Recently joining the ranks of the self-employed by starting my own firm in 2007, I no longer had the option to contributing to my previous employers 401(k). Having my own business, I was now open to a slew of retirement plan choices. I could do a Simple IRA, SEP IRA, or the Solo 401(k) plan. I had done my fair share of advising clients on the investments inside these plans, but it’s whole new ballgame when you are on the other side deciding what plan is best for you. Although, I ended up choosing the SEP IRA for the 2009 tax year (I’ll explain my reasoning in the post), I was able to learn much more information on the Solo 401(k) rules and contribution limits and wanted to pass them along.
Although the plan is designed for the individual business owner (or self employed), it is technically available to the spouse of the owner and any shareholder or partner in the business, as well.
1. A Solo 401(k) is Simple
Setting up a Solo 401(k) makes a lot of sense for sole proprietors, owners of an S Corporation, C Corporation or partnership. Currently, my business is structured as a sole proprietor so setting up a Solo 401(k) seemed like it made a lot of sense. Unlike traditional 401(k)’s, there are no complicated discrimination tests or Form 5500 filing. Not sure what a 5500 is? It’s a form that larger 401(k) plans have to file with IRS to be compliant. A Solo 401(k) doesn’t have to worry until the plan reaches in excess of $250,000 to have to file a Form 5500.
2. Who is a Solo 401(k) Plan For?
Although it is called a “Solo” 401(k), you can actually set up for you and your spouse. If you have a bona fide partnership, it would work for them as well. You are able to exclude any part time employee who works fewer than 1,000 hours per year. If you have any employee that works these hours, the Solo 401(k) is not an option for you. Also, if you plan on hiring employees in the near future, you may want to consider a different plan.
3. Solo 401(k) Maximum Contribution Limits For 2009
Contributions are discretionary (meaning you don’t have to contribute) each year and 100% vested immediately. Like the regular 401(k) contribution limits for 2009, you can elect to defer up to $16,500 of your pre-tax income. If you are over the age of 50, you can do the catch up contribution of $5,500, for a total of $22,000. On top of the $16,500, as the employer you can also make a profit sharing contribution up to 25% of your pay (which would be based on your W-2), not to exceed $49,000 for 2009. (I have an example below)
4. When Does a Solo 401(k) Plan Have To Be Established?
The plan has to be established by the end of the business tax year in order to make a contribution for that year (unlike the SEP IRA which can be setup until your tax filing). This is in part why I passed on the Solo 401(k) for 2009. Since 2008 was my first full year in business, I had opted to file an extension to allow some time for me to completely figure out my tax situation. Since I had missed the year end deadline, the SEP IRA made the most sense. Since the Solo 401(k) plan is for you ONLY, your administrative requirements are minimal. That is one of the major benefits of the plan. If you maintain a Solo 401(k), in addition to a traditional 401(k) through another employer (yes I’ve seen this done before but rare), the total salary deferral you can make, between all your 401(k)’s is $16,500 for 2009. For example, in addition to your self employment income, you work another job and contributed $10,000 to that 401(k) for 2009. When it comes to your self employed salary deferral, you can only add an additional $6,500 for 2009.
5. How Do You Contribute to the Plan?
When it comes to making the profit sharing contributions, each owner and spouse must receive the same percentage of pay contribution; there is no flexibility here, as there is with the salary deferral portion of the Solo 401(k). You can wait till year end to make the contribution, just remember that the plan has to be set up before December 31st.
6. Choosing Between Solo 401(k) Plan & SEP IRA
For somebody (business owner) who has a significant net income and wants to sock away a good chunk of money pretax, the Solo 401(k) deserves a long hard look. One big reason is that 100% of your pay can be set aside (unlike a SEP IRA), which allows you to potentially contribute a lot more to a Solo 401(k). Let’s look at a quick example for a self-employed 50 year old business owner who has $100,000 in compensation:
For both the SEP IRA and Solo 401(k) you would be able to make a $18,587 employer contribution (25% X $74,348, which is Net Earnings after self-employment tax is deducted). But here is where the Solo 401(k) kicks into hyper drive. On the top of the $18,587, the business owner can also make a $16,500 employee contribution and an additional $5,500 catch up contribution. With the SEP IRA, this is not an option. In total, the business owner can contribute $40, 587 which is $22,000 more than its SEP IRA counterpart. That is a significant difference and tax savings!
7. Can Your Borrow From a Solo 401(k)?
Just like a regular 401(k), a Solo 401(k) does have borrowing provisions. A Solo 401(k) participant can borrow up to either $50,000 or 50% of their account value with the following terms:
- To be repaid over an amortization schedule of 5 years or less
- Regular payments no less frequently than quarterly
- At a reasonable rate of interest… generally interpreted as prime rate + 1%
Be sure to check your custodian to make sure that borrowing is allowed. Some low fee custodians prevent borrowing based on the low administrative fee that they charge. Read the fine print!
A Solo 401(k) example
Just so I haven’t left you too confused, I thought I would close with another Solo 401(k) example to bring it all home:
A business owner, 48 year old Tony Stark, founder of Stark Industries, earns $150,000, has no employees, and decides that the Solo 401(k) is the best plan for him. Tony decides he can defer the maximum for 2009 $16,500. In addition, the business is typically permitted to deduct contributions up to 25% of Tony’s total compensation. In this case, 25% would be $37,500. Remember the $16,500 salary deferral does not reduce the amount of the business deductible contributions. Since the $37,500 employer contribution and $16,500 employee contribution total $54,000, Tony will only be able to contribute the max for 2009 which is $49,000. If Tony were over the age of 50, he would have been allowed a catch up contribution to be able to max out the full benefit.
My Plans for a Solo 401(k)
So how does the Solo 401(k) fit into my plans for 2009? Currently, we plan to build our first home (hopefully our last) as soon as our current home sells. We had a goal of 8 months of emergency funds — which we reached! Personally, I would like to see that get up to the 12 month range if possible. With that being our major goal, I don’t see the advantage for us with the Solo 401(k) just yet. We will most likely continue to fund our SEP IRA. 2010 though, might be the time….. Before deciding if a Solo 401(k) is right for you, be sure to consult a tax advisor first.
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Jeff Rose, CFP is the owner of Good Financial Cents, a Financial Planning and Investment Blog by a Certified Financial Planner with a goal of helping you make "Cents" of your investments.
Article copyrighted by Jeff Rose. Content published with author's permission.
Some accounts also allow Roth contributions as per
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