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Guide Main | III. Personal Balance Sheet | Retirement Plans

Retirement Plans

Ugh, retirement plans. Just one more thing for you to have to figure out! 😑

If you want work to be optional in your golden years, setting up a retirement plan is almost always a good idea. Does a retirement plan make sense for everyone? Maybe not, but for most people it sure does. 

One of their many perks is that contributions to traditional retirement plans offer a nice income tax deduction and they grow without paying any taxes along the way (that's called tax-deferred growth if you want to start practicing the lingo!).

If you worked for a large employer, chances are you'd have access to a 401(k). You'd simply pick which plan-offered investments you wanted, pick a healthy contribution percentage to come out of your pay check and away you go.

But alas, it's not that simple for you, the private practice owner. You have to decide what kind of retirement plan to set up and then make all those other decisions I described. Ugh. Bummer.

But the good news is that you actually have many more great options available to you than if you were simply an employee. Of course the challenge is that you'll have to do some work to figure out which of those great options is right for you. And that's where this page comes in!

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Standard Not Advice Disclaimer

Just a friendly reminder that none of the information included anywhere in this guide is financial, legal or accounting advice. I don't know the specific financial circumstances of your life (or your private practice), so there's no way I can make blanket statements about what's right for you.

What I offer in this Guide is a suggestion on how you might think things through and then decide (for yourself) what's right. 

For some topics, I've also included what I've learned works well for most people. But you're not most people, you're you. You might be in that minority where the general suggestions are the wrong approach. 

Take everything said here (and anywhere else online) with a grain of salt, and seek out professional advice if you suspect you need it. Of course, I'm always happy to have a no cost introductory conversation with you to see if I can help.

I know this sounds like a legal CYA (that's cover your ass) statement. And yah, it is that. AND it's also an extension of loving kindness to you, the reader.

The way I cover my ass here is by making sure I don't encourage you to do anything that ends up causing you harm. I don't want that for you, and you don't want that for you. Take your time, think things through, be deliberate and seek out professional advice if you suspect you need it.

The Two Main Options

An elegant view of pencils on marble.

When it comes to setting up a retirement plan through your private practice, you have two main options. You can either use the IRA vehicle or a 401(k) vehicle. These are not the only options, but they're the most common ones. One of the two is probably a decent choice for you, unless you're very near retirement and have a lot of saving you want to do quickly.

Which one should you use? If you're just getting started saving for retirement, it probably doesn't matter all that much which you pick. All the different retirement vehicles are similar. Yes, they have some differences, but for most people those differences aren't that relevant. 

Especially if you follow the investment philosophy I describe on the Investing Page, any of the different retirement plans are going to be just fine. Just make sure you're getting a standard plan that doesn't have anything funky going on. Funky things include annuities and whole life insurance policies, although there are other funky things to watch out for. Working with a reputable (and known cost-conscious) vendor like Vanguard can help ensure you're not signing up for something you'll later have difficulty getting out of.

What happens if you pick the "wrong" retirement plan and want to change later?

Good news! It's usually quite easy. 

Yes, you can get into trouble if you're opening and closing different retirement plans too often, and there are some unusual circumstances you can get yourself in. But if you use the standard retirement plans, in most cases you can simply roll the funds from one plan to another and go about your merry way.

One word of caution: the specific way and payment transfer mechanisms you use to move funds between retirement accounts matters - a lot. Be sure and understand the nuances here before you pull the trigger. Some actions have unintended and painful tax consequences which can't be undone. This is a good time to consult with a financial professional.

So how DO you pick a Retirement Plan?!

The biggest constraint in picking a retirement plan is whether or not you have any employees in your firm other than you. (If your practice employs your legally married spouse, they don't count as an employee since you're a single household).

If it's just you (or you and your spouse)

Good news, in this case, things are relatively easy. If it's just you (and maybe your spouse) working for your practice, things are as simple as they could be. 

