Home Base: A 401(k) Option for the Self-Employed

While running your business can offer a freedom and flexibility not available in corporate world, it also means entrepreneurs must play extra attention to their retirement goals. Sole proprietors and owners of home-base businesses are less likely to own IRAs or participate in 401(k)/Thrift plans, according to a study released by the Small Business Administration in March.

If you’re trying to figure out a retirement vehicle, a Self Employed 401(k), also known as a solo 401(k), can offer some of the same benefits of a regular 401(k) but with the flexibility necessary for the self employed.

If you are self employed and you anticipate making contributions in excess of IRA limits, you should consider a solo 401(k), says David Wray, president of the Profit Sharing/401(k) Council of America (PSCA), a national, non-profit association of companies that sponsor profit sharing and 401(k) plans. Wray broke down the advantages and disadvantages to investing in a solo 401(k).

What is the maximum amount you can contribute to a solo 401(k) annually? You can contribute up to $16,500 if you’re under age 50 and $22,000 if you’re age 50 or over. In addition to that you can invest company contributions up to 25% as well. The 401(k) contribution comes out of earned income and the company contribution comes out of profit income. Overall, the solo practitioner can actually contribute up to $49,000 – tax deferred — given contributions from income and then company contributions.

What are the tax benefits that come with investing in a solo 401(k)? You have the ability to make a significant tax deferred contribution. Your solo 401k contributions are income tax deferred but you do have to pay FICA. A solo practitioner is  typically going to be filing taxes quarterly and your solo 401k contributions will all be apart of that. Typically they’ll be paying their FICA as they go along, but they’ll be paying less in income tax as they go along too.

What’s the benefit of investing in a solo 401(k) compared to an IRA? The big difference is the limits. With an IRA there is $5,000 maximum contribution and an additional $2,500 in catch up contributions if you’re over age 50. In a solo 401k there’s a maximum contribution of $49,000 plus an additional $5,000 in catch up contributions if you’re over age 50But there are additional fees associated with a solo 401(k) because there are some filing requirements.

How does the traditional solo 401(k) stack up to the solo 401(k) Roth? The first thing to consider is the tax consequence. A Roth approach favors a situation where a person is going to pay at a higher tax rate when the money is withdrawn than when the money is initially invested. For example, if you’re putting the money in at 25% tax bracket and you’re taking it out you’re at a 12% tax bracket you would want to defer the tax because you’re only going to pay 12% on your money versus 25%.

Are there penalties for early withdrawals/borrowing against your solo 401(k)? You can borrow half of what’s in the account up to $50,000. If you take the money out a solo 401(k) just as in an IRA, you pay a 10% penalty on the amount withdrawn. This penalty is in addition to the regular tax you would pay on what is withdrawn.

If I stop running my home-base business and opt to work for an employer, can I roll the solo 401(k)? In some cases it will make sense to roll it into the new plan in some cases it may not. You want to look at the fees. If you’re going to work for a large corporation the fees are going to be much lower. In a solo 401(k) with brokerage account you have much more flexibility and for some that’s important. The new plan investments are going to be much more limited than what you currently have, a corporate plan is going to have fewer than 20 choices, typically.

For more information and resources to help you run your home based enterprise, check for Home Base each week at BlackEnterprise.com.