Increased 2009 401k Contribution Limits

January 14, 2009

In developing a plan for my 2009 goals, I stumbled upon some changes to the 401k contribution limits in 2009. I currently don’t participate in my company’s 401k, but I set up a Vanguard Individual 401k for my self-employed income. Depending on my level of self-employed income in 2009, the following changes may affect my maximum contribution amount.

2009 401k Contribution Limits

The 2009 salary deferral contribution is limited to $16,500 if you’re under 50. If you’re over 50, the 2009 salary deferral contribution is limited to $22,000 ($16,5000 plus a $5,500 catch-up contribution). This results in a $1,000 increase in the salary deferral contribution and a $500 increase in the catch-up contribution when compared to 2008.

Total contribution limits also increased for 2009. If you’re under 50, total annual contributions (salary deferrals and employer contributions) max out at $49,000, which is increased from $46,000 for 2008. If you’re over 50, total annual contributions max out at $54,500, which is increased from $51,000 for 2008.

Individual 401k Maximum Contribution Limit

My Individual 401k maximum contribution limit is roughly calculated in the following way (for a sole proprietor under the age of 50):

  • If you’re net income is less than the salary deferral contribution limit ($16,500 for 2009) you may contribute your entire income reduced by 1/2 of your self-employment tax.
  • If your net income is greater than the salary deferral contribution limit, you must calculate your net compensation.
  • Net compensation is net profit from IRS Form 1040 Schedule C with 1/2 of your self-employment tax removed.
  • As a sole proprietor, you may contribute up to 20% of your net compensation in addition to the salary deferral contribution with a maximum value of $49,000 in 2009.

A plan contribution calculator from Vanguard can be found HERE.

Conclusion

Although I doubt I will earn enough self-employed income to reach the salary deferral limit, it’s always good to know what the limit is so you can plan accordingly. Between maxing my Individual 401k and my Roth IRA contributions, I have a lot of work ahead of me for 2009.

For another resource on the new 2009 401k contribution limits:

Increased 401k Contribution Limits in 2009 by Cash Money Life.

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New Vanguard Individual 401k For Self-Employed Retirement Savings

November 11, 2008

Previously I blogged about the different self-employed retirement accounts and the different options for opening a solo/individual/self-employed 401k. I’ve been waiting for Vanguard to unveil an individual 401k to begin investing my self-employed income in a retirement plan. I originally heard rumblings of Vanguard launching it’s first individual 401k at the beginning of November. Today was the first day I was able to find any information on Vanguard’s website. I’m pretty excited about opening a Vanguard individual 401k and will do my best to detail the account details and benefits below.

Eligibility

Individual 401ks are available for self-employed individuals such as, sole proprietors and LLCs. This retirement plan will cover the plan administrator, partners and the spouse of the business owner. This plan does not cover individuals with common-law employees such as children. There are also no age and service requirements.

Contributions

Plan administrators set-up an individual 401k plan and administer the plan through Vanguard Small Business Online. There are three types of contributions allowed: employee salary deferral contributions, Roth salary deferral contributions and employer contributions. This means Vanguard offers a Roth individual 401k for those who prefer to invest after-tax money. The Roth individual 401k does not have income restrictions like a Roth IRA. Total contributions for a fiscal year are $46,000 or $51,000 with catch up contributions.

Sole proprietors may contribute up to 20% of net compensation. I am able to defer up to $15,500 as my employee contribution and up to an additional 20% of my net compensation. I will be able to contribute nearly 100% of my self-employed income. I am still on the hook for one half of the self-employment tax.

Investment Options

The investment options are the reason why I have waited patiently for Vanguard to launch an individual 401k. There are over 70 Vanguard funds available for retirement investing. None of these funds have sales commissions. Vanguard is notorious for delivering mutual funds with minimal expense ratios. They also provide target retirement funds and LifeStrategy funds. Target retirement funds automatically move funds from stocks to bonds as you get closer to retirement. LifeStrategy funds vary the ratio of stocks to bonds to cash reserves depending on how aggressive you want to be and how far away your savings goal is.

Account Management

Employers will be able to manage the retirement plan through Vanguard Small Business Online. Employers will be allowed to make contributions, review the transaction history and download forms via this online interface. Employees will have access to account balances and planning tools.

Plan Administrator

A plan administrator must be designated for an individual 401k who must maintain records and submit reports (including Form 5500 when income exceeds a certain level). As a sole proprietor I would be the plan administrator, however, they recommend a co-plan administrator to act in the absence of the plan administrator.

