If you're self-employed, a solo 401(k) plan is one of many options for building retirement savings with pre-tax money.
In addition to a regular IRA, you're likely eligible to open a SEP (Simplified Employee Pension) or SIMPLE (Savings Incentive Match Plan) IRA. For many self-employed individuals, though, the solo 401(k) is a better choice due to generous contribution limits that allow you to sock away a lot of cash for retirement and save on taxes.
If you hold an employer-sponsored 401(k) account, you can make pre-tax, salary-deferral contributions of up to $16,500 in 2009, plus an extra $5,500 if you are 50 or older. With a solo 401(k), however, you can save up to $49,000 this year ($54,500 if you're 50 or older). If your spouse has income from the business, you can double that contribution, to $98,000, or more than $100,000 if you're eligible for catch-up contributions.
Since these contributions come from pre-tax dollars, they can lower your taxable income dramatically, thus reducing your taxes. In fact, your solo 401(k) contributions may even get you down to a lower tax bracket.
In order to open a solo 401(k) account, you must meet one important requirement: You (or you and your spouse)
be the only employee(s) of the business. If you meet that criteria, your business can be any type of legal entity: sole proprietorship, partnership, limited liability company (LLC) or corporation.
Here's why the solo 401(k) may be the best option for you:
All the benefits of a traditional 401(k) and more:
Like a traditional 401(k), a solo plan allow the same pre-tax "employee" contributions up to the $16,500 federal limits, with taxes deferred until withdrawal. Alternately, you can choose a Roth solo 401(k), make contributions with after-tax money and pay no taxes on withdrawal. That's a good choice if you expect to be in a higher tax bracket at retirement.
You can even borrow from your solo 401(k) balance if your provider allows it, which isn't an option with SEP or SIMPLE IRAs.
And here's the great thing: Since you're your own boss, you can also make additional "employer" or "profit-sharing" contributions. In fact, you can stash up to 20% of your net adjusted business profit -- income, less expenses and half of your self-employment tax -- in the plan, up to $49,000 this year. If your business is incorporated, the dollar amount remains the same, but you can contribute 25% of your W-2 earnings. Either way, your adjusted gross income will drop, which can mean a significant tax cut.
Comparing the SEP and SIMPLE options:
With both a SEP IRA and a SIMPLE IRA, you can contribute up to 20% of your net adjusted business profit (or 25% of W-2 earnings in a corporation) as "profit sharing." The SEP IRA, however, has no provision for either salary deferrals (the $16,500 maximum) or catch-up contributions. SIMPLE IRAs, meanwhile, allow an $11,500 salary deferral and up to just 3% of your business profit or compensation, plus a $2,500 catch-up contribution for eligible participants. Thus, in most cases, the solo 401(k) allows you to save the most.
Let's look at how the various options break down for an unincorporated, self-employed individual with $70,000 in income:
Let's assume this person is single, and that after non-retirement deductions, she has an adjusted gross income of $60,000. Making the maximum $30,500 contribution to a solo 401(k) would significantly reduce her taxes. Without a retirement account, this taxpayer would owe $11,605. But by contributing the maximum, her tax bill drops to just $4,425, in part because it lowers her tax bracket. An extreme and simplified example, yes, but the premise works at other income levels too.
Sadly, no retirement plan will lower your self-employment tax. The IRS collects 15.3% of your business profits,
to deductions, to cover Social Security and Medicare.
When a solo 401(k) is not for you:
If you've got employees beyond you and your spouse, you can't open a solo 401(k). If you plan to hire people soon, you may want a SIMPLE IRA, because you could keep the same plan as the business grows, though you'll have to provide contributions for employees. The SEP IRA may be better for high-income individuals -- those who make enough to contribute the maximum $49,000 as profit-sharing. In 2009, that would be $245,000 in an unincorporated business, or $196,000 in a corporation.
Who provides solo 401(k) plans?
features a list of providers. The list, last updated in 2008, includes more than 100 firms, ranging from local mom-and-pops to well-known public companies such as
Fifth Third Bank
. When opening a solo 401(k) plan, consider each provider's fees and investment choices.
Mike Woelflein is a business and personal finance freelance writer. A former senior industry specialist with Standard & Poor's and managing editor of ColoradoBiz magazine, he has also written for The Denver Post and American Express.