One of the frightening things about launching your own business stepping away from your corporate sponsored 401k plan. Historically, the options available to small business owners for tax deferred retirement savings have been minimal.
But now, new options are available in the form of the “solo (or, one-person) 401k plan.” In the article below, we’ll provide you with an overview of what a solo 401K plan is, how it compares to other retirement options and additional resources for you to gather more information.
Solo 401K: The Basics
The solo 401k plan is suitable for businesses in which the owner or owners are the only employees.
This plan works in a situation where there are no common law employees. This means the plan can be used by the business owner, his or her spouse if working at the business, and any partners in the business and their spouses who work at the business. It could work well for businesses such as sole-practitioner professionals, partnerships, manufacturer’s representatives, small retail owners, freelance writers, computer consultants and electricians, to name a few.
Contributions to a solo 401k plan are based on revenue generated by your business. With a solo 401(k), annual contributions consist of two parts:
- You can contribute up to 100% of the first $15,500 of your 2007 compensation or self-employment income ($20,500 if you’ll be 50 or older at year-end).
- You can contribute and deduct an additional amount of up to 25% of your compensation income, or 20% of your self-employment income. This second part of your annual contribution is like what you can do with a traditional small-business retirement plan
You won’t be forced to contribute more than you can comfortably afford in years when cash is tight. You can always pay in less than the tax-law maximum or even nothing at all. In other words, the solo 401(k) lets you rack up major tax savings in the good years, while leaving you the option to contribute less (or zero) in the lean years, when conserving cash is your highest priority.
The Upsides
The biggest reason why you might consider opening a solo 401k plan is that it may offer higher contribution limits than other retirement plans available for small businesses.
In addition to the higher limits, the solo 401k has other advantages. These include:
Low paperwork requirements, including being exempt from discrimination testing as long as you have no eligible employees. The only annual paperwork you may be required to file is the IRS Form 5500, which applies when plan assets exceed $100,000. The IRS provides a form 5500EZ that is suited to small 401k plans.
You also have the ability to take a loan. SEP plans and SIMPLE IRAs, popular retirement plans with small businesses, don’t allow loans, although a profit-sharing plan could.
The Downsides
If you decide to hire someone, the benefits of a solo 401K strategy change radically. That’s because an employer-employee relationship adds new layers of administrative, fiduciary and financial responsibility. For example, for a very small firm with an owner-employer and a few employees, the employer will likely be required to make mandatory contributions to the employees’ 401k accounts in order for the plan to pass its nondiscrimination tests. These tests determine if the plan is offered fairly to all employees.
Here’s some additional detail. First, if you have employees, the tax law may require you to contribute to their accounts as well as your own. But this is an issue with any type of tax-deferred retirement program — including a 401(k). So, if you have employees, please take my advice and hire a competent retirement-plan professional before making any moves.
Second, setting up and operating a 401(k) plan involves some degree of paperwork and administrative work. Fortunately, with a solo 401(k), this is only a minor concern, because you’re the only participant. Also, your brokerage firm is likely prepared to assist you in handling the details.
How to Set Up a Solo 401K
First, the plan needs a trustee to hold the assets on your behalf. Many people act as their own trustee, but if you decide to do this you need to be very attentive to detail and keep the appropriate records.
If you set up a solo 401k, you need to prepare and retain records concerning the plan and its activities. The plan also requires a plan document spelling out how the plan is operated. Most people use standard plan documents, and many one-person 401k plan providers include these in the cost of setting up the plan. You can hire services and firms to do the recordkeeping jobs to save you the time and hassle, but this will cost extra.
To set up your plan, you’ll typically pay a small set-up fee, which can range in price from $150 to $300. You will likely have to pay an annual maintenance fee, with the amount depending on the services you purchase from the plan provider.
The solo 401k is a fairly new retirement tool, however, it is gaining popularity. Fidelity, Principal, John Hancock Funds, Pioneer Investment Management, AIM and Salomon Smith Barney, among others, are already in the game. More are sure to follow. For a comprehensive list of providers, you can download a free report from 401K Help Center at
http://www.401khelpcenter.com/pdf/Solok_Vendor_List.pdf.
What To Look For in a Solo 401K
Here is a list of key things to be aware of when looking for a solo 401K:
No load funds
To minimize your long-term expenses, ask whether there are broker commissions or “loads” (upfront or backend commissions) that you must pay. Many solo 401k plans require you to pay up to 5.75% of your initial investment in a “load” fee.
Low expense ratios
If you are going to be investing in mutual funds, you should know what an “expense ratio” is. It is the percentage of your assets taken by the fund managers to manage the funds. Expense ratios vary widely and directly impact your return.
Open architecture
Look for a plan with self-directed brokerage account that allows you to invest in stocks, bonds, options, real estate and mutual funds to allow for maximum investment flexibility.
Index funds
These are designed to track the major stock and bond indexes and usually have lower expense ration than actively managed funds.
No or low setup fees and annual fees
Compare the load and administrative fees of one or more Solo 401k plans to make sure you aren’t paying too much for your 401k.
Online access
Get a plan that allows you to have online access to view and modify your accounts.
Is A Solo 401k Right for Me?
To determine if a solo 401K is right for you, use the following checklist:
- Sole proprietors, partnerships, corporations (including S-corporations), LLC’s, and LLP’s may all establish their own 401k.
- Higher contribution limits than other popular retirement plans.
You can contribute more to a Solo 401k on less income than you can to an IRA, a SIMPLE IRA or a SEP-IRA. - Contribution amounts are flexible
- Multiple 401k plans
You can still have a 401k at work and open another one for your sideline business. - Roll over other plans
Once your 401k plan is established, you may roll over other retirement accounts into it. - Loans
You may borrow up to 50% of your account balance (up to a $50,000 loan) and repay it over five years (or longer, if the loan is used to acquire a principal residence). Interest is paid back into your own 401k plan at around prime plus 1%. - Self-directed brokerage accounts
The plan may include a self-directed brokerage account, allowing maximum investment flexibility. - No tax returns for the plan are necessary, as long as assets remain under $100,000.
- Extended contribution date
Employer contributions may be made after year-end (by your tax return deadline, including extensions).
Additional Resources
www.401Khelpcenter.com
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