Fees

Vanguard will not be charging an account initiation fee to the employer and there is no minimum investment to open the account. Some funds do have minimum initial investments. Vanguard mutual funds average expense ratios of 0.20%, which is always applied. An account service fee of $20 is required per year for each Vanguard fund in the account. The account service fee is waived when you become a Voyager member (total account assets of $100,000). Only two Vanguard funds charge purchase fees, however, a slightly larger number charge redemption fees if you remove funds within a certain time period.

Distributions

For individual 401ks, the standard distribution penalties and rules apply. If you are under 59.5, you will be subject to taxes and IRS penalties unless you meet certain restrictions. If you are between the ages of 59.5 and 70.5 you are only subject to income taxes. If you are over 70.5 the IRS requires minimum withdrawal distributions. For Roth individual 401ks, the standard distribution penalties and rules apply. If you are under 59.5 years of age or it has been less than 5 years since the first contribution, your money may be subject to income taxes and penalties. If you are over 59.5 years of age, distributions are tax free. At age 70.5, the required minimum distribution kicks in.

Now What

I have to set up my individual 401k by December 31st in order to participate for fiscal year 2008. I still have until the income tax filing date to fund the account for 2008. The website has a link to request a Vanguard individual 401k New Account Application either online or by mail. The link currently is not working. I will call the small business unit of Vanguard tomorrow to request an account application as I have been waiting for awhile to open this account and would like to get the ball rolling so I don’t miss the December 31st deadline.

In my opinion Vanguard is the best place to keep your retirement accounts. I already have my Roth IRA with Vanguard and am thoroughly enjoying the bare bones expense ratios. I’m currently reading Bogle’s book on mutual funds, which hammers home the point of keeping all costs to a minimum, and he certainly follows through on that at Vanguard. I will keep you all updated when I have more information regarding the application process.

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Estimated Taxes For The Self Employed And How To Avoid Them

September 26, 2008

I began tutoring in November of 2007 to supplement my income and boost savings towards my condo down payment. My 2007 income tax return only included two months of tutoring income, which was not long enough a period of time to worry about estimated taxes. In 2008 I will have a full year of self employed income, which will require me to make estimated tax payments, or will it?

Estimated Tax Payments

Estimated tax payments are required by the IRS if you expect yourself to owe the government more than $1,000 when you file your income tax return. Estimated tax payments are due using the following quarterly schedule:

  • 1st quarter due date – April 15
  • 2nd quarter due date – June 15
  • 3rd quarter due date – September 15
  • 4th quarter due date – January 15

Most of the time estimated tax payments are associated with self employed individuals. This is because self employed individuals don’t have taxes already withheld from their income. Under some circumstances a standard W-2 employee will have to worry about making estimated tax payments. This scenario occurs when an unusually large bonus is received,  irregular income is incurred from the sale of stocks or you manage to catch Barry Bonds’ record setting home run.

Penalties

In addition to paying the amount of taxes that hasn’t been paid, a penalty is assessed that is based on numerous factors and is paid along with the payment for the income tax return. An interest rate factor is used to determine the magnitude of the penalty. An interest rate factor is used because the government feels as though they missed out on income from interest. The last factor that weighs into the penalty is when the income should have been reported. If the taxes that are delinquent should have been paid in the first quarter’s estimated tax payment your penalty will be larger than if the taxes should have been paid in the third quarter’s estimated tax payment. IRS Form 2210 is used to calculate the fee.

Withholding from Wages

If you derive most of your income from standard employment, which withholds taxes from your wages (W-2), you may be able to avoid paying a penalty. As the end of the year approaches and you think you might be vulnerable to a penalty, you can ask your employer to withhold extra taxes on your last couple of pay stubs. To take advantage of this strategy you must talk with your employer and fill out a W-4 form. This is possible because wages from withholding are considered to be paid equally over all installments.

Safe Harbor Exception

The safe harbor exception stipulates that no estimated tax penalties will be incurred if the total tax payments (from estimated tax payments and withholding wages) for the year equal 100% of last year’s tax liability. This exception is possible if your AGI is less than $150,000. If your AGI is greater than $150,000 you will use a modified safe harbor exception. For AGIs greater than $150,000 the tax payments must equal a percentage greater than 100% of the previous year’s tax liability. To find this value read IRS publication 505.

Avoiding the Estimated Tax Penalty

Combining the safe harbor exception and the withholding extra wages trick you can successfully avoid paying estimated tax payments and the associated penalty. To do this make sure you withhold enough wages to stay under the $1,000 threshold or withhold enough wages to meet 100% of last year’s tax liability.

