What Is The Best Retirement Plan for Small Business Owners [EPISODE #262]
The Big Idea
Several kinds of retirement plans have sprung up for business owners over the years: The Keogh, the standard IRA, the SIMPLE IRA, the SEP IRA, the Solo 401(k) and more... which is best - which should be relegated to the dustbin of history?
Points To Ponder
- What's the bottom line on the value of each type of retirement account to the unique needs of Small Business Owners?
- Two broad categories: IRA & 401(k)
- Traditional IRA vs Roth IRA vs SEP IRA
- Solo 401(k) vs all IRA's
- 5 Reasons Solo 401(k) is superior choice
- Does it ever make sense to have more than one type of retirement account?
- Ideal structure for small business owners to have maximum flexibility with minimum cost
Jeff Brown, contributor to US News & World Report, has some great questions about the type of retirement plans that are best for owners of small businesses. Well Jeff – and all of SDI Nation – I’ve got your answers right here. This is Episode #262 of Self Directed Investor Talk.
Hello, Self Directed Investor Nation! Welcome to the show of record for savvy self-directed investors like YOU, where each day, we help you to find, understand and PROFIT from the very best investment opportunities.
This is Episode #262 – and you know what that means… you can get the recording, the transcript and all of the links and resources I discuss in today’s episode by going to SelfDirected.org/262… that SelfDirected.org/262.
Quick reminder – I’ll be speaking THIS WEEKEND at the Think Realty National Conference and Expo in Dallas, Texas. If you’re in the area, I’d love to meet you! You can get more information about the conference by visiting SelfDirected.org/expo or just drop me a line at
Ok… I subscribe to an email service where writers seek comments from experts on various topics for some strategic business reasons which are a bit different from most people who use that service. Nevertheless, when I saw that a contributor to U.S. News & World Report named Jeff Brown was seeking comments on a topic that’s squarely in the wheelhouse of the esteemed show to which you’re now listening, which is this:
I'm looking for financial advisors, retirement experts and
academics with tips on the pros and cons of options small
business owners have for retirement investing -- SEP, Simple,
Solo 401(k), Keogh, traditinal or Roth IRA....
I know the basics but would like views on what type of investor
is most likely to benefit most from each. In what circumstances
would it pay to have more than one type?
In what ways, if any, have these types of accounts changed over
the years? Which are most popular today and why?
I'm interested in tax benefits, the availability of wide-ranging
investing options, fees and tax treatment of contributions,
growth and withdrawals.
Do you find clients understand their options? Or do you have to
lead them by the hand?
A complex set of questions, yes… Fortunately, yours truly is imminently well equipped to provide this information. Now, Jeff, I’ve read a few of your other columns, so I know you’re not a beginner at this stuff. But I’m going to answer your question as if you’re starting from ground zero, ok? Great…
So Jeff, in today’s world, there are basically 2 categories of retirement plans available to the general public: the IRA and the 401k. There are others, but those are the big two. Generally speaking, IRA’s make it possible for people to save for retirement in a way that’s wholly independent of an employer, whereas the 401k is a group-oriented retirement plan that’s administered by an employer for the benefit of its employees.
Now Jeff, there are a couple of things you asked about that we can just eliminate from the discussion for the sake of simplicity. One being the SIMPLE IRA and the other being a thing called a Keogh plan. We’re not really going to look at those closely because they are both essentially archaic… The Keogh being archaic just because we now call it a 401k plan, and the SIMPLE IRA being archaic because it’s a convoluted, very unpopular option that frankly offers no advantages over a 401k plan. So for purposes of this discussion, we’re going to ignore the SIMPLE IRA and we’ll use the term 401k rather than the more generic term Keogh.
So we have IRA’s and we have 401k’s. What’s best for the small business owner?
Let’s look at the worthwhile options:
First is the standard IRA. It’s the easiest plan that a small business owner could possible use. Just pick a custodian, fill out some papers, and voila… you have an IRA. With the standard IRA, you can also pick how you want the account to be taxed. If you want to deduct your deposits against your income taxes each year, choose the Traditional tax model… but know that you’ll have to pay income taxes on every dollar you withdraw from that account in the future. On the other hand, you could opt to use the Roth tax model… you don’t get to deduct your deposits against income when you use a Roth account, but you won’t pay taxes on withdrawals you make from a Roth… zero, zilch, nada.
Basically, the Traditional tax model is a front-loaded type of model, and the Roth is a back-loaded type of model. And both tax models include another really nice advantage: Tax-free reinvestment of profits. That means when you make a profit on an investment, you can reinvest 100% of that money into the next investment without paying taxes in the middle. This is really what gives retirement plans their biggest advantage.
So Jeff, it’s really easy to set up an IRA, whether Traditional or Roth. Very easy. That’s the good news. The bad news is that plan is made for the masses, and frankly, Uncle Sam isn’t very generous with it. The max you that one can put away in a standard IRA – either Traditional or Roth – as of 2017, anyway – is $5,500… or $6,500 if you’re 50 or over. That assumes, of course, that one earns at least that much income. So, the cap on any standard IRA is rather low, and for that reason alone, the standard IRA isn’t a great choice for many small business people who may have the means to contribute more than that each year.
