Retirement Savings Options for the Self-Employed
Sole proprietors now have more options than ever to build retirement savings. While a Keogh, SEP IRA, and Simple IRA are also options, the Solo 401(k) and Roth Solo 401(k) are the most popular. They are also more easily understood, as many self-employed individuals are familiar with the features and benefits of a 401(k) from a previous employer's plan. Even if you're just starting out, establishing a solo 401(k) is one of the best business decisions you can make. Making "forced" contributions to a retirement account is an excellent way to establish the financial discipline required to manage a business. Further, knowing that your retirement savings plan is growing each year allows you to focus more on growing your business rather than worrying about saving for retirement.
In general, a Solo 401(k) is for a sole proprietor with no other employees other than a spouse. Even unincorporated business owners can establish a Solo 401(k). If the business is a partnership, and only other employees are your self-employed business partners and their spouses, you can establish a solo 401(k). The trustee of the account and the plan administrator can be you, your spouse, or a designated third party. You do not have to turn over the management of your account to a paid plan manager. Yet, you still have the flexibility of choosing a brokerage firm, a mutual fund company, or even a bank at which to establish the account. Any tax-qualified accounts (traditional IRAs, SEP IRAs, a 401(k) sponsored by a previous employer) can be rolled into a Solo 401(k).
Solo 401(k) and Roth 401(k) accounts feature higher contribution limits than most other self-directed retirement plans. They are also much less complicated in terms of rules, regulations, and compliance. For small business owners especially, this option reduces the amount of work required to maintain retirement savings accounts.
Contribution Limits of the Solo 401(k)
For 2010 and 2011, the maximum contribution that can be made to a Solo 401(k) is $49,000 for those who are under the age of 50. (Individuals over 50 are allowed to make additional "catch up" contributions to bring the total contribution to $54,500.) For older business owners, the additional $5,500 allowance can make a tremendous difference in taxes and savings growth. Be careful, however, that all assets are properly allocated given your age, risk tolerance, and the total value of all other accounts.
The amount of a yearly solo 401(k) contribution is actually comprised of two parts: the first is a profit sharing contribution and the second is salary deferral. The formula for the contribution is one part profit sharing and two parts salary deferral. Together, these two parts equal the maximum contribution limit.
Both the owner of the business and his or her spouse are allowed to contribute up to $49,000 ($54,500 if they are over age 50) provided they have sufficient income from the business.
Salary Deferral and Profit Sharing Contribution for Entities Taxed as Sole Proprietorships
Since a sole proprietorship, partnership, or LLC corporation taxed as a sole proprietorship does not issue a W-2 for the business owner's salary, the "salary deferral" term above can be misleading. Therefore, the salary deferral contribution for these types of businesses is based on the net adjusted profit. Net adjusted profit is determined by subtracting business expenses and one-half of the self-employment tax from gross income. For tax years 2010 and 2011, the owner of a sole proprietorship, partnership, or LLC corporation can contribute up to $16,500 ($22,000 if he or she is age 50 or older).
The profit sharing contribution for the owner of a sole proprietorship, partnership, or LLC corporation in 2010 and 2011 can be up to 20% of the net adjusted profits from the business. This is a huge financial benefit for those who work as consultants, sales representatives, independent contractors, or freelancers. Regardless of the industry you're in, if you receive a 1099 and are taxed as a sole proprietorship, you can establish a solo 401(k).
Salary Deferral and Profit Sharing Contribution for Enties Taxed as Corporations
For tax years 2010 and 2011, 100% of the earnings reported on your W-2 form up to a maximum of $16,500 ($22,000 if you are age 50 or older) can be contributed to a Solo 401(k) account. This applies to S, C, and LLC corporations taxed as corporations. The profit sharing contribution can be a maximum of 25% of reported W-2 earnings.
If you are the owner of a corporation — even a small subchapter S — the benefits of a solo 401(k) are immense. Not only do salary deferral contributions reduce taxable income, the profit sharing contributions can be deducted as a business expense.
If you're thinking of starting a business, even a sole proprietorship, make sure you meet with a qualified tax advisor to review your options. The corporate tax structure of your business will dictate which type of plan you can establish and the total amount of tax-deferred money you can contribute to your retirement savings plan.
The Differences Between a Solo 401(k) and a Simple IRA
The Simple IRA, sometimes called a Simple 401(k), was established to further help small business owners establish qualified savings plans. Whereas a solo 401(k) plan is set up for a business owner with no employees except a spouse, a Simple IRA can be established for a small business with up to 100 employees. Each employee, however, must have received at least $5,000 in the previous calendar year as compensation. The contributions made by the employee and any matching contributions made by the employer are deposited into an IRA or an IRA annuity.
If your business is experiencing growth and needs to hire employees, consider switching your solo 401(k) into a Simple IRA plan. A Simple IRA still maximizes tax-deferred retirement savings while providing for employees at the same time. Those age 49 or younger can contribute up to $11,500 per calendar years 2010 and 2011. Those age 50 or older can contribute an additional $2,500 in 2010 and 2011.
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