My Estimated Tax Payments

I have not been making estimated tax payments as I need the money for my down payment due in a week from tomorrow (WOOT). Additionally, I fully expect to fund a solo 401k with my self employed income, so I don’t expect my tax liability to increase at all. Also, I should have no problem qualifying for the safe harbor exception as my salary increased from my regular job and the wages withheld should have increased accordingly. I will be doing some quick calculations towards the end of the year to see if I do in fact qualify for the safe harbor exception and will file a W-4 if necessary. I encourage all of you self employed individuals to do the same.

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Detailing My Company’s 401k Plan and Why I Don’t Participate

August 25, 2008

I have been at my current company for two years now and have yet to participate in my company’s 401k plan. First and foremost, my company doesn’t match at all. If my company matched, I would be deferring the minimum amount necessary to receive the full match. Passing up on any portion of a company’s 401k match is the same thing as passing up free money.

Second, I didn’t have a strong need to reduce my taxable income as I will probably be in a higher tax bracket when I retire. Additionally, taxes will most likely increase in the long-term future. For these reasons, I decided to open a Roth IRA to contribute after tax dollars towards my retirement savings.

Third, I decided I really wanted to purchase a condo when my apartment lease ended. In order to meet my 20% down payment goal, I had to put all of my savings towards this down payment and would not be able to fully fund my 401k anyways. Additionally, I had to take on a second job, which resulted in self-employed income.

Fourth, in order to avoid as much double taxation as possible, it is more beneficial for me to invest in a solo 401k instead of my company’s 401k. Also, in a solo 401k I get to chose who my administrator is and what funds I invest in, which is important for my final reason to not participate in my company’s 401k.

Finally, I am not overly excited about the funds available in my company’s 401k, which is provided through ING. In the following table I have broken down the available funds, the category of the fund and the expenses of the fund.

As you can see, the expenses are much higher than what I consider acceptable. I am a huge supporter of index fund investing, which typically have expense ratios of around 0.20%. If my company did offer a match I would be able to mix and match with these funds to create an acceptable asset allocation. I would invest in some combination of the Vanguard Large Cap Value fund, ING Intermediate Bond Fund, Ariel Small Cap Value Fund and Fidelity VIP Overseas Portfolio.

The 401k also offers the equivalent of a life cycle retirement fund. The following table outlines the ING investment solution portfolios available in the 401k.

These life cycle retirement funds come with expense ratios greater than what I consider acceptable. Additionally, the stability of principal category is introduced too early for my risk preference. Also, the percent of bonds and stability of principal in the latter stages of the life cycle is too large.

All of these reasons mentioned above combine to make it an easy decision for me to avoid participating in my company’s 401k. I’ll take my chances with my Roth IRA and soon to be opened solo 401k.


Double the Taxes for Self Employed Income and Social Security Wage Limits

August 20, 2008

Ever since I started working as a summer intern, I have always been depressed to open up my check and see the amount of my salary that was going towards taxes. Currently, 29.2% of my salary goes straight to the government. The majority of my taxes are federal income taxes, with social security tax and state income tax coming in second and third. Medicare taxes are a distant fourth. The magnitude of the downsizing of my income due to taxes is even more readily apparent on my self-employed income.

Double the Taxation

As a part-time self-employed contractor, I am responsible for federal and state income taxes, as well as a double taxation on the Federal Insurance Contributions Act (FICA) taxes, social security and Medicare. The employer and employee are each responsible for paying half of the Medicare tax and social security tax. As a self-employed contractor, I am responsible for both the employer’s and employee’s portions of the Medicare tax and social security tax. This double taxation is the major reason why I set the goal to put all of my self-employed income into a solo 401k. I wanted to defer the taxes on my self-employed income, since it will be taxed at such a high rate due to this double taxation.

Breaking Down the Tax Rates

The combined tax rate for the FICA taxes is 7.65% for regular income and 15.30% for self-employed income in 2008. The social security portion of the FICA tax is 6.20% for regular income and 12.40% for self-employed income in 2008. The Medicare portion of the FICA tax is 1.45% for regular income and 2.90% for self-employed income in 2008.