That leads us to the SEP IRA, which is in almost every way, the same thing as a standard IRA, but it has an annual contribution limit of nearly 10x higher than a regular IRA - $54,000 per year – and that’s a beautiful thing for business owners who want to stash away a large chunk of money each year. Think of that… 10 years of maxing out SEP contributions and you’d have well over half a million in principle alone in your retirement account… very nice!
The SEP is specifically designed for small businesses and not available to others, but is otherwise easy to qualify for. But there are 2 things about the SEP that make it… shall I say… somewhat unattractive?
- First, the SEP comes only in the “Traditional” variety. If you want to use the “Roth” tax model with a SEP, you’re out of luck… unless, of course, you use the cunning and sneaky back-door Roth strategy. But that’s another can of worms we won’t open today, though I do address it with my characteristic panache in a previous episode of this very show, which is linked on today’s show page at SelfDirected.org/262
- Second, yes, the SEP has a $54,000 contribution limit. But that doesn’t actually mean you can contribute that much to it, even if your salary is large enough to support such a contribution. Why? I’m glad you asked! The SEP is technically a profit-sharing plan, not a salary deferral plan. So in addition to the $54,000 limit, there’s another limit: You can’t contribute more than 20-25% (depending on your business’ legal structure) of your business’ annual profit. So if you have a high salary and could easily make a large contribution, but your business is unprofitable, you won’t be able to contribute a single penny to a SEP!
Jeff, you asked if there was ever a time when it makes sense to have more than one type of retirement account. Well, here’s one of those times in the form of a little power-tip that many people don’t realize: There’s nothing preventing one from having BOTH a standard IRA and a SEP IRA. In fact, technically SEP contributions are not made BY you, but FOR YOU by your business, whereas standard IRA contributions are made directly by you. So you could max out a standard IRA every year, and on those years where your business is profitable, you can also have your business contribute the maximum allowable to your SEP as well.
But folks, if you qualify for a SEP IRA anyway… there’s a better tool to accomplish all of this more easily, with more flexibility and greater legal safety. And that is by using a Solo 401(k).
What is a Solo 401(k), you may ask?
It’s the Mercedes-Benz of retirement accounts for small business owners… superior to other options – head and shoulders above them – in every substantive way.
So here are the basics:
The Solo 401(k) is a simplified version of the standard 401(k). It is, in practically every way, a 401(k), except that it’s intended exclusively for small businesses where the only full time employees are also the owners or the owner’s spouses. It’s simple and inexpensive to set up a solo 401(k) and simple and inexpensive to maintain it.
But the Solo 401(k) has some huge, huge benefits over any type of IRA. Here are a few of them:
- First, it’s easier to put more money in them. With a Solo 401(k), you can contribute up to $18,000 per year – or $24,000 per year if you’re 50 or over – from your salary. No trifling with percentages of profit… it’s just a straight contribution from your salary. So right off the top, you can put away more of your salary into a Solo 401(k) than you can into any kind of IRA. But the beautiful thing is, once you’re done putting in as much of your salary as is allowed, THEN you can also put in more money in the form of a percentage of profit, just like with a SEP! The total contribution you can make to a Solo 401(k) for any year – including both salary deferral and profit sharing – is $54,000… or $60,000 if you are 50 or older. So again, the idea here is that you can put more money into a Solo 401(k) more easily than you can put into ANY IRA.
- Second, with a Solo 401(k) – unlike a SEP – you have the choice of using either the “Traditional” or the “Roth” taxation model. Actually, you can use BOTH taxation models and decide with each individual deposit whether you want to use the Traditional or Roth taxation model. This is a huge factor for many investors.
- Third, 401(k)’s are much safer in a legal sense than IRA’s. Broadly speaking, IRA’s are protected against lawsuits and bankruptcy, but only up to a point, and that point varies from state to state. 401(k)’s, on the other hand, are governed by federal law and have near-absolute protection against financial predators and bankruptcy… assuming you’re not committing fraud, of course.
- Fourth, if you are among the millions of Americans who recognize the value of investing in ALTERNATIVE assets outside of Wall Street, Solo 401(k)’s are far safer for such transactions. Alternative asset investing unfortunately gives rise to more common occurrences of so-called “prohibited transactions” – you can learn more about then on today’s show page at SelfDirected.org/262 – and the difference between committing such an error in an IRA versus 401k couldn’t be more stark. With a 401(k), the correction process is relatively simple and inexpensive. With an IRA, prohibited transactions can be nothing short of cataclysmic. And in fact, if you must use an IRA for alternative investments, it could make a lot of sense to have multiple IRA’s – a separate one for each higher-risk investment – since prohibited transactions in one IRA don’t affect other IRA’s you may own. But with a Solo 401(k), you really need not worry about such things, as repair and recovery from prohibited transactions is so much simpler.