You can either set up a SEP-IRA or a Solo 401(k). (Yes, there are other options, but these are most popular are work well in most - not all - situations.) 

There are some technical differences between the SEP and Solo 401(k), but one of the most important ones relates to how much you can contribute each year. If you want to really max out your pre-tax contributions, a solo 401(k) is best. If a lower amount is acceptable, the SEP-IRA will work just fine (and is a bit easier to set up). See the resources below for some conversations about deciding between a SEP-IRA and a solo 401(k).

Are there plans beside a Solo 401(k) and a SEP-IRA? Yes, there are several. And you could consider them if you want to. I suggest you work with a professional to do so. Chances are you'll just end up with one of two flavors I've mentioned here. But if you suspect your situation is different and unique, please do seek out professional advice.

If your practice has employees

If your practice has employees, I'm afraid things get more complicated. 

Why? Well, the government wants to make sure that retirement plans aren't set up in a discriminatory way. And here we're talking about discriminating on the basis of income. The government doesn't want firm owners to set up retirement plans for themselves and exclude their lower-paid employees. A noble goal to be sure, but one that introduces a fair amount of complexity for you, the practice owner.

It's difficult to offer accurate and simple guidelines here, but often what you'll want to set up is some type of a 401(k) plan. Why? Because the 401(k) plan can be funded exclusively with employee elective deferrals. What in the world am I talking about? And why does it matter? If you're feeling brave, let's dive into some dorky finance stuff.

The Benefits of 401(k) Elective Deferrals

An elective deferral is when each individual employee gets to make their own decision whether they want to take a portion of their compensation and funnel it to their 401(k). Each employee gets to make their own decision on how much to contribute to the 401(k) (up to statutory annual limit which is currently just over $19,000). This elective deferral comes out of the compensation that each employee was already receiving, so there is no overall increase in compensation cost from the perspective of the practice owner.

In contrast, a SEP-IRA is funded exclusively by employer contributions. What does that mean? Well, the funds flowing into a SEP-IRA don't come out of the employee's salary paycheck. Each employee keeps 100% of their salary. Your business (which is essentially you of course) has to make an additional payment to each employee and that payment is funneled into the SEP-IRA. AND each employee has to receive the same percentage of their compensation. That isn't bad (that's a really nice thing for you to do as an employer), but it is much less flexible than a 401(k).

What if you like this SEP-IRA style of direct funding from employer to employee, but also want the flexibility of the 401(k) employee salary contributions? No problem! 401(k) plans allow both employee contributions AND employer contributions. But 401(k)s don't require an employer contribution as SEP-IRA's do.

The easiest solution to get started

If you're only looking to set aside $6,000 or less each year, you can simply open a normal IRA as an individual. ($6,000 is the limit for 2021, that limit will likely increase over time. If you're age 50 or over, your annual limit is $7,000 for 2021.) 

What I mean by "as an individual" is that you don't need to set up the IRA as a retirement plan through your private practice.

There are, however, some limitations you should be aware of. An IRA can be either traditional or Roth (see below for more detail on the differences). Both flavors have some special rules (because of course they do). And as an aside, you can contribute to both types of IRAs in a given year (if you meet the other requirements discussed below), but your total annual contributions cannot exceed the $6,000 or $7,000 limit. 

For Roth IRAs, there are income limitations: once your household earns a certain amount of money, you can no longer contribute to a Roth IRA. Here's an Investopedia page which provides an overview of these Roth IRA Income Limits (as well as a bunch of other information on IRAs).

Traditional IRAs have limitations as well, but the rules are different! (Because of course they are.) If you are employed outside of your private practice, there may be limitations on whether you can deduct your contribution to a traditional IRA (although you can always contribute - that contribution might just not be deductible). You can read about the specifics on the IRS website (it's not TOO painful). 

