The solo 401(k) plan is a powerful tool for entrepreneurs to save money for retirement and reduce their current tax bill. These plans are often ignored and overshadowed by the more popular corporate 401(k) and SEP IRA plans. In fact, there is a lack of widely available public information about them. Simply put, not many people know about it.
Solo or one participant 401(k) plans are available to solo entrepreneurs who do not have any personnel or staff. If a business owner employs seasonal workers who register less than 1,000 hours a year, then he or she may be eligible for the solo 401(k) plans as well. The solo plans have most of the characteristics of the traditional 401(k) plan without many of restrictions. (For more, see: 401(k) Plans for the Small Business Owner.)
Maximize Your Retirement Savings
A self-employed 401(k) allows a business owner to save up to $54,000 a year for retirement, plus additional an $6,000 if age 50 and over. How does the math work exactly?
Solo entrepreneurs play a dual role in their business - as an employee and an employer. As an employee, they can contribute up to $18,000 a year plus a catch up of $6,000 if over the age of 50. Further, the business owner can add up to $36,000 in contributions as an employer. The company’s side of the contribution is subject to 25% of the compensation, which the business owner must pay herself.
Example: Jessica, age 52, has a solo practice. She earns a W2 salary of $100,000 from her S Corporation. Jessica set up a solo 401(k) plan. In 2017 she can contribute $18,000 plus $6,000 catch up, for a total of $24,000 as an employee of her company. Additionally, Jessica can add up to $25,000 (25% x $100,000) as an employer. She can save up to $49,000 in her solo 401(k) plan.
One important side note, if a business owner works for another company and participates in their 401(k), the above limits are applicable per person, not per plan. Therefore, the entrepreneur has to deduct any contributions from the second plan in order to stay within the allowed limits.
Add Your Spouse
A business owner can add his or her spouse to the 401(k) plan subject to the same limits discussed above. In order to be eligible for these contributions, the spouse has to earn income from the business. The spouse must report a wage from the company on a W2 form for tax purposes.
Reduce Your Current Tax Bill
The solo 401(k) plans contributions will reduce your tax bill at year end. The wage contributions will lower your ordinary income tax. The company contributions will decrease the corporate tax.
This is a very significant benefit for all business owners and, in particular, for those who fall into higher income tax brackets. If an entrepreneur believes that her tax rate will go down in the future, maximizing her current solo 401(k) contributions now can deliver substantial tax benefits in the long run.
Opt for Roth Contributions
Most solo 401(k) plans allow for Roth contributions. These contributions are after taxes. Therefore, they do not lower current taxes. However, the long-term benefit is that all investments from Roth contributions grow tax free. No taxes will be due at withdrawal during retirement. (For more, see: SIMPLE IRA vs. SIMPLE 401(k) Plans.)
Only the employee contributions are eligible to be Roth contributions. So the solo entrepreneur can add up to $18,000 plus $6,000 in pre-tax Roth contributions and $36,000 as tax-deductible employer contributions.
The Roth contributions are especially beneficial for young entrepreneurs or those in a lower tax bracket who expect that their income and taxes will be higher when they retire. By paying taxes now at a lower rate, plan owners avoid paying much larger tax bill later when they retire, assuming their tax rate will be higher.
No Annual Test
Solo 401(k) plans are not subject to the same strict regulations as their corporate rivals. Self-employed plans do not require a discrimination test as long as the only participants are the business owner and the spouse.
If the company employs workers who meet the eligibility requirements, they must be included in the plan. To be eligible for the 401(k) plan, the worker must be a salaried full-time employee working more than 1,000 hours a year. In those cases, the plan administrator must conduct annual discrimination test which assesses the employee participation in the 401(k) plan. As long as solo entrepreneurs do not hire any full-time workers, they can avoid the discrimination test in their 401(k) plan.
No Annual Filing
Another benefit of the 401(k) plan is the exemption from annual filing a form 5500-EZ, as long as the year-end plan assets do not exceed $250,000. If plan assets exceed that amount, the plan administrator or the owner himself must do the annual filing.
401(k) plans offer one of the highest bankruptcy protection than any other retirement accounts, including IRAs. The assets in a 401(k) are safe from creditors as long as they remain there. In general, all ERISA eligible retirement plans like 401(k) plans are sheltered from creditors. Non-ERISA plans like IRAs are also protected up to $1,283,025 (in aggregate) under federal law plus any additional state law protection.
You can open a self-employed 401(k) plan at nearly any broker like Fidelity Investments, Charles Schwab Corp. or Vanguard. The process is relatively straight forward. It requires filling out a form, company name, tax ID, etc. Most brokers will act as your plan administrator. As long as the business owner remains self-employed, doesn’t hire any full-time workers and plan assets do no exceed $250,000, plan administration will be relatively straightforward.
As a sponsor of your own 401(k) plan, you can choose to manage it yourself or hire an investment advisor. Either way, most solo 401(k) plans offer a wider range of investments than comparable corporate 401(k) plans. Depending on your provider, you may have access to a larger selection of investment choices including ETFs, low-cost mutual funds, stocks and REITs. Always verify your investment selection and trading costs before opening an account with any financial services provider. (For more from this author, see: Financial Planning Tips for Small Business Owners.)