Investing pre-tax

[ledo99]

I will start by acknowledging that I need to educate myself a lot more about finances/investing and that I haven't been doing very well in terms of investing my money effectively. On the other hand we've been living well below our means and saving quite a bit. This year I have earned quite a bit as an independent contractor (about $100 k so far, expect to total around $130 k by the end of 2014), this is in addition to my W2 salary. I haven't made any estimated tax payments this year on the 1099 earnings as the income has been fluctuating throughout the year. My question is; is there a way to put this money ($100-130k) in a retirement account pre-tax and save what would be a significant tax bill this year. I have an old 401k from a previous employer, no other retirement accounts yet. is is possible to set something up as an independent contractor for retirement purposes, like an IRA that would allow me to put this money (or at least a significant portion of it) pretax and to grow tax-deferred?

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[krl7044]

I will start by acknowledging that I need to educate myself a lot more about finances/investing and that I haven't been doing very well in terms of investing my money effectively. On the other hand I've been living well within our means and saving quite a bit. This year I have earned quite a bit as an independent contractor (about $100 k so far, expect to total around $130 k by the end of 2014), this is in addition to my W2 salary. I haven't made any estimated tax payments this year on the 1099 earnings as the income has been fluctuating throughout the year. My question is; is there a way to put this money ($100-130k) in a retirement account pre-tax and save what would be a significant tax bill this year. I have an old 401k from a previous employer, no other retirement accounts yet. is is possible to set something up as an independent contractor for retirement purposes, like an IRA that would allow me to put this money (or at least a significant portion of it) pretax and to grow tax-deferred?

There are two types of plans that can allow significant savings.

Here's some background information on retirement plans:
http://litovskymanagement.com/2013/04/retirement-plans-business

1) Solo 401k. You can put away as much as $52k (more if you are over 50).
2) Solo Cash Balance plan. This is where you can put away as much as $250k. Your contribution depends on your age. So for someone who is under 40, your contribution will be under ~$40k a year.
3) Combo: solo 401k/cash balance. So if you are young, this combination allows you to make the maximum possible contribution.

I typically open solo 401k plans at Vanguard for my clients. To open a Cash Balance plan (which is a type of defined benefit plan) you'll need professional help. I work with a great low cost TPA who can set up and administer such plans. The Cash Balanced plan is basically a pooled account (which I also open at Vanguard), and there are special investment considerations inside such plans.

In any case, it sounds like you have a number of factors to consider, so you might want to sit down with someone who can show you all of the options, design the right approach using the plans outlined above, optimize your contributions, and provide you with investment management services, since you don't want to make any mistakes (and time is of the essence) .

 

[Wealth Anatomy]

Ledo99, I too would look into a Solo 401(k) which will allow you to make significant contributions pre-tax relative to your income.

Careful though-it's easy to want to reduce your tax liability this year without taking into consideration how that may affect you down the road. In other words, the IRS is going to get their taxes-now or later. Have you considered a Roth IRA? These contributions are made with after-tax dollars but contributions and earnings can be withdrawn tax-free down the road.

Ask yourself these two questions: Will my income likely increase over time? Will income tax rates go up over time? If the answer is yes to either of those questions, you may want to supplement your pre-tax retirement contributions with after-tax contributions (Roth IRA or Roth 401(k)).

 

[TexasPhysician]

I opened a solo 401k at Vanguard. I'd recommend it.

 

[ledo99]

Thanks for the info guys. I will need to read more about this and educate myself. but on initial reading it looks like I can't do a Roth IRA because my income is above the limit for that (maximum contribution to a Roth is $5k anyway). Now regarding the solo 401k; from what I read it seems the maximum contribution would be 25% of income or $52 k, whichever is lower, is that correct? also do I need to set up an LLC or other entities to open an account? right now I'm getting paid those extra wages as an independent contractor without having an entity (LLC, Corp) setup.

 

[krl7044]

Thanks for the info guys. I will need to read more about this and educate myself. but on initial reading it looks like I can't do a Roth IRA because my income is above the limit for that (maximum contribution to a Roth is $5k anyway). Now regarding the solo 401k; from what I read it seems the maximum contribution would be 25% of income or $52 k, whichever is lower, is that correct? also do I need to set up an LLC or other entities to open an account? right now I'm getting paid those extra wages as an independent contractor without having an entity (LLC, Corp) setup.