You do want to be sure and follow all these rules because the financial penalties are pretty painful (at least as a % of any disallowed contribution). The penalties won't ruin you financially but it will greatly reduce (if not eliminate) any benefit from the IRA.

And if you decide to set up a more complex retirement plan down the road? No worries! In most cases, you can just roll over your IRA into the plan you set up. But be very careful to follow all the complex tax rules when rolling funds over.

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Resources & Some FAQ

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Can you open a SEP-IRA without an LLC?

"I heard I can't open a SEP-IRA unless I have an LLC."

This is a story about how we all make mistakes.

I recently heard the host of a (very popular) personal finance podcast say that self-employed individuals can't set up a SEP-IRA unless they have an incorporated business entity. This is 100% incorrect. Any self-employed person can open and contribute to an SEP-IRA. Here's a link to the IRS rules.

Which brings up two important points. First, we all make mistakes. This is especially true in finance. Why? Because the world of finance is complex and the rules are frequently changing. (This particular rule hasn't changed ever as far as I know, but still.) Because mistakes are made, take everything you hear with a grain of salt. That applies to everything that I say in this Guide as well!

The second point is that when in doubt, go do primary research. Remember primary versus secondary research sources? What I mean is, go to the definitive source. And for most things tax and retirement plan related, the IRS (or the Treasury Department) writes the rules. If you're unsure or are making a big move, go see what they have to say. IRS web pages aren't always the easiest to read, so sometimes finding secondary overviews (like this one) are a better place to begin. But if you want to find the definitive answer to a particular detail - then go to the definitive source.

Retirement Plans aren't Investments

Retirement plans hold investments within them, they are not the investments themselves.

Retirements plans are just one of the many homes available for your investments to live in. They don't come with any pre-defined investment choices. That might not be the way it seems, because once you pick a particular financial institution to house your retirement plan, you will then only see the set of investment options they choose to offer. But you can set up that retirement plan at many different financial institutions, so you can get access to virtually whatever investment fund you want.

As I explain in detail on the Investing Page, there are many great investing funds available, but the one I'm most familiar with (and have used myself) are funds from Vanguard. The simplest and quite good (although probably not the optimal) solution is often to simply pick a Vanguard target date fund and be done with it. I talk about target date funds a bit more on the Investing Page, under the Implementation heading. 

Wanna hear more about using target date funds in retirement accounts? Here's an episode of Real Personal Finance Podcast: Should You Use a Target Date Fund In Your 401(k) Plan?

How to Set Up a Retirement Plan

If you're setting up a retirement plan just for yourself (or you and your spouse), you can work directly with someone like Vanguard. It's a lot less complex than you might think. The Balance also provides a good overview of what you need to do (although I don't love all of the financial institutions they suggest using). 

Whatever vendor you go with, be sure and read through the resources they provide. Managing a retirement plan for just yourself isn't all that complicated, but there are sometimes forms and reports you'll need to submit to the IRS and other government agencies. Good vendors, like Vanguard, will help you through that process but be sure and mind the details. Good financial planners (and I do include myself in that category) will also help you navigate the regulatory burdens and complexities.

If you have employees, things get a bit trickier. You'll almost certainly want to work with a professional organization. There are a lot of different companies you can work with, but unfortunately a lot of them offer products with a ton of hidden fees. The required complexity of retirement plans gives vendors plenty of places to hide fees. A company I've heard good things about is Guideline. What they offer seems to be most transparent with regard to pricing, and I like that they offer Vanguard funds. And if you want to compare different vendors, consider having them fill out this cost comparison from from the US Department of Labor.

Roth vs. Traditional Retirement Accounts

You might have heard you should open a Roth IRA. Or execute a backdoor Roth. These are all things. And they might make sense for you, but don't sweat the small stuff here. Most of this Roth versus Traditional stuff is small stuff - at least when you're first getting started in investing. 

But since we're here, let's talk about the difference between a Roth and traditional retirement account. These details are "asset location" in action. My general overview of asset location is back on the main Balance Sheet Page.

