Is it worth it to set up a 401k for a small business LLC partnership?
January 15, 2017 11:13 AM Subscribe
I'm trying to figure out whether it's worth it to set up a 401K for a small business -- an LLC with four partners and no other employees. It seems like it's not because management fees would be worse than the benefits of a tax deferred account. Did I get my calculations right?
I'm trying to figure out whether it's worth it to set up a 401K for my small business -- an LLC with four partners and no other employees. We'd use captain401.com to manage the 401k for a .5 percent employee cost and $120 + $4 per employee in employer costs.
To me it seems like we'd lose money. Here are my calculations:
Go to this tool: https://www.calcxml.com/calculators/inc07
Input 7 percent for a taxable account, 6.5 percent for a tax deferred (7 percent minus the .5 percent employee cost for captain401). Current investment value 0, and assume four partners max out for a total of $72,000 a year in additions, for 20 years. The result: 2,444,632 for the taxable, 2,456,567 for the tax deferred (after tax value for both, assets for the four partners combined). That's a benefit of $11,935 for having a tax deferred account, until you calculate the employer cost for captain401, which is $1,632 times 20 years, for $32,640. Which means the partners lose $20,705 total. Or if they take into account the opportunity cost of having $1,632 per year in a taxable 7 percent investment for 20 years, it costs 55,412 leaving them with a $43,477 loss. None of this takes into account what they would lose in time and labor for managing some things on their end.
It seems to me that 401Ks can be good deals for employees because of matching funds and because they don't have to pay the employer fee (this is why a financial adviser will tell you only to put as much money into a high-cost 401k as you get in managing funds). But for the business partners of a small business: they are both employee and employer. This drives up the management fee to unacceptable level without giving them the benefit of matching funds (they'd be giving the money to themselves).
Is all of this right or have I missed something?
I'm trying to figure out whether it's worth it to set up a 401K for my small business -- an LLC with four partners and no other employees. We'd use captain401.com to manage the 401k for a .5 percent employee cost and $120 + $4 per employee in employer costs.
To me it seems like we'd lose money. Here are my calculations:
Go to this tool: https://www.calcxml.com/calculators/inc07
Input 7 percent for a taxable account, 6.5 percent for a tax deferred (7 percent minus the .5 percent employee cost for captain401). Current investment value 0, and assume four partners max out for a total of $72,000 a year in additions, for 20 years. The result: 2,444,632 for the taxable, 2,456,567 for the tax deferred (after tax value for both, assets for the four partners combined). That's a benefit of $11,935 for having a tax deferred account, until you calculate the employer cost for captain401, which is $1,632 times 20 years, for $32,640. Which means the partners lose $20,705 total. Or if they take into account the opportunity cost of having $1,632 per year in a taxable 7 percent investment for 20 years, it costs 55,412 leaving them with a $43,477 loss. None of this takes into account what they would lose in time and labor for managing some things on their end.
It seems to me that 401Ks can be good deals for employees because of matching funds and because they don't have to pay the employer fee (this is why a financial adviser will tell you only to put as much money into a high-cost 401k as you get in managing funds). But for the business partners of a small business: they are both employee and employer. This drives up the management fee to unacceptable level without giving them the benefit of matching funds (they'd be giving the money to themselves).
Is all of this right or have I missed something?
I agree 100% with what saeculorum wrote.
A couple of other things:
A 0.5% expense ratio seems high to me. Vanguard, for example, has many funds with expense ratios of 0.2% or lower. They do seem to offer 401(K) plans for small business, but I don't know what the fees are like for the business.
You also have to keep in mind that investments in a 401(k), IRA or other tax-advantaged accounts of this nature are tax deferred until you withdraw the money. Typically, if you were to invest in mutual funds, these funds will have periodic capital gains and dividend distributions. (Most of the time these distributions would be reinvested in the same fund by buying more shares.) In a 401(k) or IRA, you don't have to pay taxes on these distributions. But if you're investing outside of a tax-advantaged account, you'll have pay taxes on these distributions in the year that they occur. This will further erode the return rate for the money outside of the 401(k).
You can put your own money into a personal IRA, but the contribution limit is much lower than a 401(k). The limit is only $5,500 for IRAs, but $18,000 for 401(k)s. (This number is adjusted annually based on inflation).
I don't know if businesses of this type are allowed to offer 401(k) matching. If they are, and your financial situation allows you to put away more money in your 401(k), then paying a match can benefit you even more. All of the matching money goes directly into your 401(k) and will not be taxed until you start withdrawing it. This is a massive benefit if you don't need this money now.
posted by cruelfood at 12:00 PM on January 15, 2017
A couple of other things:
A 0.5% expense ratio seems high to me. Vanguard, for example, has many funds with expense ratios of 0.2% or lower. They do seem to offer 401(K) plans for small business, but I don't know what the fees are like for the business.
