The Benefits of Owning a Solo 401(k)

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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