The Benefits of Owning a Solo 401(k)
By CHM on Mar 18, 2008 in Featured, Roth 401K, Traditional 401K
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If you’re self employed and feeling kind of down because you think your retirement options are limited to a SEP or a SIMPLE IRA… I’ve got good news for you… you can create your very own Solo 401(k)!
Similar in every way to it’s larger, more complicated, weighed down, traditional corporate 401(k) cousin, minus all the administrative headaches.
How does that sound? Hopefully, pretty good!
The 1 person 401(k) goes by a few different names, but is most commonly referred to as the Solo 401(k) or individual 401(k). Although the plan is designed for the individual business owner (or self employed), it is technically available to the spouse of the owner and any shareholder or partner in the business, as well.
A Solo 401(k) is simple and straight forward
Setting up a Solo 401(k) makes a lot of sense for sole proprietors, owners of an S Corp, C Corp or partnership. It would not make sense if you had employees or were thinking of hiring any employees in the near future. It’s specifically designed for you (and your spouse or partner) ONLY!
Going back to my original example from many posts ago - let’s assume things are going well, Blogger X has successfully monetized his blog and decides to go at it full time, incorporating his business. Let’s look at the pros and cons of setting up a Solo 401(k):
The Pros of a Solo 401(k)
- Contributions are discretionary each year and 100% vested immediately
- You may exclude any part time employee who works fewer than 1,000 hours per year.
- Since the plan is for you and yours ONLY, your administrative requirements are minimal. Most Solo 401(k)’s can be setup easily at financial institutions, as detailed in this Fidelity Self Employed 401(k) account review.
- Like any 401(k), for 2008, you can elect to defer up to $15,500 of your pre-tax income.
- On top of the $15,500, as the employer you can also make a profit sharing contribution up to 25% of your pay (which would be based on your W-2), not to exceed $46,000 for 2008.
- 100% of your pay can be set aside (unlike a SEP), which allows you to potentially contribute a lot more to a Solo 401(k).
- Unlike traditional 401(k)’s, there are no complicated discrimination tests or Form 5500 filing. You will have to file a 5500 if your Solo 401(k) exceeds $100,000 (not a bad problem to have).
- If you maintain a Solo 401(k), in addition to a traditional 401(k) through another employer, the total salary deferral you can make, between all your 401(k)’s is $15,500 for 2008. For example, in addition to your self employment income, you work another job and contributed $10,000 to that 401(k) for 2008. When it comes to your self employed salary deferral, you can only add an additional $5,500 for 2008.
The Cons of a Solo 401(k)
- The plan has to be established by the end of the business tax year in order to make a contribution for that year (unlike the SEP which can be setup until your tax filing)
- The Solo 401(k) is only designed for business owners and their spouse. If you want to hire employees and grow the business, you will have to look into the more complex traditional 401(k); or you can set up a SEP or SIMPLE and allow for qualified employees to participate.
- When it comes to making the profit sharing contributions, each owner and spouse must receive the same percentage of pay contribution; there is no flexibility here, as there is with the salary deferral portion of the Solo 401(k).
A Solo 401(k) example
A Solo 401(k) is a very powerful retirement option and gives you the ability to earmark the most money towards retirement, in the easiest manner possible. Because I know some of these bullet points may have your head spinning, I’m going to leave you with an example that incorporates much of what I’ve written.
A business owner, Vincent Ferrer, owner of Chance Favors the Prepared Mind Inc., earns $120,000, has no employees, and sets up a 401(k) plan for himself. Vincent elects to defer the maximum for 2008 $15,500. In addition, the business is permitted to deduct contributions up to 25% of Vincent’s total compensation, or $30,000. Now, keep in mind, the $15,500 salary deferral does not reduce the amount of the business deductible contributions.
The deferral does however count towards the total addition to Vincent’s account, and the plan is limited to contributing the lesser of $46,000 or 100% of compensation to the owner’s account. Therefore, after reducing the $46,000 (for 2008) by the $15,500 deferral, the business would be entitled to contribute the full $30,000 (which would bring the total contribution to $45,500, exactly $500 below the maximum for 2008).
In Conclusion
I’m not sure I succeeded in simplifying things, did I confuse you more with that example? Oh well.
The bottom line: the Solo 401(k) is the easiest way to sock away as much as possible, and control the profit sharing contributions that serve to drastically inflate the monies you can earmark for retirement.
And finally, where to open the account and keep the Solo 401(k)? I’d say anywhere you can build a diversified portfolio of ETF’s…
Tags: Solo 401k
Andy | Mar 18, 2008 | Reply
Great post. It was very clear. Self-employed retirement plans are pretty confusing, so this series of posts is helpful.
