth 401k benefits younger partners the most. The longer the money is in the Roth 401k, the greater is the tax-advantaged
tailwind.
Please note that nothing in this article constitutes specific financial advice. You should always consult with your financial planner and tax accountant with regard to your personal circumstances.
What do you think? Do you have a Roth 401(k) option in your plan? Why or why not? What can you do to have one added? Would you use it if it were there? Comment below!
Does contributing to a Roth 401k preclude you from making backsdoor Roth IRA contributions?
I had the same question.
I have the option of work of putting my money into a Roth 401k but I’m not sure what the implications are regarding back door Roth.
Having a Roth 401k does not affect the ability to do a back door Roth IRA.
None.
No.
good post but most of us (employed docs, which now make up 60% and rising) are not eligible for sweet deals like 80k cash balance plans and profit sharing. We’re lucky to have any pre-tax space in addition to the 18k minimum. I’m not sure this advice applies to most folks
True that the example given with all the pre-tax space might not be relevant for you. The “to Roth 401k or not” analysis for an employee with only an $18,000 max workplace contribution available would be different but still relevant. Since the $18,000 in a Roth is post tax, for most, it is effectively a higher contribution than the same $18,000 in a traditional 401k. I believe there is another post that addresses this.
It’s beyond me why a doc would take a job that only offered $18K a year in tax-deferment. 🙂
It’s not ideal but I am in an employed position that pays nearly 7 digits a year. Tax-deferment options are admittedly pitiful (I place 18K a year in my company’s Roth 401k, 11K a year in my wife’s and my Backdoor Roth IRAs, and the rest of the 20% that you recommend in a taxable account) but hard to walk away from that kind of income
Because I get a pension???
Two great reasons!
Thanks for this post. I will be finishing up residency this year and working as an employee next year. I think the tax diversification benefit of Roth 401k and 403b contributions is too often overlooked. If I max out roth options in both accounts every year while enrolling in a pension plan available to me I will have a much lower marginal rate in my golden years, and if I don’t empty my roth accounts will be able to leave something behind for my children, and hopefully, grandchildren.
You can leave tax-deferred money behind to heirs, but you’re right that it is likely to be less due to RMDs. Remember Roth 401(k)s have RMDs too. You have to transfer it to a Roth IRA to avoid that.
I think you mean to say 457, not 403b. 403b contributions count towards your 401k elective deferral limit ($18k), making it impossible to max out both a 401k and 403b (if you’ve only got one job). Conversely, you can max out both a 401k and 457 ($18k each).
PTM, good point. As a PGY3 resident I’ve been hearing that the business model is overwhelmingly moving towards an employee-model for physicians. Large hospital groups and healthcare corporations are basically making medicine a employer-employee model instead of the private practice groups of the olden days.
A local neurologist gave a talk about how in our local town only 2 private neurology groups remain and the rest have been gobbled up by large healthcare corporations.
And I am also envious of all these pre-tax money bag availability. The IRS allows for up to 53k of total “Deferred Compensation Limit” to 401k/403/profit-sharing and (this is my low knowledge deficit as well) I suspect that most employee-physician model may be stuck with the cookie-cuter 401k without things like a Roth option or other pre-tax options.
It would be great to be able to contribute more than 18k to retirement plans. Physicians may need to sit more on the big company boards to help lobby more retirement plan options.
My group offers even its employees the ability to self-match up to $53K. If your employer doesn’t, it’s because they can get people to come work for them without that benefit. If docs would quit doing that, those jobs wouldn’t exist.
The ability of employee physicians to contribute upto $53k depends on whether your group has non-highly compensated employees or not. Most likely, your group doesn’t- otherwise, if only the HCE (highly compensated employees- ie., the doc employees, not the others) contributed, the plan would become “top heavy” and never pass discrimination testing.
I just went through this in setting up husband’s small practice 401k. So, even though we would love for our employee docs (we dont hv any yet) to be able to contribute all the way, we are unable to offer it until they become partners.
The ability of employee physicians to contribute upto $53k depends on whether your group has non-highly compensated employees or not. Most likely, your group doesn’t- otherwise, if only the HCE (highly compensated employees- ie., the doc employees, not the others) contributed, the plan would become “top heavy” and never pass discrimination testing.