The difference between a traditional retirement account and a Roth retirement account.

In a traditional retirement account, any funds you contribute to the account generate a tax deduction for you. The contributions are excluded from your taxable income in the year they are made. And as an added bonus, you don't pay any income taxes on those traditional retirement plan assets until you begin taking distributions. At that time, you'll pay income tax on 100% of the distributions you take. In other words, those distributions will be taxable income, much like the income you earn by working in your practice today.

Roth accounts work just the opposite. You get no tax deduction for the contributions you make to a Roth account. You still pay income tax on all the money you earn this year, you just take some portion of those after-tax earnings and contribute it to a Roth retirement account. But, and here's the neat part: you never pay tax on those contributions again. They can grow over time to be multiples of your initial contribution and you can take those distributions entirely tax free (once you reach the required age).

On the face of it, a Roth sounds like a pretty good deal. And it is. But it isn't really much (if at all) better than the deal offered by a traditional retirement plan. The reason is math and I won't bore you with the complicated algebra here. 

The bottom line is it all comes down to tax rates. If your tax rate is lower now than you expect it will be in retirement, use a Roth (pay today's low tax rate instead of tomorrow's higher rate). If you think your tax rate will be lower in retirement than it is now, use a traditional account (avoid today's high tax rate and pay taxes at the lower rate in retirement).

(Disclaimer: If Biden is able to implement his tax plan as it's proposed, the tax deduction for retirement plan contributions rules are about to be substantially changed. Which would mean, among other things, that my rules of thumb in this paragraph no longer apply. Stay tuned...)

Do you have a good sense of whether your tax rate will be higher or lower in retirement than it is today? I sure don't. I mean, maybe your earnings will be lower in retirement and therefore you'll be paying a lower marginal tax rate. But you can't know that for certain. You might end up with a pretty high income in retirement for any one of a number of reasons. 

And even if you could bank on your retirement income being low, God only knows what tax law and tax rates will be decades in the future. There are plenty of people who think that longer-term tax rates will have to go up to keep pace with government spending. That might happen. Or it might not. And even if overall tax rates did go up, might Congress create a special set of tax rates just for retirement accounts? It wouldn't totally shock me. If you believe tax rates on traditional retirement account distributions will be higher than your current tax rate - then the Roth will be better. But who in the world can figure all of this out?!

What's my point? It's hard impossible to predict the future. That doesn't mean we shouldn't make our best guesstimates, but it means we should be humble when doing so. 

What does all this mean when it comes to choosing a traditional versus Roth retirement account?

It means your choice probably doesn't matter all that much. BUT splitting retirement assets between both traditional and Roth accounts is usually a smart strategy. Putting all of your money in one or the other? You might end up much better off... but you might end up much worse off. I feel like it's impossible to say for certain, so I like spreading my retirement assets across both types of accounts. This is what we call having a diversified asset location strategy.

Cash Balance Plans for Special Circumstances

Another alternative to consider is establishing your own cash balance pension plan. That pension plan option is a great solution if you're very near to retirement and want to contribute a huge percentage of your income to retirement savings. That pension plan will allow you to avoid income taxes in the current year and quickly fund the pension. 

This is a VERY complex and technical maneuver, and you'll need a financial professional to implement it. If this sounds like something that could be right for you, contact me and I'll point you in the direction of some helpful resources.

Outside Resources

How much can you contribute to a SEP-IRA? The Balance provides a good overview. When calculating the maximum contribution for yourself be sure and follow the instructions in the 'Calculating Your Net Adjusted Self-Employment Income' section. Unfortunately this is complex. I'm working on creating a simpler worksheet, and I'll let you know in an update email when that's up and running.

Retirement Plans in Private Practice: YouTube overview from Dr. Marie Fang

Real Personal Finance Podcast: Should I Use a SEP IRA or a Solo 401(k)?

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