How does the proposed Republican tax reform impact your retirement account? Well, if you save for education expenses for your kids or grand-kids using a Coverdell Education Savings Account, you’re not going to be happy as new contributions to Coverdell accounts are eliminated in the House Plan. Also, both House and Senate bills eliminate the ability to re-characterize Roth IRA conversions back to Traditional IRAs. This was a nice “do-over” the IRS allowed you to use if you regretted converting your Traditional IRA to a Roth IRA, and switched it back to a traditional IRA within certain time limitations. For my prior article on how a Roth IRA re-characterization works, at least for now, check it out here.
The only good news: It could’ve been worse. There was talk of drastic changes that would have essentially called an end to Traditional IRA and 401(k) contributions in favor of Roth-only contributions (or limiting Traditional dollars to $2,400 annually). Luckily, those ideas never made it into the legislation.
Here’s a brief summary of the two major changes effecting IRAs. In addition to the changes effecting IRAs, there are numerous proposals regarding employer retirement plans such as 401(k)s, but those changes only slightly alter the ways those plans function.
||Change to IRAs
||No More Coverdell Education Savings Accounts (ESAs) Contributions
||Coverdell accounts are used as a vehicle to contribute funds (up to $2k annually per beneficiary) for education expenses. It is usually used by parents or grandparents as an account to invest the money tax-free whereby the money in the account grows without being subject to tax and comes out tax-free for the beneficiary’s education expenses. There is no deduction for the contribution. The current proposal would eliminate the ability to make future Coverdell contributions. Existing accounts may still exist without new contributions or may be rolled to a 529.
|House Bill & Senate Amendment to Senate Bill
||End Roth IRA Re-characterizations
||Under current rules, you can convert your traditional IRA to a Roth IRA, and if you later decide that such conversions (and tax due) wasn’t a good idea, you are allowed to undo the conversion and go back to a Traditional IRA.
So what should you do now? If you’ve used Coverdell accounts or wanted to, make 2017 Coverdell contributions because they may be the last time you can do them. Also, if you’ve been thinking of converting a Traditional IRA to a Roth IRA, 2017 may be the last year you can do so, and still have the ability to re-characterize back to Traditional if you later decide against it.
If you are self-employed and use a SEP IRA to save for retirement, you should carefully consider moving those funds to a new Solo 401(k) (aka “Solo K”).
Both SEP IRAs and Solo Ks are retirement plans commonly used by self-employed persons with no employees, such as: Real estate professionals, investors, consultants, direct-marketing professionals, 1099 salespersons, and other small business owners. Here’s why: Both the SEP IRA and the Solo K offer big annual contribution amounts that far exceed the $5,500 ($6,500, if over 50) that you can put into a Roth or Traditional IRA. In fact, in both the SEP IRA and Solo K, you can contribute, depending on your income, up to $54,000 annually – $60,000, if over 50 in a Solo K. That’s almost ten times the contribution limit of an IRA. And, if you’re really trying to build up a retirement account you can retire on, you’re going to need to contribute more than $5,500 a year.
Now, if you have a SEP IRA, you should really look at changing that SEP IRA to a Solo K. Sure, SEP IRAs are good, but Solo Ks are great. Here are four major reasons why you should make the switch:
1. You Can Contribute More to a Solo K on Less Income
You can contribute more to a Solo K each year on less income. Let’s consider the following example: Sally is 41 and the 100% owner of Sally, Inc. She sells products online and Sally, Inc. is taxed as an S-Corp. The total cash flow income from her company is $8,000 and she ends up paying herself a W-2 of $40,000 for the year. Based on the $40,000 W-2, she could contribute the following amounts:
- SEP IRA – 25% of Wage Income: $10,000
- Solo 401(k) – $18K on the first $18K Wage Income, plus 25% of Wage Income: $38,000
That’s right: Sally can contribute $38K a year to her Solo K on a $40,000 W-2. If she was using a SEP, she’d only be able to contribute $10,000. The significant difference is that, under a Solo K, you get to contribute $18K on the first $18K ($24k, if 50 or over), plus you get to contribute 25% of the wage income.