I just went through this in setting up husband’s small practice 401k. So, even though a group may want the employee docs to be able to contribute upto max limit, they may be unable to offer it until said employees become partners.
Its a fact that a majority of MDs are already employed. With the macro-level changes sweeping across healthcare spurred by ACA, consolidation is happening everywhere. If it hasn’t hit your city yet, just wait.
There are always going to be certain specialties and locales that will be spared, but the trend is only on the rise.
As far as why people take these jobs, its all about the big picture. To get the massive deferred income OP and WCI are getting they endure the stress of owning a business, the risk of non-guaranteed income, and often tenuous relationships with hospitals/health systems. Like Darren (above) I get a nice salary with few headaches and no risk (and in my case we do get a little extra profit sharing).
Working for someone else also carries the risk of being downsized, laid off or having salary / benefits cut unexpectedly due to factors completely out of your control. Savings and multiple income streams are two of the best ways of minimizing those risks whether you’re an employee or a business owner.
If I have an individual 401K, can I also have a Roth 401K? Can I have the complete employER portion be $53K instead of $35K and then play another $18K into a Roth 401K?
Can I also do a backdoor Roth on top of this? That would give me $23,500 in Roth space every year.
You can definitely choose to contribute to both a Roth 401(k) and a traditional 401(k). See this, for instance:
https://www.fidelity.com/viewpoints/retirement/roth-or-non-roth-401k
You’re still limited to the same overall employee and total-including-employer limits, though.
I don’t see anything that would prohibit one from doing a backdoor Roth IRA conversion–people do this all the time with regular 401(k) and 403(b) plans, and beside from the (irrelevant) income limits for deductibility of contributions there’s no direct interaction.
$53K total limit per unrelated employer. $18K total employee contribution. Roth IRA limit is separate. Maximum Roth 401(k) contribution is $18K of that $53K. All employer contributions are always tax-deferred.
As far I remember, WCI was saying if you have high income, make sure to utilize all of pretax space before going to ROTH.
While if you have low income/ tax bracket make sure to use up all of ROTH space first.
I know everything is individual but is not that thumb rule true?
Most of the time, it’s true (like any rule of thumb, it’s not perfect.)
Therefore the example in the article could simply increase the cash balance plan contributions to $80,000 without shifting to Roth 401k.
Thank you
So basically, no matter how I contribute to the 401K, Roth or regular, I am maxed at $53K?
Yup. Unless you have an unrelated employer with another 401(k).
Maybe WCI can update us on the fate of the 2016 Budget proposal by the President on the lifetime amount limits for all of your 401k (I think it was 3.6 mil), closing of “backdoor” Roth IRA, limiting tax deductions applied to 401k contributions to a maximum of 28% , instituting mandatory distributions at the age of 70 1/2 to Roth IRA’s and other things affecting retirement planning .
I personally could not find the answer to whether all these proposals actually took effect- I hope that WCI has an answer!!
Like most budget proposals, it didn’t go anywhere. None of those are current law.
Hurray!! I knew you’d have an answer!!
Time to celebrate- if they did became a law, they would rob us of untold tens/hundreds of thousands of dollars in lost retirement money…
Great article.
One point I want to comment on though is the author’s statement that Roth IRA’s can be passed down without RMD’s.
While this would be great if true, sadly it isn’t. Inherited Roth IRA’s are subject to required minimum distributions that are essentially the same as Traditional IRA’s.
While sometimes it can be beneficial to pass down Roth IRA’s to loved ones, sometimes it actually makes more sense to actually take advantage of the recipient’s low tax rate and pass the money down through a Traditional IRA.
The inherited IRA has RMDs, but the Roth IRA itself does not. So a traditional IRA gets smaller from age 70 to death than a Roth IRA would. I agree that it can make sense to leave a traditional IRA in some situations, but I’d rather inherit a Roth IRA!
I would love the ROTH option at my current employer, but it is not offered… I’ve asked about it and have not got any traction on it..
