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Solo 401(k) Contribution Limit with Another Job

A reader writes in, asking:

“For the first 9 months of 2016, I have been considered a self-employed 1099 contractor at a hospital. As of October 1st, I will be a W-2 employee, but I will be doing the same work at the same hospital.

If I have sufficient earnings as a 1099 contractor for that 9-month period in 2016, will I be able to contribute a full $53,000 to my Solo 401k with that contribution being funded as ’employer’ contributions while also contributing up to $18,000 to my 401k as an employee for the period of October 1, 2016 – December 31, 2016?”

Short answer: Yes.

[Quick note: With what follows, I am assuming that the reader is familiar with the basics of solo 401(k) contribution limits. If you are not, I’d suggest reading up on them before proceeding.]

The employee salary deferral limit for 401(k) plans (i.e., $18,000 for 2016) is a per-person limit. That is, any deferrals that are made to the plan at your job as an employee will be counted against the $18,000 limit for deferrals (i.e., “employee” contributions) to the solo 401(k) — and vice versa.

The $53,000 annual limit works differently though. This limit comes from IRC 415(c). The key point when reading that Code section is to understand that these are the rules for a given plan, rather than for a given person. That is, the plan wouldn’t be a qualified retirement plan if it let a participant contribute more than $53,000, but there’s no rule saying that a given person isn’t allowed to make more than $53,000 of total contributions if they are a participant in multiple plans.

This article from provides a very clear example:

“Greg, 46, is employed by an employer with a 401(k) plan and he also works as an independent contractor for an unrelated business. Greg sets up a solo 401(k) plan for his independent contracting business. Greg contributes the maximum amount to his employer’s 401(k) plan for 2015, $18,000. Greg would also like to contribute the maximum amount to his solo 401(k) plan. He is not able to make further elective deferrals to his solo 401(k) plan because he has already contributed his personal maximum, $18,000. He has enough earned income from his business to contribute the overall maximum for the year, $53,000. Greg can make a nonelective contribution of $53,000 to his solo 401(k) plan. This limit is not reduced by the elective deferrals under his employer’s plan because the limit on annual additions applies to each plan separately.”

Caution: Shared Ownership

While the $53,000 limit is a per-plan limit, it’s important to understand that, in some cases, multiple retirement plans will be aggregated (i.e., considered to be one plan). IRC 415(g) and 415(h) provide the relevant rules.

Specifically, multiple businesses will be aggregated as part of a “brother-sister controlled group” if five or fewer individuals (including people, estates, and trusts) own more than 50% of the stock of each business (measured in terms of voting power or value). Alternatively, two businesses will be aggregated as part of a “parent-subsidiary controlled group” if one business owns more than 50% of the other business (again measured in terms of voting power or value).

For example, if you are the sole owner of two single-member LLCs, those two LLCs will be aggregated for these purposes (and you will not be able to exceed the $53,000 total contribution limit), even if the two LLCs operate in completely different industries.

For More Information, See My Related Book:

Independent Contractor, Sole Proprietor, and LLC Taxes Explained in 100 Pages or Less

Topics Covered in the Book:
  • Estimated tax payments: When and how to pay them, as well as an easy way to calculate each payment,
  • Self-employment tax: What it is, why it exists, and how to calculate it,
  • Business retirement plans: What the different types are, and which one is best for you,
  • Click here to see the full list.
A testimonial from a reader on Amazon:
"Quick and easy read. No fluff, just straight to the point and gives you more helpful information that you might imagine. If you are looking to get the bottom line information you need to start your business right then this book is a must have."

Investing Blog Roundup: Bogleheads 2016

I’ve spent the last few days at the annual Bogleheads conference in Philadelphia. As always, it’s been fantastic. There’s no other place where I get to meet and chat with so many of you.

For those of you who have never attended, I recommend the event highly. (It’s usually announced on the Bogleheads forum sometime early in the year.) In addition to getting to spend time with a group of people with similar interests, you get to meet and ask questions of experts like William Bernstein, Christine Benz, Allan Roth, Rick Ferri, Wade Pfau, Maria Bruno, Gus Sauter and more.

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When Does It Make Sense to Prepay a Mortgage?

A reader writes in (in reply to last week’s article about calculating the after-tax interest rate on a mortgage), asking:

“I get that the point of calculating an after-tax interest rate is to determine whether it’s better to prepay your mortgage instead of investing. But where do you draw the cut-off? How high does the interest rate have to be in order for it to be better to pay it down rather than invest? Would looking at historical returns for the funds I own would be useful here?”

Prepaying a mortgage provides a safe rate of return. That is, you know that the return you’ll get from paying down the mortgage is equal to the after-tax interest rate on the mortgage.

As such, generally speaking, what you want to do is compare the after-tax interest rate on your mortgage to the after-tax expected return on the safe investments (e.g., bonds or CDs) that you hold or that you are considering buying.

For example, if your mortgage has an after-tax interest rate of 3%, and you are holding fixed-income investments that have an after-tax expected return of 2%, you’re essentially borrowing money at 3% in order to lend it back out at 2%. In most cases, that doesn’t make sense.

Conveniently, it’s fairly easy to get a decent estimate of the expected return for a fixed-income investment. In most cases, just look at the yield.*

Look at After-Tax Expected Returns

A key point here is that, just like we looked at the after-tax interest rate on the mortgage, we have to look at the after-tax expected return for the investments in question.

In the case of tax-sheltered retirement accounts, the calculation is easy. Specifically, if you would be liquidating assets from retirement accounts (or choosing not to contribute to retirement accounts) in order to prepay the mortgage, the return on the investments in question wouldn’t be taxed, so the after-tax rate of return is the same as the before-tax rate of return.

