Let me start by saying that I love the 401(k) plan. It’s the single best wealth accumulation vehicle available to the vast majority of Americans. At today’s contribution limits, you can defer up to $18,000 of income — and $24,000 if you’re 50 or older — tax free. And many companies offer corporate matches dollar for dollar (most companies match the first 20-60% you save.)
That’s great for middle-class Americans, and many can contribute the maximum allowed with a little bit of discipline. But if you have an annual income of $500,000 or more, that amounts to a paltry savings rate of less than 4%. Any savings above that amount would be subject to punishingly high taxes…and even the dreaded Obamacare surcharge.
Well, I have good news. If you earn a high income and own your own business (or are paid as a 1099 contractor), you have vastly superior savings options at your disposal. If done right, you can save well over $100,000 per year in tax-sheltered accounts.
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This strategy is designed for the self-employed, but it can also work if you get a paycheck but also earn additional income from a side business or additional contract income. A lot of doctors and consultants would fall under this umbrella.
We all know that the traditional defined-benefit pension is dead. The days when your employer guaranteed you an income for life are now something we read about mostly in history books.
Well, that might be true for corporate plans. But there is nothing stopping you from starting your pension for yourself and your spouse.
The One-Man Pension
The best retirement savings strategy is actually a combination of two separate vehicles:
1. An Individual 401(k) plan, which consists of regular salary deferral and additional profit sharing based on your company’s profit for the year.
2. A cash-balance, defined-benefit pension plan.
I’ll tackle the Individual (“Solo”) 401(k) plan first. Most investors consider a Solo 401(k) plan to be more or less interchangeable with a SEP IRA.
They’re wrong.
While both plans max out at $53,000 per year in contributions, the Solo 401(k) allows for front loading. Let’s look at an example. Let’s say your business earns $100,000 in net income. With a SEP IRA, you can contribute 20%, or $20,000, tax deferred. This is a profit-sharing contribution made on your behalf by your employer…which happens to be you.
With the Solo 401(k), you can make that same profit-sharing contribution of $20,000. But you can also defer $18,000 of salary, for a total of $38,000.
Of course, we’re talking about high-income earners, and both the Solo 401(k) and the SEP IRA max out at $53,000 on incomes of $265,000.
So, if you earn $265,000 or more, the SEP IRA and Solo 401(k) are interchangeable, right?
Wrong!
If you save via a Solo 401(k), you are also eligible to contribute to a defined-benefit plan. If you save via a SEP IRA, you cannot.
This brings me to the second prong of the retirement plan, the single-person defined-benefit plan.
Yes, you can actually make a traditional pension plan…for yourself. There are administrative fees involved, and you’ll want to hire a professional to draft the plan documents and monitor compliance. But doing all of this opens the door to massively increasing your retirement savings if you can afford it.
Annual contribution levels here depend on your age and other actuarial assumptions, but the chart below shows how they shake out. The contribution limits depend on two main variables: age and income. That’s very different from IRAs/401(k)s, so it takes some getting used to. These are sometimes (though not always -- see a list of exceptions here) insured by the Pension Benefit Guaranty Corporation.
Putting It All Together
Combining the Solo 401(k) with the cash-balance, defined-benefit plan is complicated, so I can’t stress enough the importance of hiring a knowledgeable pro to set it up correctly. But here are the basics.
Normally, you can contribute $18,000 in salary deferral and 20% of profits to a Solo 401(k) plan, up to a maximum of $53,000. But if you also contribute to a cash-balance pension plan, your profit-sharing percentage gets bumped from 20% to 6%. That effectively drops your $53,000 contribution to $33,900 if you’re under 50 and $39,900 if you’re 50 or older.
But here’s where it gets fun. If you’re 65 years old, your combined contribution to the Solo 401(k) and cash-balance pension is a whopping $284,400 ($244,500 cash balance + $39,900 401(k) plan). The numbers get smaller the younger you are, but at age 35 you can still contribute a not-too-shabby $102,200. (Breaking out the math, this is $18,000 in salary deferral, $15,900 in salary deferral at the maximum 6% rate, and $68,300 in defined-benefit contributions.)
Is There a Downside?
So, stashing away hundreds of thousands of dollars per year sounds pretty great, right? What’s the catch?
Believe it or not, there really isn’t one, assuming you earn a high enough income. This isn’t for everyone. You have to own your own business (or earn significant contract income), and you need to have a high income for this to make sense. If the business has any employees, contributions must also be made for them, which can be very expensive. And there are other costs. Expect to pay $2,000 to $3,000 in administrative expenses. But if you fall under this umbrella -- and if you’re eager to shield some of your savings from the tax man -- this is the best combination I’ve seen.
Charles Lewis Sizemore, CFA, is chief investment officer of the investment firm Sizemore Capital Management and the author of the Sizemore Insights blog.
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