If you're self-employed or have a small business, the idea of a 401(k) may make you jump to two conclusions: “My company is too small” or “I can’t afford it.” Well, you’re not too small and you can afford it!
A Solo 401(k) is inexpensive to set up and easy to maintain – and it delivers substantial tax and saving advantages. Use a Solo 401(k) plan if you’re self-employed or run an owner-only business. You could add multiple owners and a spouse to a Solo 401(k) plan, but if you add full-time employees you’ll need to convert it to a more traditional IRA plan.
Solo Benefits, Duo Roles
One benefit of a Solo 401(k) is that you assume the role of both employer and employee, which allows you to contribute up to $50,000 ($55,500 if your 50 or above) of your annual income, tax-deferred, for 2012. Contributing the highest amount could put you into a more advantageous tax bracket that can help reduce the time to reach financial retirement – another benefit!
A high contribution limit, tax advantages and penalty-free loans make the nominal price for a Solo 401(k) a wise financial move if you want to deffer more of your income than the traditional IRA limit of $5,000 a year.
Up to now, many entrepreneurs have used traditional IRAs to save for retirement – a strategy which offers lower contribution limits and includes the risk of penalties incurred on owners who accessed funds before reaching retirement age. The Solo 401(k) presents more flexibility than other retirement accounts, including IRAs.
Let’s compare a Solo 401(k) to a Traditional IRA:
| Solo 401(k) | Traditional IRA | |
| Limit Per Individual | $50,000 | $5,000 |
| Catch-up Contribution (Age 50+) | $5,500 | $1,000 |
| Income Limit on Roth | None | $125,000 * |
| Tax-free, penalty-free access | Yes (loans) | No |
* Amount you can contribute starts phasing out at $110,000 and not allowed if earning $125,000 or more.
How to Save $10,000 in Taxes in 2012
Let’s look at an example of how a sole-proprietor under 50 years of age can maximize their retirement savings and lower their taxes for 2012:
| Total Earnings | $165,000 |
| 401(k) Contribution | $17,000 |
| Profit Sharing (20% of net self-employment) | $33,000 |
| Total Savings | $50,000 |
| Taxable Income | $115,000 |
While the owner earned $165,000 in 2012, only $115,000 is IRS taxable. Assuming an adjusted gross income tax rate of 20 percent, that’s $10,000 they can keep for himself (instead of paying Uncle Sam). What’s more, the savings are likely to be even greater because his tax bracket will probably drop.
Solo 401k Contribution Deadline
While business owners will have until their tax deadline to contribute to their Solo 401(k) accounts, the IRS requires their plans be set up by December 31 in order to qualify. Many providers have deadlines well before the 31st, so setting it up sooner rather than later is a smart option.
The majority of businesses likely have until April 15, 2013 to make their contributions for 2012. However, if the company was established as a corporation, the deadline moves back to March 15. But don’t despair: by setting up a plan before the end of the year, you will have time to determine the optimal amount to best manage your tax and retirement savings.
One final tip: If the Solo 401(k) and Roth Solo 401(k) options are important to your investment strategy (i.e. real estate investments), be sure to use a provider who offers a full-featured, completely self-directed Solo 401(k) plan. Some providers offer individual 401(k) plans with administrative services and few investment options from the array of investments they support. Such plans are not truly self-directed, and limit your investment options, preventing you from investing in non-traditional investments such as rental property, and could also lack Roth sub-accounts and loan features of the plan.
