What Self-Employed Financial Advisors Should Know About Retirement

8 min read
June 22, 2020

I’ve written before about how to pay yourself as a self-employed firm owner, but today, I’m going to look beyond the present and explore how you pay yourself in the future—yup, you guessed it, I’m talking about retirement.

Here’s what I won't do in this post:

  • Give advice on how the funds you decide to put towards your retirement will/can/should grow (hey, that’s your arena, not mine).
  • Discuss strategies of Roth versus traditional other than to say they exist and the tax benefits occur at different times.

Okay, I lied. I’m actually going to talk about that second part right now. Excluding pensions (also referred to as defined benefit plans—more on this later), there are basically two tax methods of squirreling away money for retirement: traditional and Roth.

Traditional basically means you get a tax benefit now—you are saving pre-tax dollars, and will pay tax on that money when you take it out in retirement. With Roth, it's the opposite—you are putting away after-tax dollars and will enjoy taking the money out tax free (assuming you meet all the requirements).

Now that we have that out of the way, here’s what I will do in this post:

  • Discuss our three most common tax entities: individuals, Schedule C/sole proprietorship/single-member LLC, and S corporations (based on the number and type of tax returns XYTS has worked on for tax year 2019).

Plain Ol’ W-2 Employee

Just to keep things fun, let's say you aren't actually a self-employed firm owner, but rather a financial advisor working at someone else's firm. For the most part, you’re at the mercy of your employer. If you’re very lucky, you’ll have a defined benefit plan, sometimes called a pension. These have pretty much gone the way of the dodo unless you’re working for the government.  

It’s just what it sounds like—after you put in the requisite number of years, your employer pays you a certain amount of money (and/or benefits such as health insurance) for the rest of your life, regardless of how much you may have contributed to your own retirement. This is generally very expensive for the employer, which is the one of the biggest reasons why they are few and far between.

If your employer does offer a 401(k) and you participate in the plan, the tax benefits will be taken care of through your withholding versus on your tax return. This means you generally have less income tax withheld each paycheck than you would have otherwise, and you do not claim a deduction on your tax return. If you have designated your contributions as Roth, you neither see a deduction on your tax return nor is your income tax withholding adjusted on your paycheck. In both cases, if your income is below a certain level, you could qualify for a retirement savings contribution credit.

You can also contribute to an IRA: traditional or Roth. Your overall income level will dictate whether you can directly contribute to a Roth IRA or not. (From the number of Form 8606’s we filed this year I feel like everyone is familiar with the backdoor Roth contribution.)

There is no income level that prevents you from contributing to a traditional IRA, but if you’re covered by a retirement plan through your W-2 employer and exceed certain income levels, you may not be able to deduct the contribution on your tax return.

Because these are both individual accounts, you initially fund them with after-tax dollars (meaning your W-2 withholding isn’t adjusted), so if you do qualify for a deduction based on your contributions to a traditional IRA, you’ll see that on your tax return. Deductibility aside, the max contribution is $6,000 for 2020 (the amount generally increases each year or two and taxpayers past a certain age are allowed to contribute a bit more as “catch up”). 

Schedule C

As a Schedule C owner, you aren’t on payroll, so any retirement account you contribute to, if there are current year tax benefits, won’t be seen until you actually file your return. Or your quarterly estimates could be adjusted if that’s something you’re into. Let’s keep things from getting too complicated by assuming that you don’t have any employees. 

IRAs are the same, so let’s move right along.

SEP (simplified employee pensions)

A SEP is a traditional IRA that is eligible for employer contributions. As the owner, you can contribute up to up to $57,000 (in 2020) or 20% of self-employment income, net of deductible self-employment tax, whichever is less. You can make the contributions up until you file your tax return. But you also have until you file your tax return to establish the plan (including extensions!).  

This is great news if you didn’t think about retirement until after December 31. However, a major downside is that there isn’t an employee contribution portion, so the $19,500 elective deferral doesn’t play with the SEP. You will see a deduction for this contribution on your Form 1040, which reduces your taxable income.

Because a SEP is in fact a traditional IRA, you can make your “regular” annual traditional IRA contributions to this account on top of the employer contributions (those that were based on your Schedule C net profits). However, if you do, keep in mind this counts towards your overall annual limit for contributions to traditional and Roth IRAs. 