Social Security Wage Limit

The Medicare tax has no income caps, however, the social security tax has an income cap of $102,000 for 2008. This means, that if your combined income exceeds $102,000, the portion of your income above $102,000 is not subject to the social security tax. This is a very critical income cap to exceed if a portion of your income is self-employed as you are saving 12.40% of the taxes on your income, instead of just 6.20%. The wage limits for the social security cap increase yearly based on a Cost of Living Adjustment (COLA). The following table shows the increases in the wage limits over recent years.


As you can see, the wage limit has increased every year since at least 2000. The average increase in the wage limit is 3.7%, however, the average COLA is 2.8%. The difference in almost one full percentage point means that if you are getting annual salary increases that match the cost of living, you are falling further behind the wage limit and further away from decreasing your tax rate on your self-employed income.

Conclusion

Currently, my salary does not exceed the wage limit, and I don’t make enough self-employed income to fret too much over this ever increasing wage limit. I have thought about trying to extend my self-employed income as a tutor, however, I am about a year away from trying to do that. The wage limit is definitely something I’m shooting for as it is critical to self-employed individuals and I’m hoping I have significant self-employed income in my future.


Solo 401k Retirement Account for Self-Employed Income

August 20, 2008

I previously blogged about the different self-employed retirement options. In that blog I decided a solo or individual 401k was the best option for my self-employed income. To sum it up, a solo 401k allows me to put away all of my self-employed income with the exception of the deduction for 1/2 of the self-employment tax. I’ve done some research on the different administrators for a self-employed 401k account. A list of available solo 401k options can be found at the 401k help center (pdf). I’ve selected a few different options and described them in detail below.

Fidelity offers a great website that clearly explains the tax advantages of a solo 401k, the higher contribution limits and the set-up and contribution deadlines. At Fidelity you are designated as the plan administrator. As plan administrator you are responsible for the adoption agreement, file an annual tax report Form 5500 (if your account exceeds $250,000 in assets), allocate profit sharing contributions and submit a Contribution Remittance Form with each deposit.

Fidelity provides more than 175 Fidelity mutual funds. In total, you have access to over 4,600 mutual funds. 1,400 of those funds have no loads and no minimum investment. Additionally, they send a kit to assist you with your annual Form 5500. Stock purchases are between $19.95 and $8 depending on total asset value in your account. Most Fidelity funds do not have transaction fees, however, they may be subject to a redemption or exchange fee. It seems as though the only fees are for the expense ratios, which can be as low as 0.07% for select index funds.

T. Rowe Price is the second of the heavy hitters offering solo 401k accounts. There are no commissions or setup costs. T. Rowe Price offers more than 65 no-load mutual funds. An annual $10 administrative fee is charged for each mutual fund account with assets less than $5,000. The administrative fee is waived with a total account asset value greater than $50,000. There is a $10 close out fee applied to accounts closed at T. Rowe Price. It appears as though T. Rowe Price offers Roth 401ks as opposed to the traditional 401k that is offered at Fidelity.

T. Rowe Price offers target retirement funds, which are nice for individuals looking to sock money away and forget about it until retirement. T. Rowe Price offers a Total Equity Market Index Fund that has an expense ratio of 0.40%. It seems as though T. Rowe Price offers a broad range of index funds that have expense ratios ranging from 0.40% and 0.90%.

InvestSafe offers an alternative to a Fidelity or T. Rowe Price. InvestSafe acts as a traditional administrator. There is no setup fee, however, there is a annual administrative recordkeeping fee that’s between $0 and $25 depending on the account balance. The fee is waived with an account value greater than $25,000. There is a $250 fee for filing the Form 5500, which is only necessary if your account value is greater than $250,000. You may fill out the Form 5500 on your own and eliminate that fee. InvestSafe does offer a Roth 401k as part of your solo 401k. You can split up your contributions into Roth and Tradition 401k contributions. I don’t know which mutual fund company’s are part of the plan, which is a major negative.

Benefit Plans Plus

Benefit Plans Plus (BPP) offers a very expensive alternative that takes care of all of the paperwork for you. There is a set-up charge of $375 for the plan document and adoption agreement. In addition you have to pay for the postage and handling of this adoption agreement. There is a $250 annual plan maintenance fee. There is a $125 annual fee for an employer contribution calculation. A Form 5500 preparation fee is $125 annually. Mutual fund options are not available without requesting more information. I think anybody reading this blog is too interested in saving money to use a plan with so many fees.

Conclusion

Based on the above options, I would strongly consider both the Fidelity and T. Rowe Price solo 401k accounts. Fidelity has an advantage in the number of available mutual funds with lower expense ratios than T. Rowe Price. On the other hand, T. Rowe Price does appear to offer a Roth 401k option, which may be appealing to some. Personally I am more interested in deferring my taxes for this retirement account as I am also going to be funding a Roth IRA. If I had to choose between the above funds I would choose Fidelity for the lower expense ratios and range of available index funds.

