If you are a freelancer, consultant or other self-employed person, the government offers a $50,000 tax break that could help secure your retirement.
The solo 401(k) — also known as the individual 401(k) — was created by the Economic Growth and Tax Relief Reconciliation Act of 2001. For the 2012 tax year, it allows businesses with only one full-time employee-owner to contribute up to $50,000 to the plan ($55,500 for those 50 and older).
The benefit is even greater for business owners who are married. Spouses on the payroll are the only exception to the “one worker” eligibility rule, and they are allowed to make contributions equal to those of the business owner. That means a married couple can sock away a whopping $100,000 annually.
“For the truly self-employed person, it’s probably the absolute best plan available to them when you consider the amount of money you can put away,” says Rick Meigs, president of 401kHelpCenter.com.
How can people shelter so much income in a solo 401(k)? It boils down to the two ways in which contributions are made.
Participants in a solo 401(k) make the same employee salary deferral contribution that all workers make to their 401(k) plans. For 2012, those limits are $17,000 per individual, or $22,500 for people ages 50 and older, according to the Internal Revenue Service.
But in addition to being employees, solo 401(k) participants also own their companies. That means they can contribute more money through an employer contribution — just as an employer makes a matching contribution to their employees’ 401(k) accounts in any other business. In fact, IRS rules enable employers to contribute more than just a typical match.
Example: Sarah, a hypothetical 52-year-old, earns $100,000 in W-2 income from her S corporation. This year she defers the maximum employee salary deferral amount of $22,500, which includes catch-up contributions, to her solo 401(k) plan. In addition, her business contributes 25 percent of her pay, or $25,000, to the plan. She has a total of $47,500 invested in the plan in 2012.
Who offers these plans?
Many financial service providers will help you set up and administer these plans. When choosing a provider, it is important to understand your investment goals, Meigs says.
“The first thing you’d want to do is decide what kind of underlying investments you want to make,” he says.
If you plan to invest in mutual funds, many fund companies and discount brokerage firms offer a solo 401(k) option, including Fidelity, Vanguard, T. Rowe Price, Charles Schwab, OppenheimerFunds and TD Ameritrade.
Ken Hevert, Fidelity vice president of personal and small-business retirement products, says many self-employed investors who come to Fidelity are looking for just this type of product.
“What first comes out of a small-business owner’s mouth is that ‘I want to set up a 401(k),'” he says.
Fidelity offers free assistance in establishing a solo 401(k) plan and ongoing help once the account is up and running. The Fidelity program is “truly focused on making maximum contributions,” Hevert says. As a result, participants are not allowed to take loans against their accounts, an approach that helps keep costs down.
“We don’t charge fees,” Hevert says. “It’s a very streamlined plan.”
However, that doesn’t mean there are no costs. Mutual funds always have expense ratios. Plus, trading in stocks will also incur a charge.
When choosing a solo 401(k) provider, it is best to shop around. Details differ from company to company. For example, Vanguard offers traditional 401(k) plans and Roth 401(k) plans. Fidelity only offers the former.
On the other hand, both companies prohibit you from taking loans from your account.
Setting up the plan
The deadline for establishing a plan is Dec. 31, or the end of the fiscal year if you incorporate. Because the plans are discretionary, you decide when and how much to contribute.
Solo 401(k) plans are best suited for self-employed people who want to save a lot of money for their retirement accounts, and who make enough cash from their business to make large contributions.
They also are better for self-employed individuals such as consultants, freelancers and other independent contractors who do not plan to add employees.
Are there downsides to solo 401(k) plans?
“Not a lot,” Meigs says. “Probably the biggest potential downside is that if your long-term business plan is to grow your company and begin hiring employees, you’re going to have to convert this to a full-blown 401(k) plan.”
These plans do come with a few potential headaches. For starters, paperwork must be filed by the solo 401(k) administrator. If you are the business owner, that is likely to be you. Your responsibilities then will include making contributions before the applicable deadlines and filing IRS Form 5500 if your plan assets are greater than $250,000.
Meigs says for most people, “if you go to a name-brand firm, fill out their paperwork and jump through their hoops, you’re going to be just fine.”
Still, he advises seeking expert help.
“You’re really unwise if you’ve got any business going where you’re not working with a (certified public accountant) or someone qualified to help you work through all the tax issues that you have to face,” he says.