My old employer offered it and I used it as well and was able to roll over to IRA eventually…
My current employer does offer an AFTER TAX allocation which is ok if you can do yearly in-service distribution since you can roll it out at the end of the year to your Roth IRA with minimal taxes on the gains from that year. I may plan for that if I work an exit strategy here at my current employer.. and Load up the AFTER-TAX 401k before departure and just roll it over to Roth IRA.
I landed up with a SEP-IRA to which my employer (PA) is contributing 25% of my W-2 reported salary.
After finding your site, I was inquiring how we can transfer this to a 401K so I can do backdoor Roth IRAs.
Can my employer simply open a Roth 401k and contribute there with the same effect as a backdoor?
Thanks in advance for the advice.
You can do a backdoor Roth unless you get rid of the SEP-IRA. So if your employer switched to a 401(k) and you rolled all the money in there, then you could start doing backdoor Roths. But otherwise, you’re kind of out of luck. A Roth 401(k) is a decent option, but it isn’t the same as a backdoor Roth IRA. With a Roth 401(k), you’re choosing between tax-deferred and tax-free. With a backdoor Roth, you’re choosing between taxable and tax-free. Sometimes tax-deferred is better than tax-free, and sometimes tax-free is better than tax-deferred, but tax-free is always better than taxable.
Thanks for the superfast reply.
I guess, I’m also confused as to the difference between Roth IRA and Roth 401K.
Roth 401k provided by employer, has a higher contribution limit, and no income limits on direct contributions. Both are tax-free.
Can my employer have both SEP-IRA and Roth 401K open?
Not for any given year. One or the other.
My group has a similar setup as the author’s: profit sharing (pre-tax), cash balance (pre-tax), and 401k (Roth or traditional).
I have been maxing out profit sharing and cash balance, as well as the traditional 401k. I also save a substantial amount from my after tax income (40-50%) in taxable accounts.
My questions is this: With all of this post-tax income in taxable accounts, does it make any sense to change and contribute to a Roth 401k instead of a traditional?
Thanks!
https://www.whitecoatinvestor.com/should-you-make-roth-or-traditional-401k-contributions/
This may help.
I think each person should step back and take a look at how much they have saved up (or will have saved up by retirement) in different “buckets”. This is going to be extremely variable. One of the motivations for me pushing the Roth 401k option for my group was I was seeing that for many people in our group, their retirement savings was going to be very highly weighted toward the tax-deferred bucket. This was because many people were contributing quite large amounts into the Cash Balance plan. If tax rates are low when they retire, that will be great– they can take withdrawals from their large IRA/401k bucket at relatively low tax rates. But, I wanted to provide a hedge for the possibility of much higher tax rates.
It’s not just tax rates, it’s also about how much you’ve got saved. If your tax-deferred is $500K, no biggie. If it is $5M, well, that Roth option is starting to look a lot better.
Cash balance plans are pretty rare, I cant even convince my private group to start one. Most of my savings are in post-tax account. Hopefully my post tax account will be bigger than my tax deferred.
I think I should avoid ROTH IRA right now, and just stick with backdoor ROTH.
I am in a similar group as the author. My biggest take home from this is that potentially;
Roth 401k + extra DCBP > 401k + taxable account.
I really like this concept. I had originally planned on doing large Roth conversions from retirement age (60) to age 70/RMDs/SS. But I am starting to buy into the concept of diversification in case tax rates increase or some future administration takes away unlimited Roth conversions.
What say you WCI?
The Roth vs traditional 401(k) is a difficult problem for many, and may not have a correct answer due to unknown future variables.
Given that employee docs are often only limited to whatever the employer’s 401k plan offers, is it an option for doctor joining a private practice to to do as an independent contractor (1099) instead of as an employee (W2)? That way the doc would be able to start a solo 401k and be able to put away as much as $53k/year (2015 limit).
Yes, that’s a possibility. Remember there are downsides to being an IC- you pay both halves of payroll taxes and no bennies.
True, but the employer’s portion is tax-deductible. Re: bennies, sure, the IC has to pay for those, but they’re deductible, too. Seems the upsides outweigh the downsides, don’t you think?
The solo 401k plan can be designed to include after-tax contribution contribution option, loan option, brokerage account option,etc.
I wouldn’t make a general statement. If the pay is exactly the same, I’d take a job with benefits and where I only pay half the payroll tax.