Also, if you are looking to max out the Solo K contribution amount of $54,000, then you’d need to have a W-2 from the S-Corp of $144,000. However, if you were looking to max out contributions at $54,000 using a SEP IRA, then you would need to have a W-2 of $216,000. Bottom line: It’s easier to max out your retirement plan contributions with a Solo K. And, at lower W-2 levels, something S-Corp owners strive for, the contribution difference is significant. For more details on Solo K contributions, please refer to my prior blog article.
2. You Can Self-Trustee and Administer Your Solo K
All IRAs, including SEP IRAs, must have a third-party custodian – a bank, credit union or trust company – for the account. However, with a Solo K, you can self-trustee and can have control of the bank checking account and/or a brokerage account without having a third party as the trustee. This allows you to invest directly out of the Solo K and gives checkbook control. A valuable tool when investing a retirement account into alternative assets like real estate, notes, or private companies, as you can sign off on investments or process funds without waiting on a third party to process and approve your own funds.
3. You Can Loan Yourself Up to $50K from a Solo K
Under a Solo K, you can loan yourself half of the balance of the Solo K not to exceed $50,000. This is known as a “participant loan,” and is a great option to use when you need to access funds you’ve contributed and saved for retirement. Maybe you need funds to grow the business, pay for school expense, or take a trip to Vegas. Whatever the reason, good or bad, your hard-earned money can be accessed without penalty under a Solo K using the participant loan. Now, you will need to pay the funds back over five years with a set interest. But, this money goes back into the Solo K you’ve been building. For more details on the 401(k) loan, please refer to my prior blog article. Unfortunately, the participant loan cannot be done with a SEP IRA, and would actually result in a distribution, penalty and taxes.
4. No UDFI Tax on Leveraged Real Estate with a Solo K
If you self-direct your SEP IRA plan into real estate, you may have heard of a tax called “unrelated debt financed income” (or “UDFI”). This tax applies when you leverage your SEP IRA’s cash with debt. For example, you buy a rental property with your SEP IRA for $100,000. Of this $100,000, $40,000 comes from your SEP IRA’s cash and $60,000 is from the bank loaning your SEP money on the deal. By bringing in 60% debt to the investment, the IRS will require tax on 60% of the net income from the profits of the property. However, this tax on leveraged real estate does NOT apply to Solo Ks as Congress created an exemption for Solo Ks, but not SEP IRAs. So, if you self-direct and leverage real estate investments with debt, you’d be crazy to use a SEP IRA over a Solo K. The tax can be tricky to calculate for IRAs and requires a separate 990-T tax return. Check out my detailed webinar on the topic if you’d like to learn more.
There are a couple of downsides to the Solo K over a SEP IRA:
1. Solo Ks are more expensive to set up, as it requires an IRS-compliant plan document. Expect to pay around $1,000 – $2,000 for an IRS-compliant Solo K that you can self-direct and self-trustee. Under both a SEP IRA and a Solo K, you will have similar on-going annual fees to keep them compliant.
2. The other downside to a Solo K is that once you have $250,000 in assets or more in a Solo K, you must file a 5500-EZ tax return to the IRS each year. This return isn’t overly complex, but it is an annual filing requirement you’ll need to handle, or hire someone else to handle if you are self-administering your Solo K.
So, what if you have a SEP IRA and you want to move over to a Solo K? You’ll first need to establish a Solo K for your business by adopting an IRS-compliant Solo K plan. Once you do that, you can start making your new contributions into the Solo K and also roll over the existing funds from your SEP IRA (or other traditional IRAs).
The IRS announced new contribution amounts for retirement accounts in 2018, and there are some winners and losers in the bunch.
