Episode 93: The Tax Reduction Tool That Many CPAs Don’t Properly Utilize

Apr 12, 2021

This Episode

Solo Episode

You Will Learn

– The benefits of a solo 401k
– How a solo 401k will relate to traditional IRAs
– Why you should consider starting a solo 401k now

Resources & Links

My favorite account type is the solo 401k.  Congress enacted special rules at the end of 2020 to allow anyone with self-employment income in 2020 to consider opening one up to the tax deadline in May of 2021.  Don’t needlessly pay more in taxes – see if a solo 401k could help!


Justin (00:00):
A few weeks ago, I was looking at a client’s tax return right before they were getting ready to file it. And they had received a $30,000 bonus that they were not expecting. Interestingly, this bonus came instead of coming on their W2 and being withheld upon, it was paid out as a 10 99 bonus. Some special rules passed by Congress. This past year allowed us in this instance to save a portion of that income in a way that reduced his overall tax bill by almost $3,000 with one easy move. So today I’m really excited to share with you more about the solo 401k and why this is my favorite type of investment account. Thanks for tuning in,

Justin (01:06):
Welcome to episode 93 of APM success. Today’s going to be a solo episode, tackling a topic that I’m hoping is going to potentially save you some money on your 2020 taxes. And if not something you can keep in your back pocket for the future, it’s a really versatile, a really powerful, a really unique type of investment account that has characteristics all its own. And I’m perpetually surprised that this account is not more popular. And I’m going to talk today about the solo 401k also known as the individual 401k. I frequently talked to CPAs for many of my clients who will recommend a different type of account called a SEP IRA. The SEP is inferior to the solo 401k in almost every way in my humble opinion. And let me also take this opportunity to say that all of the content following is just that it’s my opinion.

Justin (01:58):
It’s here for your entertainment and informational purposes. Only. This is not advice. This is not any type of formal analysis that I’m presenting to you that you should enact. So please don’t do anything financially or otherwise without consulting a personal CPA CFP investment advisor who understands your unique situation. So with that disclaimer, out of the way, what is the solo 401k? Why was I so excited when I saw this client situation, when I could save them money? You’re right out of the gate, a solo 401k is a one-person retirement plan. Just like it sounds at work you have a solo or you have a 401k or a four Oh three B set up by your employer. This is the same type of account. This type of account is one that allows you in conjunction with your employment to make contributions in either a pre-tax or a Roth slash after tax basis to save for the long run for retirement.

Justin (02:57):
I want to take a minute and explain some of the benefits of the solo 401k and how it’s a little bit different. The solo 401k is a specific type of account that applies to your self-employment income. So this could be a little bit of income from a side gig. This could be a more substantial amount of income from a locums engagement, or this could be all of your income. Maybe you’re a locums physician, or you have a business that the income generated is defined as self-employment income in its totality. So this type of account would allow you to save some amount pretax and thereby reducing your income tax paid in the year that the contribution is made. This is going to be a growing topic of interest because I was reading a little bit about Joe Biden’s proposed tax policy the other day.

Justin (03:48):
And there’s a lot of things that are still to be worked out. Corporate tax rates are going up and there’s some talk of individual tax rates for higher earners. Also going up, it’s unclear at what thresholds the most startling headline I read was that Hawaii, sorry for any physicians residing in Hawaii, they’re increasing potentially their state income tax rate to 16%. That’s one six which is still, it was approved by the state Senate the other day in a 24 to one margin, I believe. And it’s now wending its way through the legislative process. But the point is, if you make $400,000 in Hawaii, almost 48 grand of that is going to go to the state itself before you pay any social security before you pay federal income tax. So the point is tax savings strategies are probably as important as they may ever be for you right now.

Justin (04:38):
And they’re going to continue to potentially grow in their importance depending on this future tax policy. So that’s one of the reasons that I like the solo 401k. It gives you flexibility to reduce your taxes. Another reason, and this is more of a fringe benefit is it allows you to facilitate the backdoor Roth IRA. So for high income professionals, and this would be defined as if you’re married, making, having a modified, adjusted, gross income of somewhere in the low $200,000 range. If you make more than that, you can’t put money into a Roth IRA directly. However, you can do this thing called the backdoor Roth IRA. If you don’t have money already in a traditional IRA, some people out there, they have money in a traditional IRA and they want to do the back door, but they can’t. One of the benefits of a solo 401k is you can open this up, roll any traditional IRA, a SEP IRA, a simple IRA potential.