The IRS has rules re: who is an IC.
http://www.irs.gov/pub/irs-pdf/fss8.pdf
“Not bad, until you realize you owe taxes on the capital gains of $92,000 ($110,000 – $18,000). Today that means you would owe about $18,400 in taxes. After paying Uncle Sam, you have a grand total of $91,600”
I’ve got a “back to the basics” question concerning the above comment. If you invest in only muni bonds in a taxable account, would you owe any capital gains tax at all? I understand that interest is income tax free, but what about long term capital gains? Just a little confused on the basics of bonds I guess…
If you bought and sold a bond fund, you might have a gain or a loss. Same goes for individual muni bonds – if you bought a bond now, and sold it when interest rates are high (before maturity), you would have lost money, so that would be a capital loss. Actually, some individual municipal bonds will require that you pay capital gains on a small part of your proceeds even if you hold them to maturity.
Yes, you have to pay taxes on any capital gains in a muni bond fund. Bond funds tend not to have to many (compared to stock funds) but they do occur.
Does anybody know where the convention of typing ROTH in all caps came from? It’s not an acronym, after all. Even my employer types it that way on our yearly 401k form.
I think it is simply to emphasize it isn’t a traditional IRA.
I’m a CPA… a tax CPA with a masters in finance and then another masters in tax.
You need to remember in any analysis about Roth accounts to look at the tax rate differential.
Most people (and physicians would be a prime example) have a much higher marginal rate while working than they do when retired.
Absolutely I agree.
Please do not forget – there is a new option for those of you who own small practices with retirement plans (or who are part of a group that has control over their own plans). You can do what’s called ‘in-plan Roth conversion’. Basically, this is a much better deal than just doing Roth deferrals. You can convert to Roth (and pay the tax) any assets that are inside your retirement plan, with an appropriately drafted plan document. This way you can decide to do strategic Roth conversions (for example, when your income is lower for that year).
This is relatively new (as of 2013), and most plans do not have updated plan documents that allow this option. There is no income limit to make in-plan Roth conversions, so you can convert as much or as little as you want IN ADDITION TO backdoor Roth and Roth salary deferrals.
http://www.irs.gov/Retirement-Plans/Retirement-Plans-FAQs-on-Designated-Roth-Accounts#irr
This can be especially useful if you are rolling over assets into your plan, and have not done the Roth salary deferrals (but would like to) for the year. Another use of this option is if you are semi-retired (or working part-time) and you want to convert the assets inside your 401k (or solo 401k) to Roth inside your plan.
this would be really helpful for part time workers
And for practice owners and contractors with variable income. This can also be done inside your solo 401k plan:
https://www.whitecoatinvestor.com/improving-the-vanguard-individual-401k-with-a-customized-plan/
I always instruct my TPA to create plan documents with in-plan Roth option, so if you want your plan to have it, get your TPA to amend the plan document. This might or might not work for larger plans – your TPA might charge more for this option (I know mine doesn’t).
And if you want to do this inside your solo 401k, I would doubt that even a single provider is offering in-plan Roth conversions, though it would be very interesting to find out whether they include it into the standard plan documents.
No reason not to have the option, even if you don’t think you need it now.
Off-topic question: those of you that have a cash balance plan, how is the account invested? I.e. Equity:bond ratio. Also, where is your account held? Vanguard, etc?
This really depends on very many factors. One CB plan might be drastically different from another one. You have have a very ‘quick’ plan that unwinds in 7 years, with no stocks in it, and you can have a group practice CB plan that is supposed to run for multiple decades that can have a small component in stocks. Any plan that has 50% in stocks or more is being mismanaged – A CB plan is not supposed to have much volatility, and ideally you should have most of the money invested in bonds. You can open a Trust account at Vanguard and use Vanguard’s low cost index funds (Admiral shares). When it comes to managing CB investments, and especially if you have employees and/or partners, I’d get some professional/fiduciary advice on how to manage CB/DB investments. First thing to do would be to come up with an investment policy statement that describes the investment strategy in detail and to make sure that it is always followed.
Ours is held at Schwab. It used to be 53/47, but just before it closed it was 72/28.