In a taxable brokerage account, however, determining the after-tax return can be somewhat trickier. It’s simply calculated as the before-tax expected return multiplied by (1 – your marginal tax rate). But your marginal tax rate will depend on your tax bracket, what type of investment we’re talking about (taxable bond? muni bond?), and on other factors such as whether or not you’re subject to the 3.8% tax on net investment income.

A Reason Not to Prepay

Regardless of the above comparison of rates of return, it definitely does not make sense to prepay your mortgage if doing so will cause you significant liquidity problems.

For instance, if you have an “emergency fund” sitting in a savings account earning little to no interest (and you truly would need that money in the event of a large unexpected expense), it’s not a good idea to use that money to pay down your mortgage, despite the fact that doing so would earn you a higher rate of return than the savings account is earning.

*Specifically, you’ll want to look at the yield to maturity for most bonds, the yield-to-worst for callable bonds, and the SEC yield for bond funds.

Investing Blog Roundup: Should Spending Stay Constant Throughout Retirement?

In retirement planning, a common strategy is to try to determine a level of annual spending such that you can spend at approximately that same level (adjusted for inflation) for the rest of your life, without running out of money. This week, behavioral economist Shlomo Benartzi explains why a constant-spending strategy is not a happiness-maximizing strategy for many people.

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How Do You Calculate the After-Tax Interest Rate on a Mortgage?

A reader writes in, asking:

“I’m in the process of buying my first home, and I keep reading about how I need to know the after tax interest rate on my mortgage. Does that just depend on my tax bracket or is there more to know here?”

If you’re already itemizing every year before you take out a mortgage, the calculation is simple. The after-tax interest rate on the mortgage is the interest rate, multiplied by (1 – your marginal tax rate). In other words, it’s the interest you pay, minus the tax savings you get back.

Example: Celeste is unmarried, with a standard deduction of $6,300 per year. She’s in the 25% federal tax bracket and 5% state tax bracket, for a total marginal tax rate of 30%. She already has itemized deductions totaling $10,000 per year, so she chooses to itemize each year rather than use the standard deduction. If she takes out a mortgage with an interest rate of 4%, the after-tax interest rate on her mortgage will be 2.8% (calculated as 4% x 0.7, because she gets 30% of the mortgage interest back in the form of tax savings).*

But in a situation in which you don’t already itemize, a part of the deduction is essentially wasted, because all it’s doing is bringing your itemized deductions up to the level of deduction you would have already had with the standard deduction. And it’s only the amount beyond that point that’s actually saving you any money on your taxes.

Example: Martin and Johanna are married, with a standard deduction of $12,600 per year. They’re in the 25% federal tax bracket and 5% state tax bracket, for a total marginal tax rate of 30%. Prior to taking out a mortgage, their itemized deductions are just $7,000 per year, so they currently choose to use the standard deduction each year. They’re considering taking out a mortgage with an interest rate of 4%.

Despite the fact that Martin and Johanna have the same marginal tax rate as Celeste, and are considering a mortgage with the same interest rate, their after-tax interest rate on the mortgage will be higher than hers, because they will get less tax savings from the deduction than she gets. Specifically, the first $5,600 of their deduction for home mortgage interest will serve no purpose other than to bring their itemized deductions up to the level of the standard deduction. They will only achieve tax savings for any home mortgage interest they pay that is in excess of $5,600 per year.

So for Martin and Johanna to calculate their after-tax interest rate for the first year of such a mortgage, they would calculate the amount of interest they would pay over the course of the year, then subtract $5,600. The resulting amount would be multiplied by 30% (their marginal tax rate) to determine the amount of their tax savings. Then they would subtract that tax savings from the amount of interest they paid over the year to determine the after-tax amount of interest they paid. And if they divide that after-tax interest amount by the outstanding balance on their mortgage, they’ll arrive at their after-tax interest rate.

A key point here is that Martin and Johanna will have to revisit this calculation whenever they want to know the after-tax interest rate on their mortgage, because the figures involved will change over time. (For instance, the amount of interest they pay each year will decline over time as they pay down their mortgage balance. And their itemized deductions from things other than home mortgage interest will change over time as well.)

*This is a simplification. As we’ve discussed before, your marginal tax rate is not necessarily the same as your tax bracket, but I’m keeping things as simple as possible in our examples. We’re also assuming here that all of the interest on the mortgage does qualify for a deduction. (IRS Publication 936 has the details on that topic.) In addition, if you are itemizing, your state income tax can be claimed as a deduction against your federal taxable income, thereby slightly reducing your overall marginal tax rate.

For More Information, See My Related Book:


Taxes Made Simple: Income Taxes Explained in 100 Pages or Less

Topics Covered in the Book:
  • The difference between deductions, exemptions, and credits,
  • Itemized deductions vs. the standard deduction,
  • Several money-saving deductions and credits and how to make sure you qualify for them,
  • Click here to see the full list.

A testimonial from a reader on Amazon:

"Very easy to read and is a perfect introduction for learning how to do your own taxes. Mike Piper does an excellent job of demystifying complex tax sections and he presents them in an enjoyable and easy to understand way. Highly recommended!"

Investing Blog Roundup: Fund Expenses Still Matter

Earlier this year, an article for the Journal of Financial Planning made a claim that index funds are not as great as we’ve been led to believe, because 80% of actively managed funds outperform their benchmark. This week Allan Roth explains the critical flaws in that claim:

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