Justin (05:34):
You can roll those into a 401k, a solo 401k specifically, and then you can start to do the backdoor Roth. So it can open up this Avenue that may be otherwise not available to you. So a little bit about the individual 401k, how does it work? Who should be thinking about using it? As I mentioned, the 401k is a plan set up by your so in an individual 401k, this is when you are the employer. For example, an independent contractor you’re getting paid in 10 90 nines, maybe a K one with certain types of active income, you would be eligible to use an individual. 401K 401k in general is a type of plan in employees, lawyer, retirement plan governed by this set of rules, known colloquially as ERISA, which is, is an acronym E R I S a it’s the employee retirement income security act of 1974.

Justin (06:31):
So this was some legislation founded, you know, back in the seventies, that was the Genesis of which was to protect participants in employer retirement plans, specifically with corporate pensions, there were some weird shenanigans going on. Things were not clear and transparent. And Congress was trying to look out for the little guy and in so doing past URISA Arista has a lot of requirements for how 401k plans are to be administered. There’s a lot of rules, a lot of types of testing non-discrimination testing, as it’s known to make sure that the employer who opens it, doesn’t really stack a bunch of money for the owners of the company, to the detriment of what we’ll call the rank and file employees. This batch of laws also make sure that funding happens appropriately, that people who need access to their accounts to their investments, et cetera, can get that right access.

Justin (07:21):
If you violate ERISA, that’s a big problem. The department of labor is going to come after you and you don’t want to mess with the DOL the good news and why that relates to the individual 401k is that ERISA provides a lot more flexibility around this type of plan. So you don’t need to worry about a big long list of rules necessarily. It’s a shorter list. There are still some rules, but it’s a much easier to administer. And the rationale is, well, if it’s a solo 401k, and you’re gonna screw the little man or whatever, or administer your planning properly, the only person, the only person you’re hurting is yourself. So you’re incentivized to do this the right way. And so having said that there are some rules, some things you need to be aware of which I’m going to summarize, but you definitely should not try to, in my opinion, implement a solo 401k without qualified help, because there’s definitely some things to look out for your CPA at minimum is going to be involved to help you calculate the amount of money that you’re able to contribute and potentially a financial advisor or financial planner to put the plan in place, maintain it, invest the assets, et cetera.

Justin (08:27):
One other thing that I really like about you using an individual 401k, is it forces you to think like an entrepreneur, like a consultant, like a business owner and this mindset shift. When you start thinking about how do I earn some money that I can put into an individual retirement account, or sorry, an individual 401k. Okay. That is a shame. Yeah. A mindset shift that can pay significant dividends potentially in unexpected ways throughout the course of your life. So there’s two classes of physician that should definitely consider an individual 401k. If you don’t already have one, one is anybody who does locums work, meaning you’re getting paid by a 10 99 from an institution where you’re doing part-time locums medicine and that 10 99 income is self-employment income. It is unshielded from taxes in any way. There’s also no withholdings. And there’s also no retirement plan available to you with this hospital you might be working at because you’re not an employee, you’re an independent contractor.

Justin (09:30):
And so that income would be eligible for inclusion in a, an individual 401k contribution. The second type of physician circumstance that should consider an individual 401k is this is particularly common in the pain management space. When physicians have consulting arrangements where they’re collaborating with industry to you know, complete studies, teach workshops provide their intellectual capital for the development of devices, treatments, et cetera. Whenever you get these 10 90 nines from device companies, this is self-employment income. This is income that would qualify for inclusion in a, an individual 401k contribution. Here’s a few things that I really like about the solo 401k or individual 401k. And then we’ll get to a few case studies to try to help you kind of locate yourself in this story and see how this might apply to you. The first thing I like is that there are essentially no cost to open and fund an individual 401k.