Thanks for the post.
Quick question, I have a Roth 401 with my current company, unfortunately I think they don’t offer good investment options. .. I have been considering rolling my Roth 401 to my Roth IRA in Vanguard (that I created through a back door). Is this possible? Do I have to pay any taxes or fees (besides the actual moving the money)? Thanks
Probably no fees. Definitely no taxes. Your plan may not allow in-service withdrawals. Read the document to see.
WCI is in service withdrawl a rule set up by a group or set up by the Government?
If you have a group plan, you can change any plan rules to anything that’s legally allowed. In-service withdrawal rules can be changed. They are often made strict because the TPA might not want to deal with a constant request of withdrawals from the plan, and often this option is not enabled.
Most often they are strict because someone is making money based on AUM, and withdrawals decrease AUM.
I wanted to say that one but you beat me to it! Yes, that’s exactly true. They want money coming in but not out in part for that reason because most record-keepers get to either charge AUM fees or get revenue sharing (some of which they often do not return to participants).
But to be fair, I think the issue is also that if everyone just takes money at will it becomes a hassle to manage all of these outgoing transfers. The TPA will not want to be drowned by paperwork and multiple transactions.
It’s in the 401(k) plan document. The government is fine with it.
Hi,
This question is specifically for WCI based on his statement: “My group offers even its employees the ability to self-match up to $53K. If your employer doesn’t, it’s because they can get people to come work for them without that benefit. If docs would quit doing that, those jobs wouldn’t exist”.
I am an employee for a 1 owner practice. I contribute 18000 to my 401K. He self matches 3%. I want to put in upto $53000. What should I tell my boss and how do I contribute the extra 35K? Thx
For a group practice, the ‘self-matching’ comes out of their pay, so instead of taking their pay, they can make a profit-sharing contribution into the plan. If you are an employee, this would require a new plan design. The problem is that this contribution would come from the company profits, so the owner might be reluctant to allow this. However, it never hurts to discuss this. Maybe the owner wants to contribute $53k himself.
There are two ways to get the $53k: one is via profit sharing (owner’s contribution) and one is via matching (again, owner’s matching contribution). In both cases the owner would have to pretty much give you a $25+k raise. So this would be up the owner.
But he could make the $25K contribution and lower your pay by $25K, no? It’s all the same in the end.
Yes, exactly. This is a good solution that we always recommend in such cases. Not all practice owners go for it though.
That’s a great question. It is a little mysterious to me. All I know is the accountant for my practice let me do it for a couple of years before I made partner. It wouldn’t surprise me to learn the practice is illegal. Anyone have a link to a reliable source for this issue?
Are you asking about ‘self-matching’? Or about lowering salary for making the contribution?
Both I suppose.
If the owner is fine with lowering of the associates’ salary by the amount of profit sharing contribution, this is definitely not illegal, and might be part of the contract with the associate. After all, the owner has full control over the retirement plan, and they can decide to give the profit sharing or not. Associates are often excluded from the plan altogether, but their 401k plan matching/profit sharing can legally be included as part of their compensation. Anything over a certain amount can be taken out of their salary. So this would be a job for the attorney to make sure that the contract is written correctly, but there is no reason why an associate can’t ask the owner for profit sharing and reduce their salary in exchange (and add this clause to the contract). This is because the 401(k) plan is part of the benefits, and the owner has full say on which benefits to provide.
However, this rarely happens because associates are often young (so they won’t be maxing out their 401k plan), the plan is often just a safe harbor 401k without profit sharing, and in other cases they are 1099 contractors, so they are by default excluded from participation. In other cases, the owners might not want to contribute the maximum, and in any case, designing a plan with customized profit sharing is not easy – you’d really have to work with a great TPA who knows what they are doing, as most do not.
I see ‘safe harbor’ 401k plans everywhere, which often end up being top-heavy, so the HCEs who are not owners are precluded from making even an $18k salary deferral. This is because plan design for small practices is terrible.
When it comes to ‘self-matching’, this is also very much legal, precisely because this is a plan where all participants are HCEs. It is exactly the same idea as above: you can either take your share of the profits as salary, or you can contribute it to a retirement plan, and every participant can decide whether they want to do either one or the other. According to my TPA, this can be done if the plan is designed appropriately and can pass the testing, but this shouldn’t be an issue when you don’t have non-HCE employees.
