Opportunities For Planning with Self Employment Income

Many of our clients receive Self Employment income each year, which is to say income earned from a business as a sole proprietor, independent contractor, or through some form of partnership or Limited Liability Company (LLC).  For some, this income is generated from a business with no other employees, or through a side business.  Perhaps it comes from a consulting engagement in a related field to their primary business or a part-time job in retirement.  Regardless, business owners with no employees and Self Employment income have some unique planning opportunities.

While most people think of qualified retirement plans, such as 401(k)s, as tools used for larger organizations, the reality is that they can be used in their various forms for businesses of any size including single person businesses.  While some will be best suited by simple SEP or SIMPLE IRA plans, others may benefit from more complex strategies.  When properly structured and utilized, these plans can mean significant tax benefits, improved creditor protections, and other benefits for the owner.  Since there are no other employees there are no required contributions to others and very limited testing requirements.  These types of situations are best suited to individuals that have excess income that isn’t needed or individuals that have large amounts of liquid non-retirement assets, like cash and securities.

Let’s look at some examples:

Case Study #1

Jane, age 50, recently sold her business at the end of last year, netting her $3 Million.  After the sale, Jane began consulting for a friend’s business in a related field.  Jane makes $175,000 a year as a consultant and is paid via 1099.  Her income, while enough to live comfortably, is generally fully consumed each year to cover her living expenses. Her business sale proceeds, along with her other long-term savings, are intended to fund her retirement.

Jane put together an Individual 401(k) plan (also called a solo(k) or an i401(k)) that allows her to contribute $26,000 as a personal deferral, plus a profit-sharing contribution of up to 25% of her net self-employment income.  Jane also set up a Cash Balance Pension Plan that allowed her to contribute over $80,000 on a pre-tax basis.  Additionally, Jane added a voluntary after-tax contribution feature to her Individual 401(k), which allows her to add additional funds to her plan balance, but without a tax deduction.  She will use this option to bring her total 401(k) contributions up to the maximum section 415 limit ($58,000 in 2021 plus $6,500 Age 50 and over catch-up contribution for a total maximum contribution from all sources of $64,500).  She also built in the ability to convert these after-tax contributions to her Roth IRA, thereby giving her about $30,000 of Roth after-tax funds that will grow tax free into the future (subject to certain requirements).

In all, Jane’s total taxable income was reduced by over $110,000.  By getting funds into ERISA based plans she now enjoys some of the strongest creditor protections available on these funds.  Since her income was needed to support her living expenses, she utilized the proceeds from her business sale to help balance her funding and spending needs, thereby making this a cashflow neutral event for her household budget.  She can continue this strategy for as long as she has liquid assets to support it and Self-Employed income.

Case Study #2

Joe, age 55, works as an executive for a large manufacturer, though he only works part-time as he begins winding down his career.  He receives W-2 Income of over $750,000 a year from this role, which is more than enough to fund his family’s lifestyle.  He also consults for two other businesses, earning him an additional $550,000 combined in 1099 income each year.  His goal is to get this excess income working for him while also lowering his tax obligation.

Like Jane, Joe also sets up an Individual 401(k) with an attached profit sharing and Cash Balance Plan.  His high level of Self Employment Income allows a total tax deductible 401(k) contribution of over $40,000, after tax contributions of over $20,000 (later to be converted to Roth) and a Cash Balance Plan contribution of over $200,000.  In all, Joe has over $250,000 of tax deduction and a $20,000 Roth balance that will grow tax free into the future (subject to certain requirements) in the first year alone.

Conclusion

These strategies are not without their complexities.  The intricacies of plan design and funding calculations requires the assistance of a professional Third Party Administrator, which comes at a cost.  Depending on the income level and amount of other liquid assets available, that cost may be more than the tax savings. There are also certain funding requirements that need to be planned for carefully before establishing a strategy.  Every situation is different, requiring a thorough review of your individual facts and circumstances to determine the most effective path forward.  However, when properly structured, executed, and maintained these more complex planning strategies can be very useful to the right individual.

DISCLAIMER: Jane and Joe are fictional characters.  Actual contribution rates and tax benefits will vary based on specific facts and circumstances.  Please consult your tax advisor for tax related advice.