Solo 401(k) lets self-employed shelter more of their income
If you’re self employed and yearning to shelter some of your income from taxes, you probably know all about SEP-IRAs, the retirement plan for small-business owners.
But do you know about so-called solo 401(k)s?
Probably not, unless you can afford to put a substantial amount of your income into tax-sheltered accounts. If you do, solo 401(k)s can offer some advantages.
“They give you a lot more options,” said Stuart Robertson, head of ShareBuilder 401k, a subsidiary of ING Direct.
The solo 401(k) rules allow you to play the roles of both employer and employee, allowing you to contribute more to the plan than you could to a SEP, or simplified employee pension plan.
To be specific, a SEP allows you to contribute up to 20% of net self-employment income to the plan, maxing out at $49,000 in contributions per year.
But with a solo 401(k), as your own employee, you can contribute as much as 100% of your earnings to the solo 401(k), up to $16,500 in contributions annually (that goes up to $22,000 annually if you’re over the age of 50). Then, in the role of your own employer, you can contribute an additional 20% of the business’ net income as a profit-sharing contribution.
The ability to contribute in this lavish manner would be of concern only to the smashingly successful. But if that spells you, the individual 401(k) is definitely worth a look.
Consider a hypothetical 52-year-old with $150,000 in net business income. If he used a traditional SEP, the most he could contribute to the tax-sheltering account would be $30,000 (20% of the $150,000).
Now consider a hypothetical businesswoman in the same situation who chooses a solo 401(k). She’d be able to contribute $22,000 as the employee, plus $30,000 more as the employer, sheltering a total of $52,000 annually. That extra $22,000 in contributions to the plan would cut her federal income tax bill by nearly $6,200, assuming she’s in the 28% federal tax bracket. If she’s in a high-tax state, such as California or New York, she would save considerably more.
For those who are as concerned about future taxes as they are about those that they pay now, the solo 401(k) has another unique feature. It allows you to set up your employee contributions Roth-style. That means you don’t get to deduct those contributions when they are put into the account, but when that money is taken out of the plan in retirement it’s 100% tax free. (The employer, profit-sharing portion of the contributions would be, as usual, tax sheltered before retirement and then subject to taxes in your golden years.)
For people who want to put aside substantial savings, “the solo 401(k) is clearly the best option,” Robertson said.
What’s the catch? If you want all the bells and whistles, setting up a 401(k) can be cumbersome and costly.
You can set up solo 401(k) accounts with big mutual fund companies, such as Vanguard and T. Rowe Price, which each charge about $20 a year to set up and administer the plans. It’s about the same rates as for their SEPs. But both fund companies note that with solo 401(k)s, you may have to fill out additional IRS forms once your retirement plan balance exceeds certain levels.
And neither Vanguard nor T. Rowe Price offers the option of borrowing from solo 401(k) accounts. If that flexibility is important to you, you may have to pay some hefty fees.
ShareBuilder, for example, charges $125 to $195 to set up a solo 401(k) with a borrowing option. There’s an additional $75 administrative fee if you do end up taking out a loan.
ShareBuilder also charges a $15 monthly fee to anyone with less than $250,000 under management. A 401(k) loan that reduced your balance to below that threshold could trigger the monthly fees, making that type of loan a very costly way to borrow.
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