SBO 401(k) Definition

What Is an SBO 401(k)?

A SBO 401(k) is a tax-deferred, government-registered retirement savings plan that is specially designed for small business owners (SBOs). Eligible participants for a SBO 401(k) are businesses that employ the business's owners and their spouses. The business must not have any other eligible employees. It is also known as an independent 401(k).

Understanding an SBO 401(k)

A SBO 401(k) provides self-employed small business owners the opportunity to participate in a tax-deferred retirement savings plan. These types of savings plans may be either self-directed or professionally managed.

As with standard 401(k) plans, the contribution limit for 2022 is $20,500 (increasing to $22,500 in 2023). Additionally, catch-up contributions of up to $6,500 are allowed for those age 50 and above who have SBO 401(k)s (increasing to $7,500 for 2023). Contributions made to the plan as an employer are also tax-deductible, which can help to save the sole proprietor a great deal in taxes.

The SBO 401(k) offers many of the same features as a Keogh plan or a SEP IRA, but an independent 401(k) can be cheaper to establish and maintain, and loans are often allowed against an independent 401(k). The major drawback to the independent 401(k) is that no outside employees can be hired or the window of applicability closes.

SBO 401(k) Versions

There are two versions of the individual 401(k) plan: a traditional version and a Roth version. With the traditional version, your tax-deferred money is only taxed when it is withdrawn; the Roth version involves putting away after-tax money and allowing it to grow tax-free with no taxes owed on withdrawals.

You can use financial calculators to help determine the best option for you between the two versions of the individual 401(k) plan. It is also possible to opt for both and divide contributions between the two plans.

The amount you can contribute to these plans is appealing. "The highlight of the Self-Employed 401(k) is the ability to contribute to the plan in two ways," notes investment giant Fidelity. Here's how these two contribution routes work:

• As an employee: For 2022, you can make deferrals of your salary up to $20,500, or $27,000 if you're age 50 or over. For 2023, these numbers are $22,500 and $30,000.
• As an employer: In addition to your annual employee contribution, you can also contribute up to 25% of your compensation to your SBO 401(k).

Note that the maximum yearly contribution from both sources is $61,000 for 2022 ($67,500 with the catch-up contribution). For 2023, the maximum contribution from both sources is $66,000 ($73,500 with the catch-up contribution).

In addition, notes Fidelity, "If your business is not incorporated, you can generally deduct contributions for yourself from your personal income. If your business is incorporated, you can count the contributions as a business expense."