Since my Roth IRA is through Vanguard, I decided to ask Vanguard if they had a self-employed 401k plan. Currently, Vanguard does not offer a solo 401k retirement product, however they are planning on introducing an individual 401k product designed for self employed individuals later this year. I will follow up on this development as I would like to keep all of my retirement accounts with Vanguard to gain access to admiral shares and Voyager and Flagship services as soon as possible.


A Rundown of Self Employed Retirement Options

August 14, 2008

As I mentioned in my about section, part of my income comes as a self-employed contractor for tutoring high school students in Math and Science. I tutor through a company that pays me by the hour once a month without taxes. My income is reported in the form of a 1099-MISC. I am looking for a good self-employed retirement plan to shelter as much of my income from the IRS. Through internet searches, speaking with local banks and an accountant friend, I discovered my options were limited to a SEP (Simplified Employee Pension) IRA, SIMPLE (Savings Incentive Match Plan for Employees) IRA, Keogh Plan or solo 401k. Below is a rundown of the four options from the perspective of myself, an unincorporated self-employed contractor with no other employees.

SEP IRA

The SEP IRA is the simplest plan to setup and administer. Most financial institutions provide SEP accounts and are as easy to setup as a regular bank account. Additionally, a SEP account may be setup and funded anytime before the due date of the income tax return, including extensions. The maximum annual amount that I can fund is the lesser of 20% of net self-employment earnings or $46,000. The annual percentage invested is not fixed, which is good for self-employed contractors who don’t make fixed salaries.

SIMPLE IRA

Like the SEP IRA the SIMPLE IRA is easy to open, however, it must be opened prior to October 1st of the year the contribution will be made. The SIMPLE IRA limits the contributions to $10,500 for 2008. Due to this contribution limitation, the SIMPLE IRA doesn’t make sense for a self-employed contractor. The real advantages of a SIMPLE IRA come into play for small businesses as employees can defer a portion of their salary as a pre-tax contribution with possible employer matches.

Keogh Plan

Keogh plans come in two varieties: a profit-sharing plan or a defined benefit pension plan. The plan must be set up by the end of the year the contribution is for, however, the actual contribution may be invested anytime up until the due date of the tax return. For a profit-sharing plan the contribution may be 20% of self-employed income with a cap of $46,000. The profit-sharing plan requires a plan document and an annual report, which may cost a few bucks. With a defined benefit pension plan can contribute up to $185,000. The contribution is calculated by an actuary and it depends on income, target benefit, anticipated investment returns and years until retirement. There are fees and reports that can cost up to a thousand dollars.

Solo 401k

Solo 401k’s allow for contributions of 100% of your first $15,500. Additionally, you can contribute and deduct 20% of your total self-employed income. The solo 401k must be setup by the end of the year, however, contributions may be made up until the due date of the income tax return. The total salary deferral from a solo and traditional 401k must not exceed $15,500, however, I don’t participate in my companies’ 401k since they don’t match. A Form 5500 has to be filed once the account exceeds the value of $100,000. I have not experienced this yet (I will very soon), but the account setup typically goes through a brokerage and involves a set-up fee ($100ish) and an annual fee ($50-$250).

In summary, a SEP IRA is easy to open, especially last minute, however, I can only shelter 20% of my self-employed earnings, which leaves a large amount of my income taxable. SIMPLE IRA plans are easy to start and allow for a contribution of $10,800, however, it is more suited for a small business. A Keogh profit-sharing plan is similar to a SEP IRA in terms of contributions, but it is more time consuming to open. A Keogh defined benefit pension plan allows for a very large contribution, but is only attainable with extremely large incomes and minimal years until retirement.

For me the solo 401k is the best way to sock money away for retirement and shelter it from the IRS. In my first full year as a self-employed contractor I am estimating an income of $10,000. With a solo 401k I am able to shelter the entirety of my income, with the exception of 1/2 of the self-employment tax (I think, I will relay this info in a future post). With the SEP IRA and Keogh plan I am only able to shelter $2,000. The SIMPLE IRA will allow me to sock away all of my earnings this year, however, if I increase my self-employed income I will be limited to $10,800.

In my efforts to sock away as much as possible in tax sheltered retirement accounts, the solo 401k allows a max contribution in the present and future.