Justin (10:39):
There are some companies that will open this account and perhaps charge you a nominal set-up fee. Others will charge really no fee. It’s the same as opening like a Roth IRA in their eyes. And so you can do it very affordably. Another thing that I really like is it allows you to raise the ceiling, the maximum amount that you can save on a pretax basis. You’re not subject to the traditional $19,500 limit. If, for example, I’m working at, you know, one of the big anesthesia groups, I’ve got a 401k that I can participate in the most I can save in that account is $19,000, $19,500 in calendar year 2021. That is the employee maximum deferral also known as an elective deferral. Now there’s also built into this 401k plan at anesthesia management company, ABC and employee ER, contribution, which they could do a profit share.

Justin (11:37):
They can do other have other mechanisms whereby they may be able to also contribute. The nice thing about a solo 401k is that although the employee portion, which that 19,500, you can only do that one time per tax year, no matter how many 401ks you participate in. So if hypothetically, you worked for USAP and envision at the same time as a W2 anesthesiologist, and you got paid $200,000 from each of those, you could only do 19,500 in total between the two 401k plans. However, there is a separate limit, a separate category of contribution, the employer contribution that applies on a per plan basis. Meaning if envision and USAP in this example, both said, we want to contribute 3% of your contribution. We want to give it to you as a match. Both of them can do that. And the limits are much higher up to, I think it’s $58,000.

Justin (12:38):
It’s adjusted for inflation each year, per plan, not per taxpayer. And this distinction is going to become relevant when it comes to the solo 401k. And here’s why if, instead of working for envision and USAP you work for USAP and you do some locums work, that is self-employment when you’re working for USAP you can do the 19,500 into their 401k plan. When you do locums work, you’re making another couple of hundred grand. You can contribute the employer portion into an individual 401k based on your locums income. So it’s going to be, and this calculation varies based on a few different factors, but for simplicity sake, we’ll call it 20% of your net income net business income in this case. So if you have $200,000 that you make as a locums physician, 20% of that, or $40,000, you can contribute into an individual 401k.

Justin (13:39):
So if we look at the big picture, now we’ve got 19,500 that you’re contributing into your employee. USAP income, 401k, as well as $40,000 that you’re contributing to the individual 401k. So 40 plus 19 five, that’s $59,500. That is obviously more than the 19 five that you could contribute at maximum as an employee, but because you’re an employee earlier in this instance of yourself, it does raise the ceiling. So that’s one thing to be aware of. I want to look at a couple of other examples in case studies to sort of flesh out how this will work. And one other thing to note before I do that is there’s no need for an LLC for an escort for any other entity was talking to a client recently. Who’s like, you know, I want to do this solo 401k thing. I want to get an LLC set up.

Justin (14:32):
I need an EIN, et cetera. And you can do that. And there are certain reasons, depending on which state you live in or other factors that that could make sense, but you don’t need an LLC. You don’t need an S Corp. You don’t need anything. You just need to be paid yourself as a self-employment or consulting income from any other entity and be issued at 10 99, claim that on your schedule C tax return. And then that will make you eligible to make contributions, to open and fund a solo 401k. So I want to look at a couple of other case studies. These are some situations that I frequently run into. Number one, we’ve got perhaps a pain management doc, who’s making $400,000 of W2 income with their practice. They’re an employee with a practice. They get W2 taxes withheld, and they participate in that 401k.

Justin (15:26):
They max it out at $19,500. They have an additional $150,000 of consulting income from teaching workshops, doing research, et cetera, collaborating with industry. This, this physician can do. In addition to the 19 five with their employer plan, an additional 20% of quote unquote business income, also known as that self-employment consulting income, which if it’s 150 K, that means they can do another 30,000 to the solo 401k as the employer contribution. And I find that physicians frequently forget, or just aren’t aware that any self-employment income does raise the ceiling of potential pre-tax contribution. If you’re, if you have self-employment income and you have the ability to save based on cashflow, and you’re not using a self-employment retirement plan in this instance, an individual 401k, you’re probably paying more in taxes than you need to. So you definitely need to investigate this further. Another instance, if we have and this is another case, it’s a little bit of a different benefit, but I do run into this use case frequently.