So in either case, this is not an IRS thing but more about using benefits in a creative way.
Thanks.
In practice for 35 yrs, employee for past 10 yrs. I have had countless discussions with financial advisors, CPA’s, physicians and family members about tax sheltered vs. non sheltered accounts. I can state without hesitation that most of what people tell you including professionals is wrong. This has to do mostly with fact that returns on most investments, including bonds, are not linear but lumpy. Anyway, here is my advice without too much explanation:
1. Successful business/practice offers best tax shelters (self employment has challenges, but for those who can deal with it, rewards, including from tax standpoint are great)
2. HSA (tax deductible contribution, tax deferred accumulation and tax free withdrawal for health expenses)
3. Annual back door conversion for your self / spouse, and MAYBE for accounts that have lost money or haven’t appreciated much. It makes no sense to convert 401 K to Roth if you gonna end up paying taxes in the highest tax brackets. I DONT CARE WHAT EXPERTS OR CONVERSION CALCULATORS TELL YOU.
4. Roth IRA is good, but for high earners, in high tax states, traditional 401 K maybe is BEST bet
5. Put your growth stocks in non tax favored account. Index fund is fine. When market correct, and they alway do, tax harvesting can be very beneficial. Over last twenty yrs I haven’t paid a single penny in capital gains including on dividends. I also get to deduct $3000K annually from capital losses carried forward.
6. Have 5 – 10 % in gold coins (talk about options for you and you family. Use you imagination)
7. Finally, and without reservation, one of the best financial tool available for high earners is WHOLE LIFE INSURANCE. Better then bonds, CD, annuities and at times even beats stock returns on tax adjusted basis. Do not over analyze it. Forget the buy term and invest the difference nonsense. Get yourself whole life as early as possible in your career ALONG with TERM. At my age with all of my investment I don’t need a term insurance and frankly CANT afford term premiums. So it expired couple of yrs ago. My whole life pays for it self (dividend). I have taped cash value so many time and for so many reasons that I can’t even begin to tell you. I have done very well, and my only regret is that I didn’t by more whole life earlier in my life
Your only regret in life is you didn’t buy more whole life insurance? What a great life!
Obviously I disagree on the merits of whole life as discussed ad nauseum elsewhere on the site.
He’s been in practice for 35 years. There were “whole life” like policies that were much more beneficial back then than they are now. It was almost like an unlimited way to place money pretax and even cash it out pretax. Those loop holes have been closed for a while. I know of a few older physicians who have this policy. That’s why he wants wants more “whole life” I think.
So have kind of a specific question for my situation.
I am currently employee of a small private practice. Currently, I am offered a traditional 401k with decent match (100% match up to 4% of my salary). I am maxing this out, plus maxing out backdoor IRA and HSA.
I am about to become partner in this group (currently sole owner, I will be second doc). I am by no means a financial expert, but would like to be able to offer suggestions on how to best manage my/our future earnings and have several questions.
1. How do I go about contributing above the 18k for a 401k? I keep seeing the number 53k, but don’t know how to go about contributing more earning above my 18k + match.
2. Can I set up a Roth 401k on top of my traditional 401k and make what would normally be contributions into a taxable account (after maxing out traditional 401k, Roth IRA, and HSA), and instead make them into the Roth 401k?
3. If there is not a cash balance plan or profit sharing, is there a good way to set these up? Is one superior for a smaller practice? Are these both pre-tax (i.e. treat them like my traditional 401k).
Where do you find good information on these things. Everyone seems to talk about them like they are already very knowledgeable and I don’t get some of the explanations in the comments. Thanks!!
If there will only be two owners and no other employees, you can set up a solo 401k plan just for the two of you that allows you to contribute $53k. You can potentially contribute $53k on top of your employee contribution, except that the salary deferral ($18k) can not be exceeded for both plans, but the $53k can be contributed via higher profit sharing contribution into your solo 401k plan for the new practice.
