The Individual 401(k)

The Individual 401(k)—also known as “The Solo 401(k)” or “the Solo (k)”—works much the same as standard 401(k) plans offered by large corporations. This plan is reserved for self-employed individuals and for business owners with no full-time employees other than a spouse. If you work alone or in conjunction with your spouse, this type of account offers a great opportunity to save for retirement while saving on taxes. Sole proprietorships, partnerships, subchapter S corporations, C corporations, and LLCs all qualify for Solo 401(k) plans. If you are a self-employed individual you are regarded by the plan as your own employer so you can set one of these up, too. The rules for the Solo 401(k) permit you to play the roles of both employer and employee, allowing you to contribute a much larger amount to the plan in any given year than other self-employed plans.

As of this writing, the Solo 401(k) allows you to make a contribution of $18,000 (or $24,000 if you’re age 50 or older) from your self-employment income as either pre-tax or Roth-employee-deferral contributions each year. Since you can designate your “salary deferral” as a Roth contribution you won’t get a tax deduction for it, but the Roth portion of the account will grow tax-free thereafter. Plus, since you are the employer, you can also make what’s called a profit-sharing contribution to your plan of 25% (20% in the case of a sole proprietorship or single member LLC) of your self-employment earnings, which could bring the maximum contribution up to $53,000 or $59,000 if you’re 50 or older for the year. Given sufficient income, a husband and wife working for the same business may contribute up to $106,000 combined or $118,000 combined if they are 50 or older. The deadline to open a new plan is December 31st (or fiscal year-end).

The Solo 401(k) is unique in that, compared with other self-employed retirement plans, it allows for greater contributions to be made at identical income levels, thereby maximizing retirement contributions and valuable tax deductions. Because of the way the contribution is calculated, a larger contribution can usually be made into a Solo 401(k) than into, for instance, a SEP IRA at the same income level. Therefore, the Solo 401(k) is usually the best option for maximizing retirement contributions and valuable tax deductions while reducing income taxes. The ability to contribute in this extreme manner is typically of interest to high earners. But if that spells you, the Solo 401(k) is definitely worth a look.

Another fantastic benefit of this type of retirement plan is that tax-free loans from the account to the IRA owner up to 50% of the total 401(k) value, with a $50,000 maximum, are permitted in an Individual 401(k) plan. This is not an option with any other type of IRA. Solo 401(k) loans generally have a five-year term and the principal and interest are repaid back into your solo 401(k) typically with at least quarterly payments. A Solo 401(k) loan can be provided to you tax-free, penalty-free, and without credit checks or income qualifications, and the money can be used for any purpose. The loan feature of the Solo 401(k) loan is a key benefit for many self-employed business owners.

For people who want all the bells and whistles, and to be able to put aside substantial savings, the Solo 401(k) is clearly the best option. What’s the catch? Setting up this type of account can be costly. The initial set-up and maintenance are more than IRAs as there has to be a specialized plan administrator involved to establish the plan documents and handle the yearly bookkeeping and reporting to the IRS. Many firms will levy hefty setup charges (I’ve seen these range from $1,000 to $2,500, depending on the level of service and the size of the account). That’s in addition to the normal annual maintenance fees charged by the custodian or administrator who handle your investment transactions. Generally speaking, these fees are well worth the added benefits and potential large tax deductions provided by this plan. All in all, the Individual 401(k) is an incredibly powerful tool that all self-employed individuals should consider.

Matthew A. Tillack