Justin (16:32):
And I want to just point it out. If we have, for example, a pain doctor in an academic setting perhaps has bounced around to a few different institutions. You may be having an old 401k and an old four Oh three B maybe from residency. Maybe you’ve got a traditional IRA that you rolled out an old 401k into a traditional IRA. You’ve got a lot of straggler accounts out there. What an individual 401k in this instance would allow you to do is consolidate, consolidate all these accounts. And in this specific instance, because this doctor has a traditional IRA, they’re not eligible to do a backdoor Roth IRA contribution, but if we find a way for this doctor to, you know, do literally anything to get some 10 99 income do some like medical surveys or a little bit of locums, or some other type of consulting arrangement, then you can open and fund this individual 401k.

Justin (17:28):
And when you do, you can take that old 401k, that old four Oh three, be that old traditional IRA and roll them all in, into this solo 401k. There’s a couple of benefits to this. Number one, is it unlocks the ability to do the backdoor Roth because that traditional IRA that we had funded is no longer a problem because it’s not there anymore. Another thing this is helpful for is in reducing costs, because if you’ve got a 401k at an old employer plan and another four Oh three B at an old academic center employer plan, those plans have plan fees associated with them. So you’re going to be paying more fees on average than if you just had your own type of account, which doesn’t have any fees in general baked into it. So this can be really helpful in feeding two birds with one stone.

Justin (18:18):
If you will, another case I want to look at, imagine you’re an anesthesiologist, you’re doing all locums anesthesia, maybe you’re doing part-time work shift work, making, call it $200,000 a year. This might be somebody who is doing a combination of traveling and, you know, doing locums to kind of cover your living expenses and save a little bit. You want to continue to save for retirement because you’re, self-employed, you basically have to create all of your own infrastructure as an employee slash employer. And maybe this person is using the SEP IRA because their CPA told them to, because CPAs love the SAP because in many cases, they just don’t understand how the individual 401k is superior to it. So in this example, the SEP IRA maximum contribution is 20% of net business income. So if this anesthesiologist makes $200,000 a year, what that means is they can save 40,000 into a SEP.

Justin (19:16):
Now there’s a couple of problems with this. Number one, the SEP contribution is inferior to the individual 401k. It’s a lower ceiling. And number two, this creates the same backdoor Roth problem. Once you have a SEP IRA, you can’t do the backdoor Roth anymore. So in this instance, if you have income and the 200 K range, you can use a solo 401k, this would allow them. Now, in this case, remember, I made this distinction between the employee and the employee or contribution for this case. I just described where the anesthesiologist is doing all locums work. They don’t have a separate W2 income floating around, out there where they’re doing an employer plan that they participate in. The only plan that they have is the plan that they create for themselves as a result. There’s two types of contributions they can make to this plan.

Justin (20:08):
They can do the employee contribution, also known as the elective deferral up to 19,500 that’s then going to reduce their 200 K down to 180,500. And then that lower number that 180, we can then apply the 20% of net business income to that number to get additional savings capacity. So we get the 19,500 and then an additional 36,000 as the employee or contribution for a total savings amount of 55,500. Now I’m just using round numbers. So my math might be okay, a little bit off here, but the point is a solo 401k allows 55,000 of tax reduction savings. Whereas a SEP IRA only allows for 40,000 of tax reduction savings. So we’re probably, we could be talking about, you know, a $5,000 tax differential, just because of using a different type of investment account that can be really big savings. So again, there’s many other specific case studies in which I find unique uses for the solo 401k.

Justin (21:14):
Definitely something to be aware of before wrapping up here. I want to give you a couple things to look out for that you want to make sure that you be careful to mind these rules. Like I said, there’s not a million rules. Like there is for a normal 401k program, but there are some rules by which you need to abide. The first is that you need to set up a plan by the end of the year in which you want to make a contribution. So for example, if you want to make a contribution based on 2020 income, you need to have the plan open by December 31st, 2020 in order to be able to offset that income. However, this is one big caveat that with some of the legislation that Congress passed before the end of the year, they actually extended the deadline this one year only to the new tax deadline.