The biggest win goes to 401(k) owners, including Solo K owners, who saw employee contribution amounts go from $18,000 to $18,500. Health savings account (HSA) owners won a small victory with individual contribution maximums increasing $50 to $3,450 and family contribution amounts increasing by $150 to $6,900.
However, IRA owners lost with no increase in the maximum contribution amount for Traditional or Roth IRAs. The IRA maximum contribution amount remains at $5,500 and hasn’t increased since 2013.
Here’s a quick breakdown on the changes:
- 401(k) contributions also increased for employees and employers: Employee contribution limitations increased from $18,000 to $18,500 for 2018. The additional catch-up contribution for those 50 and older stays the same at $6,000. The annual maximum 401(k) (defined contribution) total contribution amount increased from $54,000 to $55,000 ($61,000 for those 50 and older).
- HSA contribution limits increased from $3,400 for individuals and $6,750 for families to $3,450 for individuals and $6,900 for families.
- IRA contribution limitations (Roth and Traditional) stayed at $5,500, as did the $1,000 catch-up amount for those 50 and older.
There were additional modest increases to defined benefit plans and to certain income phase-out rules. Please refer to the IRS announcement for more details here.
These accounts provide tax advantageous ways for an individual to either save for retirement or to pay for their medical expenses. If you’re looking for tax deductions, you should determine which of these accounts is best for you. Keep in mind there are qualifications and phase out rules that apply, so make sure you’re getting competent advice about which accounts should be set up in your specific situation.
You have until April 18th, 2017 to make 2016 IRA contributions for Roth and Traditional IRAs. If you’re self-employed and are using a SEP, your deadline is determined by your company’s tax filing deadline (e.g. s-corp, partnership, or sole prop). So, if you were an s-corp or partnership in 2016, then your filing deadline was March 15th, 2017. II you are a sole prop, then the deadline is April 18th, 2017. If you extended your company return, that extension will also apply to your SEP IRA contributions. The table below breaks down the deadlines and extension options for Traditional, Roth and SEP IRAs.
|Type of IRA
||April 18th, 2017: Due Date for Individual Tax Return Filing (not including extensions). IRC § 219(f)(3); You can file your return claiming a contribution before the contribution is actually made. Rev. Rul. 84-18.
||Roth, Not Deductible
||April 18th, 2017: Due Date for Individual Tax Return Filing (not including extensions). IRC § 408A(c)(7).
||N/A: Employee contributions cannot be made to a SEP IRA plan.
|Employer Contribution, Deductible
||March 15/April 15th: Due Date for Company Tax Return Filing (including extensions). IRC § 404(h)(1)(B).
As outlined above, you have until the 2016 individual tax return deadline of April 18th, 2017 to make 2016 Traditional and Roth IRA contributions. The deadline for Traditional and Roth IRAs, however, does not include extensions. So, even if you extend your 2016 tax return, your 2016 Traditional and Roth IRA contributions are still due on April 18th, 2017.
SEP IRA contribution deadlines are based on the company tax return deadline, which could be March 15th if the company is taxed as a corporation (“c” or “s”) or partnership, and April 15th if it is a sole proprietorship. Keep in mind that this deadline includes extensions, so if you extend your company tax return filing, you will extend the time period to make 2016 SEP IRA contributions.
As 2015 comes to an end, it is critical that Solo 401(k) owners make year-end retirement plans. There are three important deadlines you must know if you have a solo 401(k) or if you plan to set one up still in 2015. A solo 401(k) is a retirement plan for small business owners or self-employed persons who have no other full time employees other than owners and spouses. It’s a great plan that can be self directed into real estate, LLCs, or other alternative investments, and that allows the owner to contribute up to $53,000 per year (far faster than any IRA).
New Solo 401(k) Set-Up Deadline is 12/31/15
First, in order to make 2015 contributions the solo 401(k) must be adopted by your business by December 31, 2015. If you haven’t already adopted a Solo 401(k) plan, you should be starting right now so that documents can be completed and filed in time. If the 401(k) is established on January 1, 2016, or later you cannot make 2015 contributions.
