Everything You Ever Wanted to Know About Solo 401k

As a business owner saving for retirement is even more confusing because you have more account options to choose from.  Yet this should be looked at as an advantage in getting the exact right account for you.  One of the account options that you have as a self employed individual is the Solo 401k.  Also known as: self employed 401k, uni k, or one participant k. Following is what you need to know to help you understand this retirement savings option.

What it is not:

The solo 401K is not a different plan than a traditional 401K.  It is comes from the exact same section of the IRS code, however rules allow for different reporting and testing requirements because you are the only person utilizing the plan.  Kind of hard to test for discrimination if you are the only person in the equation!

The reason that it has become popular is that in 2001 Congress passed a bill that changed how you are allowed to figure how much could go into the 401K.  This made it more appealing to those that owned their own businesses with no employees because it pushed the limits higher than it was for the SEP.  Previously the SEP had the same limits. With this change the investment companies began to push these one person 401K plans as a different option.

What it is:

• A great way to save large sums of money from your business for retirement.
• A way to reduce your current and future tax liability.  The employee deferral is pre-tax for the employee as long as you are not using a Roth.  The company contributions are a tax deductible business expense.  Plus your earnings grow tax free, so they can compound quicker.
• Usable by any business entity from sole proprietor to corporation.

Who can be covered?

The solo 401K can cover you and your spouse if they earn income from the business.  If you hire someone who qualifies for the plan, it becomes a traditional 401K.  This means that you will be required to do discrimination testing and file annual reports.

Those employees that you can exclude:  under 21 years of age, less than one year of service, and are covered by a collective bargaining agreement that does not provide for plan participation.

How much can I Invest?

As of 2013 you can put up to $51,000 in a 401K.  Unless you are eligible for catch-up, these contributions are above and beyond the $51,000 limit.  So if you are over 50 you could actually contribute up to $60,500.  (More specifics on the limits)

You can achieve this number can be through employee contributions, employer matching and employer non elective contributions (profit sharing).

Employee

The employee is allowed to defer $17,500, plus $5,500 in catch up contributions if the employee is over 50.  This amount is not to exceed their income.  So if you only make $10,000 you cannot put in more than the $10,000.

Company

The company can contribute up to 25% of the employee’s compensation.  If your business is a corporation and you get a W-2 your contributions are based on the W-2 amount.  If you are a sole proprietor your contributions are based on earned income which is calculated as net earnings after deducting half of yourself employment tax and contributions for yourself.  This calculation actually lowers the 25% closer to 20% due to self employed taxes, but you can still go up to the $51,000 limit. You can find a worksheet for figuring this out in the IRS publication 560.

Costs:

Costs can cover a wide range depending on what company you open the account with and how frequently you trade in and out of investments.  I did a review of five of the larger brokerage companies that offer solo 401K’s and found that most of them did not charge a maintenance fee, but instead charged for trades. (Most of them had it set up that the account was a traditional brokerage account with the individual 401K designation.)

In order to find the right plan for you, search a few brokerage firms and reviews costs, investment options and services.  Then select based on your preferred firm based on how you like to invest fitting with each company.  For example if you prefer just index mutual funds you would probably want to consider Vanguard, but if you would rather mix it up and buy funds, ETF, and other products then one of the more traditional brokerage firms may be a better option.

Additionally you may encounter other costs if you outsource administration, investment decisions and paperwork responsibilities.

Roll Old Small Business Retirement Accounts:

You may be able to roll old retirement accounts to your new solo 401k.  You will need to check with your CPA or the investment firm to ensure you are eligible for this.  This is a great way to consolidate funds and make management of all investments easier.  In addition some of the firms give you lower prices and bigger perks the more money you have invested, so combining accounts can increase your chances of qualifying.

Accounts that may be eligible to roll:  profit sharing, money plans, old 401K, SEP’s, SIMPLE (after 2 years of participation), 403b, 457b, and traditional IRA’s.

Deadlines:

You must open the account by December 31^st or the last day of your fiscal year.  The company profit sharing contributions must be made by the tax filing date for the business.    Employee contributions and matching contributions depends on if you are incorporated/LLC or not.  You must make the salary deferral election by the end of the year and then it depends on your entity as to when you need to contribute the funds.

How to pick investments:

Most of the solo 401K accounts are set up as brokerage accounts.  So you can access just about any investment you desire.  Don’t get caught up thinking about it like a large company 401K that presents you with only a few options.  Instead you have the ability to combine stocks, bonds, mutual funds and other investments into your 401K.

Because of this flexibility you have many ways to choose the right investments for you.  Including selecting your own investments, hiring a fee only planner to select investments in your account that you then carry out the purchasing, or set up an account with a financial planner that will manage the entire thing for you.  Some of the companies that you can open accounts with will even assist you in selecting the right funds.

Other Information:

• You can take a loan against the balance if you need to.  You can take a loan out for ½ of the total of the account or $51,000 whichever is less.  Make sure your administrator offers this if you want to have access to loans.  (FYI – I do not recommend loans against any retirement savings unless it is for an extreme situation.  Better to leave the money working.)
• You can do a ROTH 401K in the individual plan.  Again you need to make sure your provider offers this if you want this as an option.
• If you make withdrawals before 59 ½ you will pay a penalty, unless it falls under one of the hardship factors.
• You do not have to fund every year, you have the flexibility to only fund when you are having a good year.  Or to adjust when you are having a great year to add more money to your retirement accounts.

Cautions:

• While you can contribute the most with this account, you do need to be highly compensated to reach this level.  In fact $200,000 in earned income is what you would need to max out the 401K.  Because of the extra rules, make sure you can invest up to the extra limits.
• If you add employees that meet the eligibility requirements, you must also allow them to invest.  If they decide not to, then you may not be able to contribute either, unless you convert your plan to a Safe Harbor 401K.  If you plan on hiring in the future ask your 401K company about making adjustments latter on, some might not be able to accommodate you.
• If the plan has more than $250,000 you are still required to file annual paperwork (Form 5500 or one of its other versions).
• The employee contribution maximums for the employee not the plan.  So if you have a day job and your self employed income is additional then you need to make sure that you do not go over the allowable amount for all plans.  This is a great time to work with your CPA to ensure you are within all limits.
• You will need a plan administrator to take care of the details.  This can be you, your CPA, or a specialty firm.  This will add to the cost of the plan beyond what the brokerage charges you.

Hopefully this gives you the information that you need to understand the individual 401K.  If you need additional help please check out the resources below.

Resources:

To find out how much you can contribute to 401K, SIMPLE and SEP I like to use the Bank Rate Calculator.

This book covers all small business retirement options: 100% Deductible: Tax-Advantaged Business Retirement Plans (Affiliate Link)