With nearly 1 out of every 10 U.S. workers self-employed, at least 10% of workers are going without a traditional 401(k) plan. While some may create future retirement income from the sale of their business, generating substantial retirement income from a business sale tends to be the exception rather than the rule.
What are the options for self-employed savers? Are IRAs, with their relatively small contribution amounts and income restrictions, all that’s available?
Just as a company with thousands of employees is allowed to have a 401(k) plan, part of the IRS tax code allows businesses with just one employee--that’s YOU--to have a 401(k) as well.
It’s called a Solo or Individual 401(k), and it’s an excellent retirement saving tool for sole proprietors.
Who is eligible to use Solo 401(k) plans?
Eligible participants in Solo 401(k)s must be sole proprietors with no full-time employees. Solo 401(k)s can be used by consultants and independent contractors, too.
It doesn’t matter what type of business you’re running. Anything from a flower shop to consulting work will do. You don’t need to be do it full-time either. For instance, you may work full-time at your regular 9-5 job and earn some extra business income on the side working as a contractor 10 hours a week. Up to 100% of the money brought in by your part-time business can go into your Solo 401(k) (assuming you don’t exceed the contribution limits).
However, be careful as your business continues to grow. Even if you started contributing to your 401(k) when you had no employees, as soon as you pick up your first employee you’re no longer eligible to make additional contributions, but traditional 401(k) options will still be available to you.
How Solo 401(k) contributions work
Most retirement account contributions, such as traditional and Roth IRAs, tend to limit the maximum amount you can contribute, but total contributions allowed is where Solo 401(k)s really shine.
Maximum contribution amounts for 2017 are $54,000, with employees able to contribute up to $18,000 of that amount (the rest must come from the employer). There are catch up contributions for those over age 50, too. IRA contributions, on the other hand, are $5,500 in 2017 and they are also subject to income limitations. Are you married (filing your taxes jointly) and earning more than $196,000? Sorry, no Roth IRA contributions for you. Solo 401(k)s, on the other hand, have no income restrictions.
Are Solo 401(k) contributions tax deductible?
With traditional 401(k) plans, both the employer and the employee make separate contributions. Do companies contribute to your 401(k) simply out of the goodness of their hearts? Not exactly. Employer contributions to 401(k) plans are tax deductible. They’re still paying money, but it’s “less” because of the deduction. In addition to company contributions, the employee also makes their own contribution and also receives a tax deduction.
Solo 401(k) plans work much the same way. There are employer contributions (from your business) and employee contributions (from you). Your business’s contribution is deductible as a business expense and your personal contributions go in as either pre-tax contributions or Roth contributions (where you take future withdrawals from your account tax-free).
How do Solo 401(k)s compare to regular 401(k) plans?
Regular 401(k) plans carry fairly high administrative costs. Most of this comes as forms and documentation which need to be regularly submitted to ensure the 401(k) is being handled appropriately. There’s lots of paperwork to file when setting up a traditional 401(k) plan, and annual filings too.
Administrative requirements for Solo 401(k)s, however, are minimal since it’s a 401(k) plan for only YOU, not a group of other employees as well, like a regular 401(k). The burden is still on you to get everything filed that is necessary, but there’s much less paperwork comparatively.
What about my investment choices?
Solo 401(k)s are only as good as the plan provider. Prominent investment companies like Fidelity, Vanguard, Charles Schwab and others all offer these retirement plans but they can widely vary. One way is by the types of investment choices offered.
For instance, some companies will allow you to buy a huge variety of mutual funds, stocks, or bonds in your Solo 401(k). Others only provide access to mutual funds and ETFs and leave out individual investments. Most large companies will provide an large list of investment options to choose from.
Above all else, your investment options will almost certainly provide greater flexibility when it comes to asset class, variety and costs compared to traditional 401(k) plan investment choices.
Solo 401(k) Plans - A Great Wealth Building Tool for Small Business Owners
I hope this has been a helpful rundown of the benefits of Solo 401(k) plans. For small business owners with no employees, these can be a powerful force to help your business--through tax incentives--and build your own wealth at the same time.
If you have any questions about how Solo 401(k) plans might fit into your financial picture, let me know.