As a small-business owner, you don’t have the luxury of relying on an employer for things like vacation benefits or a retirement plan. When it comes to building your nest egg, there are lots of options for the self-employed. But choosing the right one is no easy task. A SIMPLE or SEP IRA, for example, may make sense if you have employees, but for some entrepreneurs, a solo 401(k) likely offers a bigger bang for your savings buck.
Solo 401(k) Eligibility Rules
The rules about who can chip in money to a solo or individual 401(k) are fairly straightforward. These plans are open to sole proprietors and businesses whose only employee is a spouse. Partnerships and corporations without employees are also covered under these guidelines. Your ability to contribute to this kind of 401(k) isn’t limited by your income.
Annual Contribution Limits
As the owner of a solo 401(k), you act as both the employee and the employer for contribution purposes. As the primary plan participant, you’re allowed to make elective deferrals equaling as much as 100 percent of your compensation, up to the annual contribution limit. For 2014, you could put in up to $17,500 unless you’re over 50, in which case the contribution ceiling is bumped up to $23,000.
You can also make profit-sharing contributions as an employer totaling up to 25 percent of compensation. For 2014, the maximum amount on which these contributions can be based is capped at $260,000. The total combined amount you can save in a solo 401(k), including both employee and employer contributions, is currently set at $52,000. The IRS routinely adjusts the limits for inflation.
Tax Advantages of a Solo 401(k)
In terms of the tax benefits of contributing to an individual 401(k), it’s pretty much a win-win if you’re self-employed. All of the money you save through the plan is generally tax-deductible, and income tax is only due once you start making qualified withdrawals. Unless you expect your tax bracket to increase substantially once you get closer to retirement age, that should work in your favor.
The rules for withdrawals are similar to those for a traditional 401(k). You can withdraw money penalty-free once you reach age 59 1/2. Try to pull the cash out before then and you’ll have to pay taxes on the money along with a 10 percent early withdrawal penalty. You may be able to borrow against your account balance, but not all plans allow loans, so you’ll have to read the fine print to make sure. Once you turn 70 1/2, you’re required to begin taking minimum distributions from your account; otherwise, you’ll get hit with a tax penalty.
What Are the Drawbacks?
Perhaps the biggest hassle that goes along with a solo 401(k) is getting the plan set up. It usually requires a little more paperwork compared to other retirement accounts, and, as the plan administrator, you’ll be responsible for making sure you’ve completed everything accurately. The deadline for establishing a new plan for the current tax year is December 31, so it can be a bit of a headache trying to get things in order if business is booming during the holiday season.
Another issue worth considering is your business’ general outlook. If you think you’ll need to add employees at some point, for example, you’d have to jump through some additional hoops to convert your solo plan to a full-fledged 401(k).
Even if you don’t bring anyone else onboard, there are some additional tax-reporting requirements you’ll have to meet if your account assets exceed $250,000. These generally aren’t things you’d have to worry about if you went with another kind of small-business retirement plan.
Finally, aside from the amount of time that’s required to open and maintain a solo 401(k), business owners also have to be aware of the financial cost going in. There are a number of investment firms that offer these types of plans, and the maintenance fees vary from one company to the next. Carefully reading through the prospectus before settling on a plan helps ensure that fees aren’t substantially detracting from your savings efforts.