Justin (22:06):
Meaning if you made money in 2020, some of it was self-employment income. You’re thinking, Holy cow, I love the idea of an individual 401k. I want to save some money in it right now, based on 2020 income, you can still do it. You have a bit of a window through March 17th, or I’m sorry, May 17th of 2021. So another month from the date of this recording, another month to open an individual 401k and fund it with some amount of money, and that will reduce your tax income for taxable income for 2020 going forward. Generally, you’ve got to open it in the tax year, by the end of the calendar year. And I will point out this is one area. And in fact, I think it’s the only area that I’m aware of, where the SEP IRA is better than the solo 401k, because the SEP, you can open up to the tax deadline, April 15th, the solo 401k you’ve got to open by December 31st.

Justin (23:01):
So if you don’t realize until March that you had some self-employment income, do you want to make some savings on it? Then you can open a SEP. You can fund the CEP that does create the backdoor Roth problem that I mentioned. But what you can also do is then open a solo 401k, as long as you’re still going to continue to have self-employment income, open the solo 401k at the same time fund to the SAP, roll the PSAP into the solo 401k, and then use the solo 401k ongoing. So that can be a little workaround. Another thing to be aware of is if you’re using an individual 401k, there’s a balance above which you need to do an extra regulatory filing. That balance is a quarter million dollars. So 250,000. If you have an individual 401k with more than $250,000, then in the eyes of the department of labor, you’re sort of getting called up to the big leagues.

Justin (23:51):
You have sufficient assets that they want to be aware of you, and they want to regulate you a little more closely. Now it’s not a big deal, but you do need to fill out this form called the 5,500. What that is is it’s a regulatory disclosure required under ERISA to the department of labor that says, here’s the plan. Here’s the name of the plan? You know, the John Smith MD individual 401k plan. Here’s the number of participants. Here’s the amount of money in the plan. Here’s the amount of money that’s been rolled out, et cetera. So that it’s an administrative disclosure that has to happen every year. It’s not a big deal, but it is something that needs to happen. You need to make your CPA aware of that. And then you need to file that every year that your balance is in excess of that quarter.

Justin (24:35):
Another thing to be aware of is you can’t do this. If you have employees, now, there is an exception for spouses. If it’s you and your spouse in the same business, you can have a solo 401k for each of you and make these contributions. But if you are a physician with a practice and you’ve got an NP in two MAs, you can’t just open a solo, 401k and contribute to it for yourself and not give access to it, to other employees, the department of labor doesn’t like that for obvious reasons, you’ve got to look out for your employees too. And so you have to have a more what I’ll call a traditional 401k set up. Another thing to be aware of is if you’re thinking, Oh man, I’ve got a traditional IRA and I hate it because I can’t do the backdoor Roth right now because I have a balance and you’re thinking I can open a solo 401k.

Justin (25:24):
That can be the answer you want to make sure that the solo 401k that you open allows for roll ins, which is when you take that traditional IRA and you roll it into this old 401k that you’re planning, how’s that each customer, I was going to handle this a little differently, whether you open it at TD Ameritrade or fidelity or Vanguard, or E-Trade not every one of these custodians and the plan docs that they provide, they don’t all handle that the same. So I do most of my individual 401k work at TD Ameritrade on the institutional platform. They do allow for this and it may be the same on the retail side, fidelity, Vanguard trade. I know that there is more I’ll call it diversity of perspective on this and not all the plan docs allow for a roll ends. So if that’s something that’s really important to you, you want to make sure you’re aware of that.

Justin (26:14):
I hope this has been helpful. This is a somewhat technical topic. There’s a lot of numbers, try to use as many stories as possible to illustrate why the solo 401k is for me, my very favorite investment account. So if you have any other questions or you’re interested in learning more, you can shoot me an email send it to the advisory side, justin@apm-wealth.com. We’d be glad to hear more about your situation and see if I can help illuminate anything for you as always thanks for your time and attention. I don’t take for granted that you take time out of your busy day. You dedicate attention to this show and listen to me ramble on for 30 minutes about some kind of technical

Justin (26:52):
The topic. Thank you very much for tuning in, and I look forward to speaking with you next week. If you liked what you heard this week, I don’t over to APM success.com, where you can find more content and free resources to help you build a successful career in anesthesia and pain management. If you want to leave a review in iTunes, that also really appreciate it. Thanks for using some of your valuable time to join me today on APM success.