Solo 401(k)

The first thing to remember about a Solo 401(k) plan is that it is, in fact, a 401(k) plan—all the same limits apply, you just get a break on a lot of the administrative requirements. You can contribute up to $19,500 (in 2020) in deferred compensation as the employee, and you can contribute up to 20% of self-employed income net of 1/2 of self-employment tax as the employer or $57,000 (for 2020), whichever is less.

Now, if you happen to also be a W-2 employee somewhere else and you have already deferred $19,500 to that 401(k), you can’t defer another $19,500, but you can still make the 20% employer contribution. Not only can you contribute to this type of plan as the “employee” and the “employer”, but you also have until your return is due (including extensions) to make both contributions.

Be careful though. If you ever decide to have your single-member LLC taxed as an S corporation, your timeline for the employee elective deferrals changes. When you file your taxes, you’ll see a deduction in arriving at taxable income in the amount equal to the employee contributions and the employer contributions. You do have the option of designating the contributions to this account as Roth. However, if you do this, the deduction for arriving at taxable income will only be equal to the employer contribution amount. This type of plan needs to be established by the end of the tax year, so even though you have until the return is due to make the contributions, the plan needs to be set up no later than December 31 of the year in question.

S Corporation

For simplicity, we’re again assuming you are the only employee at your firm.

Again, IRAs are the same, so we’ll spend no more time on that.

SEP (simplified employee pensions)

SEPs are pretty much the same, but replace the 20% of self-employed income bit with 25% of compensation. As an owner of an S corporation (S corp) who works for that S corp, you already know that you’re required to pay yourself a wage and that it must be reported on a W-2. These W-2 wages are what count as compensation when determining the 25% of wages SEP contribution limit (don’t forget about the $57,000 alternate limit). Distributions, draws, dividends, loan repayments, none of that counts in arriving at 25% limit, just wages.  

S corp owners, their CPAs, and their financial advisors perform a tax balancing act by keeping their W-2 wages low enough to maximize FICA tax savings while still maintaining a “reasonable compensation” level. If you are retirement savings minded you will also need to throw in the cost of paying more FICA tax (to increase wages) so that you can put away more money towards retirement.  

Just like a SEP for a Schedule C business, there aren’t “employee” contributions per se, but you can contribute to your SEP IRA just as you would a traditional IRA. The employer contribution will be a deduction on your S corp’s Form 1120S, reducing the ordinary income that gets passed out to you in Box 1 of your K-1, thereby reducing your overall taxable income.

Solo 401(k)

Again, pretty much the same, but the HUGE thing to watch out for here is the timeline for the employee deferral portion of the contributions to the account. As a Schedule C entity, you can make the employee deferrals AND the employer contributions by the time the tax return is due (plus extensions); for an S corp, however, the employee deferrals are due “as soon as reasonably possible, but no later than 30 days after the end of the month to which the contribution relates.” This means if you decide to make your entire deferral with your December paycheck, that whole deferral amount needs to be put into your Solo 401(k) account no later than January 30 of the following year. You will still have until the tax return is due (plus extensions) for the employer contribution to be deposited into the account.

This is particularly surprising to business owners when they transition from a Schedule C or single-member LLC entity to an S corp. Like the SEP, the employer contribution will be a business expense that impacts Box 1 of your K-1, thereby reducing the owner’s taxable income on his or her Form 1040. The employee’s elective deferrals will be taken into consideration when withholding is calculated with each paycheck. Again, you do have the option of having these treated as Roth contributions. And of course, this type of plan needs to be set up before the end of the year, no change from the Schedule C plan establishment timeline.

This is by no means an exhaustive list of all the retirement options available to you; these are just the ones I’ve seen most frequently this year at XYPN. If you have questions about the tax implications of any of these types of plans, or any other plan you might be curious about, get in touch with me or XYTS Managing Director Michael Law.

Jason Brown

About the Author

Jason Brown, XY Tax Solutions’ Senior Tax Manager, is nerdy even among CPAs. He enjoys tax research and doesn’t mind spending a nice evening at home with the Internal Revenue Code. Perhaps that’s a bit of a stretch, but he certainly spends a fair amount of time reading federal and state tax laws, and even the occasional court case. While knowing tax laws for the sake of knowing them is reward enough itself, he also finds job satisfaction in being able to interpret tax rules and regulations for clients in a practical, meaningful way in an attempt to help clients shift their tax mindset from a once-a-year splitting headache to a proactive and strategic approach.

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