Solo 401(k) Offers Big Tax Savings For Self-Employed

How would you like to put away almost $50,000 in your own 401(k) plan? Well, if you're self-employed, you should check out the solo 401(k). It provides opportunities for large retirement plan contributions, and there's still time to open one for 2009.

What Is It? A solo 401(k) plan is a 401(k) that can be created by people who are self-employed, such as consultants (and plenty of people are working as consultants these days). The key to the solo 401(k) plan is that you must not have any employees besides yourself and a spouse. But if you work alone or in conjunction with your spouse, then you've got a great opportunity to save taxes.

• The solo 401(k) plan allows you to make a contribution of $16,500 (or $22,000 if age 50 or older) of your self-employment income each year. Plus, you can also make what's called a profit sharing contribution to your plan, which could bring the maximum contribution up to $49,000 for the year.

Here's How They Work. Assume you're a self-employed consultant and you generated $30,000 this year in consulting income. You can create a solo 401(k) and contribute the $16,500 (or $22,000 if 50 or over) this year. Compare that to an SEP plan that would basically limit you to about 20% of your $30,000 of income, or $6,000 for the year.

• Moreover, you can also make a profit sharing contribution up to 20% of your net self-employment income. There are some technical tax adjustments necessary to come up with this number. But in a simplified example, this means you could contribute another $6,000 into the plan, which would put you at $22,500, or $28,000 if over age 50. Wow, that's a huge tax deduction based on only $30,000 of income.
• And the funding is flexible. So if you have good year or extra cash around, you can maximize your contributions. If times are tight, you can skip them or cut back.

Planning Ideas. Here are a few scenarios under which a solo 401(k) might provide you with some good tax savings opportunities:

• Let's assume your spouse works as a regular employee and you are self-employed earning $30,000. Your spouse can contribute to his or her 401(k), and then you can max-out the contribution to your solo 401(k) of $16,500 plus about another $6,000 of profit sharing contributions.
• Let's assume you work as a regular employee for one company but also have outside consulting income of $30,000. If you don't have a 401(k) in your regular job, you can establish your own solo 401(k) and contribute to it using your consulting income.
• Or, if you have a 401(k) in your regular job but for some reason you can't maximize the contribution, you can use your solo 401(k) to reach the annual deferral limits of $16,500 ($22,000 if 50 or over). But remember, the 401(k) deferral limits are per person, not per employer. So if your limit is $16,500 for the year, and you contributed $8,000 to your work 401(k), you can't do more than $8,500 to your solo 401(k). But once you top-off your solo 401(k) contributions, you can still make a profit sharing contribution of 20% of your self-employment earnings, which is about another $6,000 in this example. If, however, you're an owner of another business (not just an employee), certain IRS rules may prevent you from opening your own solo 401(k), so check with your pension advisor.
• If you and your spouse both work in the business (and have no other employees), you can both contribute the maximum deferral amount and the business can make a "profit sharing" contribution on behalf of both of you. Depending on your total earnings in the business, the contributions could approach $100,000 for the two of you.
• You can also designate your "salary deferral" contribution (the $16,500 or $22,000 for those 50 and over) as a Roth contribution. You won't get a tax deduction for it, but the account will grow tax free hereafter.

Compliance. In general, the solo 401(k) plan is easy to operate. The most difficult part of the process each year is calculating what you can contribute to the plan. You have to figure out how much can go in as a salary deferral and how much can be contributed under the profit sharing feature. It's well worth it to spend a few dollars to have your accountant do this for you, and to make sure you've met all the requirements and record keeping for the plan.

• There is a filing requirement with the plans. Once your solo 401(k) plan exceeds $250,000 in assets, you need to file a Form 5500 with the IRS. It's just an informational return, and it's not a big deal, but you do need to file one.

Where To Find One. Many discount brokerage firms and mutual fund companies offer solo or individual 401(k) plans, and some don't charge anything for the plans. It won't take you long to find a provider who offers a low or no cost plan with plenty of competitive investment options.

Compare. There are a number of retirement plan options available for small businesses. So it's prudent to compare the various plans, such as a SEP, traditional profit sharing, or SIMPLE IRA. But for many self-employed individuals who want access to large contribution limits, the solo 401(k) may prove the most flexible.

Bottom line. If you have self-employment income, a solo 401(k) offers a simple way to not only generate big tax savings but to significantly accelerate your ability to accumulate assets for retirement. You've got until December 31st to open one for 2009.

As with all tax matters, consult your individual tax advisor prior to making any decisions.

Learn More: Want to learn about a simple way to manage your personal finances and prepare for retirement, investigate my upcoming book Your Money Ratios: 8 Simple Tools For Financial Security, available for pre-order at amazon.com

Disclaimer: The copyright of this article belongs to the original author. Reposting this article is solely for the purpose of information dissemination and does not constitute any investment advice. If there is any infringement, please contact us immediately. We will make corrections or deletions as necessary. Thank you.