2015 Contributions Can Be Made in 2016
Second, both employee and employer contributions can be made up to the company’s tax return deadline INCLUDING extensions. If you have a sole proprietorship (e.g. single member LLC or schedule C income) or partnership then the tax return deadline is April 15, 2016. If you have an s-corporation or c-corporation, then the tax return deadline is March 15, 2016. Both of these deadlines may be extended 6 months by filing an extension and the date to make 2015 contributions will also be extended. This a huge benefit for those that want to make 2015 contributions but who won’t have funds until later in the year to do so.
W-2’s Force You to Plan Now
Third, while employee and employer contributions may be extended until the company tax return deadline you will typically need to file a W-2 for your wages (e.g. an s-corporation) by January 31, 2016. The W-2 will include your wage income and any deduction for employee retirement plan contributions will be reduced on the W-2 in box 12. As a result, you should make your employee contributions (up to $18,000 for 2015) by January 31, 2016 or you should at least determine the amount you plan to contribute so that you can file an accurate W-2 by January 31, 2016. If you don’t have all or a portion of the funds you plan to contribute available by the time your W-2 is due, you can set the amount you plan to contribute to the 401(k) as an employee contribution and will then need to make said contribution by the tax return deadline (including extensions).
Now let’s bring this all together and take an example to outline how this may work. Let’s take Sally who is a real estate professional and who owns an s-corporation. She is the only owner and only employee and has a solo 401(k) established in 2015. She has $120,000 in net income for the year and will have taken $50,000 of that in wage income that will go on her W-2 for the year. That will leave $70,000 of profit that is taxable to her and that will come through to her personally via a K-1 from the business. Sally has not yet made any 2015 401(k) contributions but plans to do so in order to reduce her taxable income for the year and to build a nest-egg for retirement. If she decided to max-out her 2015 Solo 401(k) contributions, it would look like this.
- Employee Contributions – The 2015 maximum employee contribution is $18,000. This is dollar for dollar on wages so you can contribute $18,000 as long as you have made $18,000. Since Sally has $50,000 in wages from her s-corp, she can easily make an $18,000 employee contribution. Let’s say that Sally doesn’t have the $18,000 to contribute but will have it available by the tax return deadline (including extensions). What Sally will need to do is she will let her accountant or payroll company know what she plans to contribute as an employee contribution so that they can properly report the contributions on her payroll and W-2 reporting. By making an $18,000 employee contribution, Sally has reduced her taxable income on her W-2 from $50,000 to $32,000. At even a 20% tax bracket for federal taxes and a 5% tax bracket for state taxes that comes to a tax savings of $4,500.
- Employer Contributions – The 2015 maximum employer contribution is 25% of wage compensation for Sally. Since Sally has taken a W-2 wage of $50,000, the company may make an employer contribution of $12,500 (25% of $50,000). This contribution is an expense to the company and is included as employee benefit expense on the s-corporations tax return (form 1120S). In the stated example, Sally would’ve had $70,000 in net profit/income from the company before making the solo 401(k) contribution. After making the employer matching contribution of $12,500 in this example, Sally would then only receive a K-1 and net income/profit from the s-corporation of $57,500. Again, if she were in a 20% federal and a 5% state tax bracket that would create a tax savings of $3,125. This employer contribution would need to be made by March 15, 2016 (the company return deadline) or by September 15, 2016 if the company were to file an extension.
- In the end, Sally would have contributed and saved $30,500 for retirement ($18,000 employee contribution, $12,500 employer contribution). And finally, she would have saved $7,625 in federal and state taxes. That’s a win-win.
Keep in mind, you need to start making plans now and you want to begin coordinating with your account or payroll company as your yearly wage information and W-2 are critical in determining what you can contribute to your Solo 401(k).