Yes, you can set up a Roth 401k, and also you can add in-plan Roth conversion to your solo 401k plan with a custom plan document. More on this here:
https://www.whitecoatinvestor.com/improving-the-vanguard-individual-401k-with-a-customized-plan/
You can also have a cash balance plan on top of the 401k for your practice. In any case, it sounds like you need answers to specific questions about your situation, and any answers that I can offer here are not very accurate without knowing more about what you are trying to do, how much you’d like to contribute, timing, etc.
Here are some links that will provide more information on what you can do:
http://quantiamd.com/player/ygvmhdmbm?cid=1467
http://quantiamd.com/player/ygrmdgmtk?cid=1467
There are two limits for a 401(k). The first is the employee contribution limit, which is $18K if you’re under 50. That’s the only amount that can go into a Roth 401(k). This is where the tax-deferred vs Roth arguments happen. The second limit is the employer contribution, i.e. match or profit-sharing. This can combine with the $18K for a total of $53K. It really comes down to how the plan is set up. You have to read the plan document. Some plans don’t offer a match or a profit-sharing component, so if you’re an employee, all you get is $18K. If you’re joining a practice as a partner, it seems a good time to really examine what your practice is doing. Several of my blog sponsors would love to help you with it, and chances are very good the current plan can be improved significantly.
Hi, I’m reading this article and trying to figure out why our company doesn’t also offer a defined benefit plan for its partners. Does the plan count as a company owned asset and thus corporate profit at the end of the year? We tend to not have any profit as all income is paid out to the partners. Is it a big liability to the company as people retire? In what ways does a company provide a retiree his benefits when he retires?
Maybe technically, but not really.
No.
Depends on the plan. In our plan, most people just roll it into an IRA or the 401(k) upon separation. But there is an annuity option and I think you can just keep it in the plan too, but I would have to read the document.
Thanks. I think that considering the plan as a company asset that can be taxed would be a non starter. How do I find out more about this?
Why could it be taxed? It’s not taxable to the company. It’s a deduction to the company. It is taxable to you as it is pre-tax dollars. The risk isn’t losing the money to the IRS, it’s losing it to the company’s creditors.
That’s what I don’t understand and why I’m here. You replied “Maybe technically, but not really” to what I think was my question of whether the plan can can considered company profit and taxed at year end.
Thanks for your patience.
No, a plan is not taxed unless it violates IRS rules. If the plan is not administered according to the IRS/DOL guidelines and breaks rules, it can lose its tax deductible status. Other than that, a DB plan is a tax shelter.
Sorry, I thought you were asking if it was accessible to the company’s creditors, which it is.
Are we discussing DB plans or non-governmental 457b? A DB plan is certainly off limits like any other ERISA plan.
Hi, I’m referring to the DB plan that Dr. Lim mentions in the article at the top.
Yes, a DB plan is an ERISA plan, so that should provide good creditor protection. These types of plans probably have the highest level of protection from creditors. But as I mentioned before, if the plans are mismanaged, IRS can levy penalties and disallow tax deductions. But that should not happen if your plan is in good hands.
I’m not sure now. I’m replying to multiple threads (one on 457s and one on DBPs) today and it is possible I was mistaken at some point between them.
Oh no, now I remember. I was thinking the DBPs. I suppose they are protected by ERISA, aren’t they. That was probably an error I made above.
Its almost time to hire some moderators. In a little bit you will need to clone yourself to be everywhere at once 😉
I’m hoping the forum will take the pressure off me. A few more days….
Wow, thanks guys for the great answers. I think this brief discussion may provide the impetus for our group to seek more info.
A DB plan is a very complex vehicle that ideally has to be custom-designed for a group practice with multiple partners of different ages and different retirement dates. It is not something you can buy off the shelf and there are not too many providers who could offer this type of service. This often requires a customized plan document, and someone also has to manage the assets, as DB plans are pooled investment plans. If structured properly and managed correctly, a DB plan can be a great plan for the group on top of the 401k plan.
Very few plans require annuitization. You can usually take the vested balance as a lump sum on termination or retirement. As WCI said, you can roll this into your 401k or an IRA once the plan terminates (which it does by itself when the asset level reaches something like $2.5M which is inflation adjusted).
Thank you very much! Hope it helped you out.