Yes, you can do a Roth IRA using a 'backdoor' technique. You contribute to a Traditional IRA and then do a Roth conversion. You want to make sure you have no other IRAs around though, so keeping your old 401k plans where they are might be a good idea (unless you convert the balance into a Roth).

Maximum contribution will be $17,500 + 20% of your profits if you have a self-employment income. So with $130k you can contribute around $40k. How old are you currently? If you are over 40, a Cash Balance can makes a lot of sense.

No need to have any entity set up. Sole proprietor is fine. LLC is a pass-through anyway.

 

[ledo99]

I'm 37. is it possible to set up multiple accounts at the same time to maximize my contributions; so something like an IRA, solo 401k and a cash balance plan? also to clarify; that IRA contribution you mentioned, is it pre-tax or post-tax? and the limit is still $5500/year for any IRA, right?

it seems so far based on the info posted that the maximum I can put pre-tax is ~ $40 k in the solo 401 k and another $5500 in the IRA. I would still have another ~ $80 or so, any other options to protect these from uncle Sam this year?

 

[ledo99]

also what about a self-directed IRA? is this a good option here or it does have the same limits of the traditional/Roth IRAs?

 

[ThoracicGuy]

I'm 37. is it possible to set up multiple accounts at the same time to maximize my contributions; so something like an IRA, solo 401k and a cash balance plan? also to clarify; that IRA contribution you mentioned, is it pre-tax or post-tax? and the limit is still $5500/year for any IRA, right?

it seems so far based on the info posted that the maximum I can put pre-tax is ~ $40 k in the solo 401 k and another $5500 in the IRA. I would still have another ~ $80 or so, any other options to protect these from uncle Sam this year?

I'm not real familiar with the cash balance plan, but as far as the others, you can set up a solo 401k and an IRA at the same time. Now you can only put $5500 into a traditional or roth or combination of the two. For the IRA, if your salary is too high to allow for it to be pre-tax money as you will likely be, this will be post-tax money into the traditional IRA and then rolled over to the roth IRA. The rest of your investments would be taxable accounts. You will need to be careful on what options you choose for those accounts as well to minimize your taxes each year.

If you currently have any traditional IRA money out there, that will limit your ability to do a backdoor roth. You have multiple places you can open a solo 401k. I have mine at Fidelity and was able to transfer my traditional IRA money into it to protect it from the roth pro-rata taxation calculation. Vanguard's solo 401k does not allow transfers of IRAs into it.

In the future, if you have w2 and 1099 earnings, you can contribute to the work AND solo 401ks. You can have up to (currently) $17,500 as an employee contribution between the two. You can't contribute that much to both. Then you can contribute your 20% of net profits from your 1099 income to the solo 401k as the employer contribution.

 

[krl7044]

I'm 37. is it possible to set up multiple accounts at the same time to maximize my contributions; so something like an IRA, solo 401k and a cash balance plan? also to clarify; that IRA contribution you mentioned, is it pre-tax or post-tax? and the limit is still $5500/year for any IRA, right?

it seems so far based on the info posted that the maximum I can put pre-tax is ~ $40 k in the solo 401 k and another $5500 in the IRA. I would still have another ~ $80 or so, any other options to protect these from uncle Sam this year?

Yes, you can have all of this simultaneously, though one would have to run a calculation to confirm to various contribution limits into retirement plans. So you might be able to put away another $35k into a Cash Balance plan (which limits solo 401k plan contribution, unfortunately, so there is a tradeoff: you can put everything into a solo 401k or put less and the rest into a Cash Balance plan). Total contribution can be around $60k-$70k or so, but I'd have have an actuary runs the numbers to make sure this is correct. As far as IRA, you can do Roth - it is after tax (since you are most likely phased out for a traditional IRA deduction).

Are you working with an accountant? As a self-employed contractor you are eligible to write off your business expenses and office space (if you work at home), as well as travel/car expenses. So this might give you a nice tax deduction.

I guess you are limited to tax writeoffs + solo 401k (and possibly Cash Balance plan if you expect to reasonably contribute for at least several years). This is not bad at all. Without tax writeoffs, you might be able to contribute as much as $60k-$70k, bringing down your tax liability pretty low. I have no idea what the rest of your finances look like, or whether there are other ways to minimize your tax liability, but if you have a 401k in the future, that's one way that you can offset some of your liability going forward.