You also have to keep in mind that investments in a 401(k), IRA or other tax-advantaged accounts of this nature are tax deferred until you withdraw the money. Typically, if you were to invest in mutual funds, these funds will have periodic capital gains and dividend distributions. (Most of the time these distributions would be reinvested in the same fund by buying more shares.) In a 401(k) or IRA, you don't have to pay taxes on these distributions. But if you're investing outside of a tax-advantaged account, you'll have pay taxes on these distributions in the year that they occur. This will further erode the return rate for the money outside of the 401(k).
You can put your own money into a personal IRA, but the contribution limit is much lower than a 401(k). The limit is only $5,500 for IRAs, but $18,000 for 401(k)s. (This number is adjusted annually based on inflation).
I don't know if businesses of this type are allowed to offer 401(k) matching. If they are, and your financial situation allows you to put away more money in your 401(k), then paying a match can benefit you even more. All of the matching money goes directly into your 401(k) and will not be taxed until you start withdrawing it. This is a massive benefit if you don't need this money now.
posted by cruelfood at 12:00 PM on January 15, 2017
T.Rowe Price has some individual 401(k) accounts that I think are just plain investment accounts with the right paperwork to make them valid 401(k)s. I don't think there are are management fees, but I guess I should probably check.
Check with a tax professional, but I believe the "matching" done by some companies is actually meant to advantage the higher-earning employees -- IIRC, they can't put as much into their accounts if the average across the firm is below a certain level. So the firm does matching to raise the lower-earning people's 401(k) contributions, so that the higher earners can put in their full allowance.
posted by spacewrench at 12:08 PM on January 15, 2017
Check with a tax professional, but I believe the "matching" done by some companies is actually meant to advantage the higher-earning employees -- IIRC, they can't put as much into their accounts if the average across the firm is below a certain level. So the firm does matching to raise the lower-earning people's 401(k) contributions, so that the higher earners can put in their full allowance.
posted by spacewrench at 12:08 PM on January 15, 2017
I've had "Simple IRAs" at small employers in the past. Not really sure what the difference is, but might be worth checking out.
posted by COD at 12:36 PM on January 15, 2017
posted by COD at 12:36 PM on January 15, 2017
Best answer: I just went through setting this up for my small business (2 partners + 2 employees). Here are a couple things to consider:
1) You can only contribute money that's subject to employment taxes. If you are passive partners, taking partner distributions and not paying employment taxes, you cannot tax-shelter that money in a 401k. We are a good example of this: my partner actually works in the business so he can contribute because he takes a small salary in addition to partner distributions but I am a passive investor so I cannot contribute since I only take the partner distributions.
2) If you do take salaries (or pay employment taxes on your distributions), you can set up a Simple IRA for $25 per person per year at Fidelity (similar prices at other providers but I loooove Fidelity's customer service). You can contribute a little less than a 401k, up to $12,500 per year/$15,500 if you are over 50, but you can add a company match, which is also tax deductible. If you choose a 2% non-elective company match, your labor is minimal: once a year, transfer your individual contributions plus the 2% company match to 4 Fidelity Simple IRA accounts.
I'd say $25 + 1 hour per year is more than worth the tax shelter savings.
posted by rada at 1:04 PM on January 15, 2017
1) You can only contribute money that's subject to employment taxes. If you are passive partners, taking partner distributions and not paying employment taxes, you cannot tax-shelter that money in a 401k. We are a good example of this: my partner actually works in the business so he can contribute because he takes a small salary in addition to partner distributions but I am a passive investor so I cannot contribute since I only take the partner distributions.
2) If you do take salaries (or pay employment taxes on your distributions), you can set up a Simple IRA for $25 per person per year at Fidelity (similar prices at other providers but I loooove Fidelity's customer service). You can contribute a little less than a 401k, up to $12,500 per year/$15,500 if you are over 50, but you can add a company match, which is also tax deductible. If you choose a 2% non-elective company match, your labor is minimal: once a year, transfer your individual contributions plus the 2% company match to 4 Fidelity Simple IRA accounts.
I'd say $25 + 1 hour per year is more than worth the tax shelter savings.
posted by rada at 1:04 PM on January 15, 2017
Are all the individuals both owners and employees? If so you might be able to set up a SEP IRA. I think the limits are 25% of pretax or 53,000 whichever is less.
posted by cheez-it at 3:23 PM on January 15, 2017 [1 favorite]
posted by cheez-it at 3:23 PM on January 15, 2017 [1 favorite]
Response by poster: Thanks everyone this is all very helpful. I can see I was doing the calculations wrong; will look at some of these other options as well.
posted by studio2054 at 1:33 PM on January 16, 2017
posted by studio2054 at 1:33 PM on January 16, 2017
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You're not making a fair comparison. A fair comparison is $13,500 in a taxable account and $18,000 in a tax-deferred account.
posted by saeculorum at 11:28 AM on January 15, 2017