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How A Solo 401(k) Plan Provides You With An Edge

Do you run your business as a sole proprietor? For years, the options for tax-advantaged retirement plans for one-person outfits were relatively narrow, restricted to specialized small-business plans such as simplified employee pensions (SEPs). But recent legislative changes have made it possible for sole proprietorships to use the same type of retirement vehicle—the 401(k) plan—favored by bigger companies. A special “solo 401(k)” may provide a distinct advantage over comparable retirement options, enabling you to salt away considerably more money for the future.

People who work for an employer offering a 401(k) plan have the opportunity to direct part of their salary into a personal retirement account that they can invest in mutual funds or other basic vehicles. The money deferred to a 401(k) isn’t taxed, and there are no capital gains taxes on investment profits. Instead, account owners pay income tax on money they withdraw during retirement. Many corporations match a portion of employees’ contributions.

There’s an annual limit on how much can be contributed to a 401(k). For 2010, salary deferrals are capped at $16,500 ($22,000 for those age 50 or over). In addition, the total annual contribution for 2010 to a “defined contribution plan” such as a 401(k) or a SEP is generally limited to 25% of compensation or $49,000 ($54,500 for those 50 or older), whichever is less. If you’re self-employed, the cap is 20% of what you earn, and the maximum compensation for these purposes is $245,000 in 2010.

Thanks to a recent change in pension laws, however, you now may be able to combine the annual deferral to a solo 401(k) with an employer’s matching contribution so that the total going into your plan exceeds the normal percentage limit for defined contribution plans. For example, suppose you’re 45 years old, self-employed, and earn $150,000 in 2010. If you contribute to a SEP in 2010, your contribution would be limited to 20% of $150,000, or $30,000. But if you establish a solo 401(k) plan instead, you may be able to save considerably more. First, you defer the employee’s maximum $16,500 to the plan. Then, because you work for yourself, you can sweeten the deal with the maximum employer contribution of $30,000. Add the two together and you can contribute $46,500 to the plan this year.

The more you make, the more you can put into a solo 401(k), though you’ll still be subject to the overall dollar limits of $49,000 or $54,500 that apply to defined contribution plans. Once your compensation reaches $162,500—20% of which is $32,500, the maximum you can add to the $16,500 individual contribution without exceeding the $49,000 cap—the comparative advantage of having a 401(k) instead of an SEP begins to decline. But you’d have to make the full $245,000 to be able to contribute as much to an SEP as to a 401(k).

How much more can you accumulate if you choose a solo 401(k)? It depends on the maximum contributions at your income level for a 401(k) compared with an SEP and how long you have until retirement. But if, for example, you’re able to put away $15,000 more each year in a solo 401(k), you have 25 years to retirement, and you earn 8% annually on investments within the plan, you’ll pile up an additional $1,143,549.

A solo 401(k) plan may also provide other benefits, including:

·        The flexibility to put as much or as little as you choose into the plan each year. If your business is having an off year, you can reduce or suspend contributions until conditions improve.

·        The possibility of taking loans or hardship withdrawals from the plan. If you borrow from your plan, you’re effectively paying yourself back with interest.

·        The ability to accept rollovers from other qualified retirement plans or traditional IRAs.

It used to be that the administrative cost of a 401(k) plan was too high for many sole proprietors, but fees have come down during the past decade. Typically, you’ll now have to pay a set-up fee of about $100 plus ongoing expenses of a few hundred dollars a year. Keep in mind, though, that the benefits of a solo 401(k) really apply only to solo businesses. If your company employs other full-time workers, you must cover them as well and make employer contributions to their plans. But that requirement also applies to other types of retirement plans. If you run a successful one-person business and you want to build up your retirement plan balance as quickly as possible, a solo 401(k) could be your best option.

This article was written by a professional financial journalist for Legend Financial Advisors, Inc. and is not intended as legal or investment advice.

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