- Fifth, if both you and your spouse work for your small business, your contribution limits are DOUBLED, and also… and this is HUGE… you can pool your funds together to do larger investments. This can be a wonderful thing, and is wholly prohibited within IRA’s.
Now Jeff – and all of SDI Nation – Look, there are actually even more reasons that a Solo 401(k) is an extraordinarily superior alternative to any type of IRA. In fact, I did an entire show about the distinction between Solo 401(k)’s and SEP IRA’s specifically, and if you’d like to listen to that, the link for it is on today’s show page at SelfDirected.org/262.
If you’re a small business owner, you really need to make sure you understand these options and their distinctions, because here’s the reality:
Many, many financial advisers have very little knowledge or experience with the Solo 401(k)… and the reality is that it is, generally speaking, the best option for anyone who qualifies to use it… which will include many small business owners. So you’ve got to make sure you know what you want, and ask for it specifically.
Furthermore, most advisers have little understanding of the astonishingly broad degree of flexibility that the law provides to you in terms of investing your retirement savings, whether in an IRA or a 401(k). Remember this: Almost without fail, any restrictions on your investments are imposed by your custodian, not by the law.
For IRA’s, the only absolutely prohibited assets are life insurance and collectibles. For you legal beagles, all of the citations you’ll need are on today’s show page at SelfDirected.org/262. So where IRA’s are concerned, if it’s not life insurance or collectibles, there’s a very high chance that it’s legally allowable. And frankly, 401(k)’s are even more flexible than that.
But that doesn’t matter if you place your IRA or 401k with a custodian that won’t allow you that type of flexibility. Look, the biggest firms… the Charles Schwabs, eTrades, Vanguards… they’re great if all you’re ever going to do is buy exchange-traded assets like stocks and mutual funds. But the law allows so much more… and it’s up to you to choose a custodian who will ENHANCE rather than ERADICATE your investment options.
There is, of course, a list of custodians who provide these types of accounts at SelfDirected.org/262.
Yes… I know that Scwab and eTrade and Vanguard claim to offer self-directed retirement accounts. But ask them if you can buy real estate or precious metals with their accounts, and you’ll find out just how self-directed they really are… or aren’t, as the case happens to be.
The only downside to using self-directed custodians rather than the more narrowly targeted companies I mentioned before is that the self-directed custodians tend to be more expensive. Rather than making money from charging you commissions on stock trades, for example, self-directed custodians will usually charge you based on the number of assets in your account, or sometimes they’ll charge on the basis of your account size.
So here’s a little tip for your business owners who want the ultimate in freedom and flexibility, with the lowest possible expense.
First, open up a Solo 401(k) – I recommend using the Great One, attorney Tim Berry – to set it up. His contact info is on today’s show page. But whoever you use, be sure to use a non-custodial plan so you don’t have to use a financial company as an intermediary because – surprise surprise! – it’s totally kosher with the law for you to serve as the administrator of your own solo 401(k) without having a a custodian involved, and frankly, there are some HUGE benefits to doing it that way, which I covered in a previous episode of this show and is linked at SelfDirected.org/262.
Now for step #2 to make sense, you must understand that your Solo 401(k) is, under the law, essentially just a specialized type of trust. And trusts are entitled to have financial accounts.
So step two is to open 2 accounts at your favorite brokerage – like Schwab, eTrade or Vanguard. One of them should be a money market account checking account to hold cash for your Solo 401(k), and the other account should be a trading account where you can buy and sell listed securities for your 401(k).
Step 3 is easy – when you want to buy conventional Wall Street assets, transfer the right amount of cash from your 401k’s money market account into the investment account, and buy the asset you want. And whenever you want to purchase alternative assets, use the check-writing feature associated with your money market account to purchase those assets in the name of your 401k.
There… problem solved. You avoid custodial fees entirely. You should probably still plan to spend a couple hundred bucks a year to make sure your plans remain up-to-date with any changes in the law, but it shouldn’t cost much more than that.
If for some reason you can’t use a Solo 401(k) – and if you have full-time employees than are not your spouse, you won’t be able to use the Solo 401(k) – then look at the SEP IRA… but only if your business is profitable.
Barring those things, go with a standard IRA.
So, SDI Nation – and Jeff Brown at US News & World Report – there you have the unvarnished truth about the types of plans that work best for small business owners.
So, folks… questions? Comments? Even… dare I say… critiques? You can drop those on me over at SelfDirected.org/262 in the comments area. Seriously, I love your feedback and would be delighted to hear from you.
That’s all for today, my friends, and remember this:
Invest wisely TODAY… and live well forever!
Bryan Ellis is host of Self Directed Investor Talk, America's #1 radio show and podcast for affluent self-directed investors. He's also an expert in self-directed IRA's, solo 401k's and turnkey rental property investing... at least, that's what his wife tells him 🙂 He's a contributor to well-respected publications like TheStreet.com, Entrepreneur and ThinkRealty. Bryan lives in metro Atlanta, Georgia with Carole Ellis - his wife, business partner and best friend - and his 4 children ranging in age from 2 to 19.