Sounds like you might want to sit down with an adviser and do some tax planning. It is not a good idea to leave tax planning for the end of the year, since there are various deadlines. Your solo 401k and/or CB accounts have to be open by Dec. 31st of this year (contributions can be made next year). This is how a lot of people end up with SEP IRAs, since that's the only thing you can do in April of next year ;-)

 

[ledo99]

Thanks for the information. I don't currently work with an accountant and I've been doing my own taxes since residency (Turbotax) and definitely plan to use all the writeoffs I can via business expenses, etc. I also own a small business (LLC that I set up a couple of years ago with my wife as co-owner, it's an export business that generates small income on the side), haven't established a retirement account through the business yet, but will probably setup a 401k there as well.

one more thing I am learning about is self-directed IRAs. is this a good option here or it does have the same limits of the traditional/Roth IRAs? I have a friend who established a self-directed IRA with its own LLC, uses that to invest in real estate and seems to be doing well there, not that I would do the same kind of investment but I'm wondering if that is another option to explore in addition to the great ideas you guys mentioned already.

 

[ThoracicGuy]

Thanks for the information. I don't currently work with an accountant and I've been doing my own taxes since residency (Turbotax) and definitely plan to use all the writeoffs I can via business expenses, etc. I also own a small business (LLC that I set up a couple of years ago with my wife as co-owner, it's an export business that generates small income on the side), haven't established a retirement account through the business yet, but will probably setup a 401k there as well.

one more thing I am learning about is self-directed IRAs. is this a good option here or it does have the same limits of the traditional/Roth IRAs? I have a friend who established a self-directed IRA with its own LLC, uses that to invest in real estate and seems to be doing well there, not that I would do the same kind of investment but I'm wondering if that is another option to explore in addition to the great ideas you guys mentioned already.

A self-directed IRA allows contributions in some things other than mutual funds. Personally, I wouldn't recommend it. Stick with the traditional/Roth IRAs. I personally like Vanguard for my IRAs. I use Fidelity for my solo 401k.

 

[krl7044]

Thanks for the information. I don't currently work with an accountant and I've been doing my own taxes since residency (Turbotax) and definitely plan to use all the writeoffs I can via business expenses, etc. I also own a small business (LLC that I set up a couple of years ago with my wife as co-owner, it's an export business that generates small income on the side), haven't established a retirement account through the business yet, but will probably setup a 401k there as well.

one more thing I am learning about is self-directed IRAs. is this a good option here or it does have the same limits of the traditional/Roth IRAs? I have a friend who established a self-directed IRA with its own LLC, uses that to invest in real estate and seems to be doing well there, not that I would do the same kind of investment but I'm wondering if that is another option to explore in addition to the great ideas you guys mentioned already.

If you have self-employment income, you are not saving much by not having a good accountant, especially since you have two sources of income other than your main W2 income. You also have to be very careful how much you can contribute to two solo 401ks set up for two companies, and to your 401k plan at work. Also, deciding where to contribute is important.

Self-directed IRA is something you might want to avoid. Would you want to invest in actual real estate with your IRA money? There is no separate contribution limit for this IRA. It is nothing more than your existing IRA doing something that an IRA probably shouldn't be used for - investing in assets such as real estate, businesses, artworks, gold, etc.

 

[fahimaz7]

If I'm reading this dinosaur of a post correctly, it seems that to contribute to a solo401k (employer max of 25% gross earnings as a 1099) you do not need to form a pass-through company such as a LLC or S-corp. I will however have to get a EIN. Correct? Any benefit, directly related to the contributions or limits of forming a pass-through?

The majority of my income is coming from a W2 where I will be maxing my employee contributions into a typical 401k. The Solo401k is just to reduce the tax burden on moonlighting income.

Thanks guys,

 

[ThoracicGuy]

If I'm reading this dinosaur of a post correctly, it seems that to contribute to a solo401k (employer max of 25% gross earnings as a 1099) you do not need to form a pass-through company such as a LLC or S-corp. I will however have to get a EIN. Correct? Any benefit, directly related to the contributions or limits of forming a pass-through?

The majority of my income is coming from a W2 where I will be maxing my employee contributions into a typical 401k. The Solo401k is just to reduce the tax burden on moonlighting income.

Thanks guys,

You do not need an LLC/S Corp to do the i401k. The EIN you can get very easily from the IRS online a matter of minutes. You can contribute up to $18k between your two 401k as well as what works out to be 20% of your net income as the employer contribution to the i401k up to the limit of $54k. To maximize this income, you would need net earnings of 270k via your 1099 job.