Self-employed people have various options to save for retirement with tax deferral and tax saving options, and one of the most attractive is the solo 401(k) — sometimes called an individual 401(k).
Some of its advantages are large allowable contributions and a Roth 401(k) option.
There is one potential disadvantage. The plan is meant for self-employed proprietors and their employed spouses. If the self-employed owner hires a person other than a spouse, the owner must contribute the same percentage of the employee’s income to the employee’s account that he contributes to his account. Accordingly, an owner who anticipates hiring other employees, and who does not want to contribute the same percentage he intends to invest for himself, should consider a different retirement option.
–Who can participate: Self-employed individuals with no common-law employees are eligible, as are their spouses who are employed by the business. The owner can contribute both as an employer and as an employee. Also allowed are C corporations, S corporations and limited partnerships (LLCs).
–Contribution limits: The absolute contribution limit in 2019 is $56,000 ($62,000 for those 50 or older). As an employer, a person can contribute up to 25% of his compensation. The contribution limits generally change each year. Employer contributions are generally deductible each year as a business expense. It is not necessary to make a contribution each year.
As an employee, a person can contribute up to 100% of his/her compensation or $19,000, whichever is less, for 2019. For individuals 50 or older, the limit is $25,000. All participants must contribute the same percentage of their compensation.
–Roth option: After-tax contributions can be made to a Roth 401(k) or to a traditional 401(k). If the Roth option is used, withdrawals, including interest, dividends and capital gains, would not be subject to federal income taxes for participants older than 59 1/2 as long as the contributions were made for at least five years. Withdrawals prior to age 59 1/2 and withdrawals of contributions not invested for five years are subject to a 10% penalty.
If a traditional 401(k) is used, contributions are not taxable. Dividends, interest and capital gains are tax-deferred. Withdrawals after age 59 1/2 are subject to federal income tax at ordinary income tax rates. Withdrawals prior to 59 1/2 are subject to a 10% penalty
–Loan option: Regulations do allow account holders to take a loan from their solo 401(k). However, financial institutions that offer solo 401(k)s are not required to offer this option. Accordingly, if you believe this is a necessary option, make sure the financial institution you are considering offers it.
–Timing considerations: A solo 401(k) must be established by year end in the year the owner wants to make contributions. However, the funding is allowable up to April 15 the next year and can be extended if the owner requests an extension.
Selection of financial institution: Many large financial institutions offer solo 401(k)s, including Vanguard, Fidelity and Schwab. Naturally, you should select a financial institution based on fees and available investment options. There are no regulations that limit investment selection for solo 401(k)s. You will have a wide selection of investment options.
–Switching accounts: If you do establish a solo 401(k) and wish to change financial institutions, have the assets transferred directly to the new provider. If you transfer the assets to yourself first, you will incur unnecessary penalties.
–Hiring employees later: It is not unusual for employers to initiate a small business and later decide to hire employees later. This will cause problems for the employer if he does not wish to contribute the same percentage of income to his employees’ accounts. In this situation the employer can stop making contributions to his/her solo 401(k) and consider other retirement options.
(Article written by Elliot Raphaelson)