Stuart | Mar 18, 2008 | Reply
Good overview and like the solo 401k. Another advantage is that 401ks offer extra piece of mind. In case you need access to cash to get through a tight spot, it’s possible to take a loan from your 401k without any penalties (in fact, interest is paid back to your account).
For those looking for an ETF-based 401k plan, you may want to check out ShareBuilder 401k. They appear to be a leader in this and offer a solo K. And you can get special pricing through their deal with Costco if you’re a member. Just go to Costco.com and type 401k into their search box and you it should pop up.
Good luck,
Stuart
CHM | Mar 19, 2008 | Reply
@Andy - thanks, if you’re ever confused feel free to ask.
@Stuart - thanks for adding a bit more, the Solo 401(k) has all the loan options available to a traditional 401(k). And I’m going to loo into Share builder, and maybe write a post about it soon, thanks for reminding me.
Matt | Mar 19, 2008 | Reply
I have a day job 9to5 and run a small business on the side. Can I open a SEP IRA or 401(k) for my small business even though my RothIRA is maxxed out by the 9to5? Can I open a Solo401(k) for my business even though im contributing (though not maxxing) my 401(k) through the 9to5?
CHM | Mar 19, 2008 | Reply
If you run a small business on the side and file a schedule SE then you can open a SEP (or Solo 401(k)if you’re the only employee.)
Yes you can open a Solo 401(k) for your side business. If you were making the max $15,500 salary deferral (for 2008) in your 9 to 5 job (which your not) then you wouldn’t be able to defer any more of your salary from the side business towards it.
In your case, take the difference between $15,500 and what you are contributing in the 9 to 5 plan and that’s what you can still defer in a Solo 401(k). However, you could always make the profit sharing portion of the contribution… the difference b/w your $15,500 deferral and the amount which is the lesser of 25% of side biz salary or $46,000.
Kristin Demarest | May 6, 2008 | Reply
My question is similar to a post above except for a couple of details. I contribute the maximum to my 403b at my regular work. I also do freelance work. I would like to shelter some or all of that freelance money from taxes (it is only a few thousand a year). Can I at least take 25% of what I earn off of that freelance work and contribute to a solo 401k as profit sharing? If not, it sounds like a solo 401k is not for me. How about a SEP? Is there anyway for me to shelter some of that extra income given that I max out my 401k at work?
Thanks so much!
401 K Plans | May 23, 2008 | Reply
This is an awesome blog that is related to 401 K Plans that there are regulations concerning depositing money into and withdrawing money out of a 401k and you should understand them before you open an account to make sure your don’t incur unnecessary fees. A 401k retirement account is sponsored by your employer and your deposit into the account is taken directly from your paycheck before taxes are calculated.
Andrew | May 31, 2008 | Reply
My main job I contribute 15,500 to my 401K
I now have a part time job. I would love to be able to put all the money I make on my part time job into a 401K. Reason I don’t want to be put in the next higher tax bracket is there any plan I can use to keep this from happening?
Bruce | Jun 1, 2008 | Reply
If I’m self employed (single proprietorship LLC, which is reported on Schedule C) and I open a Solo 401K, where do I get “credit” for the deduction on my income taxes? Does this go on the line typically used for IRA’s? (while with a real company and a real job, they did this “pre-tax”)
Jay | Jun 7, 2008 | Reply
If I own a business (S-Corp) and pay myself $100,000 of income and have additional $600,000 of S-Corp income. I have one part-time employee who works less than 1000 hours.
For my example:
Defer $15,500 (compensation)?
Employer Match $25,000?
Total $40,500?
CAN I EXCLUDE MY PART TIME EMPLOYEE?
Willem | Aug 11, 2008 | Reply
real situation in Georgia
real situation in Georgia
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Julie | Sep 14, 2008 | Reply
Still not clear with all 401(k)s. If I contribute $6,500 to my employer’s 403(b), I can also put $9,000 into my own solo 401(k). Can I still put another 25% (or 20%) of my self-employed earnings into the plan. If not, I should not contribute to the employer’s plan b/c I want to put away all of the $15,500 and additional 25% (20%) of self-employed earnings. I want to maximize with $24,000 of W-2 earnings and $ 60,000 self-employed. Which way do I invest?
Mike | Dec 14, 2008 | Reply
Hi Ciaran,
I am a doctor and have three different income.
1 My salary (has 403 b account)
2 Profit Sharing with the hospital with my practice. (w2 earning )Which added every month to my salary.
3 1099 income from different hospital.
Do you think I can open self employed 401k and use some of my income from no.-2 and no. 3 source of income to this account ??
Thanks,
Mike