The solo 401K can be a great retirement plan for independent EPs
I still don’t understand how emergency physicians can be classified as independent contractors. While you have some say in your shift schedule, you’re bound by rules you can’t control: you’re told how to do your job, how you’re paid, etc. That’s against the IRS definition of an independent contractor.
Nevertheless, many emergency physicians are classified as independent contractors, and one of the benefits of this status is the type of retirement plan you can set up. While many of you have SEP IRAs, you should strongly consider setting up a solo 401(k). The fact that it’s a 401(k) might discourage you, but I’m going to lay out the fundamentals of this great option and also discuss some advanced strategies.
The basics of a solo 401(k)
Like a hospital-sponsored profit sharing or 401(k) plan, the solo 401(k) is a qualified retirement plan. This means it has to comply with the complex IRS rules and regulations to allow you to make contributions on a tax deferred basis. While that seems daunting, if you open a “prototype” solo 401(k) at any of the major institutions (Fidelity, Vanguard, etc.) these plan documents are pre-packaged for you and have already been scrutinized and approved by the IRS – which means you don’t need to hire a retirement plan specialist to draft anything.
Unlike a large employer, with a solo 401(k), only you and your spouse can be part of the plan. This is generally not an issue with EPs.
Once you’ve got the plan document, the application to open a solo 401(k) consists of an adoption agreement (stating that you’re adopting the plan), your personal information, the title of the plan, and beneficiary designations. That’s basically it. While that’s more involved than opening a SEP IRA, it’s really not that bad. You have to open the solo 401(k) by December 31st to contribute to it for that calendar year.
The solo 401(k), like an employer-sponsored profit sharing 401(k) plan, consists of two types of contributions. The first is the employee contribution (called an elective deferral) and the second is the employer contribution (called a discretionary contribution, not a match). The maximum employee contribution for 2012 is $17,000, and the combined employee and employer contributions cannot exceed $50,000 for 2012. If you’re over age 50, you can make an additional $5,500 employee contribution (known as a catch up contribution) so if your income is high enough, you can contribute $55,500 total this year.
That’s a pretty sweet deal.
At this point you might be wondering what the employer contribution refers to since it’s just you, but if you formed a corporation then the employer contribution comes from your corporation. Even if you’re a sole proprietor, you can still make an employer contribution.
Speaking of your classification as either a sole proprietor or a corporation, while there’s a maximum contribution limit, this also depends on your income, and that also depends on your classification as a sole proprietor or an employee of your corporation.
Let’s take an example to show you the difference.
Suppose you formed a corporation and you take a salary of $200,000 from it. You can contribute $17,000 as an employee contribution, but the rules limit your employer contribution to 25% of your salary, in this case $50,000. However, the combined employer and employee contribution can’t exceed $50,000 total so your employer contribution is limited to $33,000.
If you’re a sole proprietor (you don’t have a corporation), the rules are a bit different. You can still make the $17,000 employee contribution. Since you don’t have a salary, your employer contribution amount is based on the net income you make. This means that you take your gross physician income, subtract your business expenses, deduct half of your self employment tax, and then multiply that amount by 20%. So if your net income is $200,000 then your max employer contribution is $40,000. Again, this is subject to the combined max of $50,000.
The deadlines for contributions are also different depending on whether you’re a corporation or a sole proprietor. For a corporation, your employee contribution deadline is generally January 15th of the following calendar year, and the employer contribution deadline is generally March 15th of the following calendar year. For a sole proprietor those deadlines are generally April 15th.
So what financial planning strategies can you use by having a solo 401(k)? First, since you can open an account at almost any custodian, you’re not limited to just a few mutual funds. I’ve looked at many employer sponsored retirement plans, and most of the mutual fund choices just plain suck. They’re loaded with high fee funds and limited choices. With a solo 401(k), you have wide open choices that you control.
Second, you can designate your employee contribution as Roth 401(k) contributions. This means that you won’t get a tax deduction for these contributions, but the gains grow tax free and withdrawals are tax free. It’s like contributing to a Roth IRA (with some additional rules) regardless of the income you make. Note that while Roth IRA contributions are limited to $5,000 if you’re under age 50, the Roth 401(k) limit is much higher – $17,000. Since most physicians can’t contribute directly to a Roth IRA anyway, this becomes our way of taking advantage of the Roth tax structure. When you retire or stop practicing medicine, you can then rollover the Roth 401(k) portion into a Roth IRA and let it continue to grow tax free.
Third, if you work part time in emergency medicine, then the solo 401(k) allows you to sock away more money than a SEP IRA. Suppose you’re a 52-year-old sole proprietor, work 8 to 9 shifts per month and make $150,000 in net annual income. You can contribute $22,500 as an employee contribution ($17,000 plus $5,500 catch up over age 50) and then an additional $30,000 as an employer contribution for a total of $52,500. With a SEP IRA, the employee contributions don’t exist so you’re limited to $30,000.
There are also other benefits, such as providing a bit better asset protection over IRAs. And also allowing you to shelter money in a 401(k) structure so you can convert IRAs to Roth IRAs. You can also take loans from a solo 401(k) (though not recommended) whereas IRAs generally don’t allow loans.
While the benefits are big, there are some downsides you should know:
- There is extra time and effort associated with opening a solo 401(k)
- Once the plan assets reach $250,000 you will need to file an annual IRS form showing the plan’s assets. If you fail to file this form, you could potentially face hefty penalties
- As plan assets grow, you may need a third party administrator, resulting in an additional annual fee
As I’ve hopefully laid out, I think the benefits of having a solo 401(k) outweigh the downsides and provide a wonderful opportunity for you to save for your retirement.
Setu Mazumdar, MD practices EM and he is the president of Lotus Wealth Solutions in Atlanta, GA www.lotuswealthsolutions.com