Self-Employed: Go Solo With a 401(k)

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Are you a sole proprietor or small business owner? If so, the most effective retirement plan for you may be the solo 401(k). Why? You can save more for your future retirement and receive a larger income tax deduction today.

Standard 401(k) retirement accounts are the most widely used retirement savings vehicle offered by employers. Most everyone is familiar with them. However, a solo 401(k) isn't as well known. But if you are self-employed, there are a lot of reasons to gain a quick understanding!

The solo 401(k) provides a larger retirement contribution each year than possible through other traditional plans available to the self-employed, such as the Simplified Employee Pension (SEP), Keogh, and profit sharing plans.

Who is Eligible for a Solo 401(k)?

This plan works for small business owners or sole proprietors with no employees other than a spouse. If other employees work for the business, the standard employer 401(k) or other retirement plan that includes those employees will be required.

What is a Solo 401(k)?

This retirement vehicle has all the tax benefits of a standard employer 401(k), including tax deductible contributions and tax deferred investment growth. It also has the same rules around early withdrawal penalties.

As a sole proprietor, you are considered an "employee" of your business as well as the "employer." Because of this dual role, tax deductible employer and employee contributions can be made to a solo 401(k).  Here are the limits for each:

  • Employee Contribution: Similar to the standard employer 401(k) plans, the 2018 employee contribution limit is 100 percent of earned income up to a maximum of $18,500 ($24,000 if age 50 or older).
  • Employer Contribution: If the business earns more than $18,500, a profit sharing contribution can be made as the employer. The profit sharing limit is 20 percent of self-employment net income for sole proprietors and single-member LLCs or 25 percent of the total compensation paid if the business is incorporated.
  • Overall Maximum: For 2018, the combined employee and employer contributions cannot exceed $55,000 ($61,000 if age 50 or older).

Example: If a 40-year old sole proprietor earns $100,000 and has $20,000 of deductible business expenses, then net earnings are $80,000.  A tax-deductible solo 401(k) contribution of $18,500 can be made as the "employee."

This employee contribution would reduce net earnings to $61,500 ($80,000 - $18,500). As "employer," our sole proprietor would be able to make a profit sharing contribution into the same solo 401(k) up to 20 percent of $61,500 or $12,300. This is a total retirement savings contribution of $30,800!

What's left to pay tax on? After the solo 401(k) combined contributions, taxable income from the business would be reduced to $49,200! This is less than 50 percent of the gross business earnings of $100,000. These tax savings would be even higher for a sole proprietor age 50 or older!

Advantages of a Solo 401(k)

The advantages of a solo 401(k) over other self-employed plans include the following:

  • Higher contribution amounts. Generally eligible to contribute a larger amount than allowed with other retirement plan options.
  • Rollover eligibility. Funds from former employer 401(k) plans, IRAs, SEPs, Keogh plans, or Section 457(b) plans can be consolidated in a solo 401(k) plan.
  • Borrowing privileges. Loans from the solo 401(k) are permitted with some restrictions. This is a distinct advantage over the traditional IRA account where loans are not allowed.
  • Investment flexibility. Self-directed brokerage account can be established as the custodian of the funds, allowing for maximum investment flexibility.
  • No annual report. As long as the total value of the solo 401(k) is under $250,000, there is no requirement to file the annual IRS Form 5500.
  • Contributions not required. You can contribute nothing or less than the maximum to the plan in any year and not be in violation of the plan.
  • Creditor protection. The solo 401(k) is generally protected from the claims of creditors.

Some costs will be incurred to establish and maintain the solo 401(k). In addition, an investment account must be established. Sources for these services include banks, brokerage houses, and independent companies that can be accessed through the Internet.

Summary

While there are distinct advantages of a solo 401(k) plan, there are several retirement plans that the sole proprietor or small business owner can use. The optimum plan will depend on income generated, ability to contribute to the plan, and the cost of the plan administration. Therefore, it is recommended that you discuss your options with your financial or tax advisor.

Evan D. Bedel, CFP, is a Financial Planner and heads Generation NeXt services for Bedel Financial Consulting, Inc., a wealth management firm located in Indianapolis. For more information, visit the Bedel Financial website at bedelfinancial.com or email Evan.

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