Solo 401(k) helps to self employed

With the economic downtown, our country has surprisingly witnessed a rise in self employment. In fact, according to the Kauffman Index of Entrepreneurial Activity, the establishment of new businesses has surged to a 14-year high.

While entrepreneurship can provide a lucrative opportunity, chasing the “American Dream” of owning a business can be tedious and challenging, especially for those who are the sole owner and employee. The risks, tax burdens and many efforts taken to increase the bottom line can be strategically addressed simply by considering the business’ retirement plan or lack of one.

In 2001, Congress passed the Economic Growth and Tax Relief Reconciliation Act, which created the Solo 401(k). Before this time, self-employed individuals had few incentives to use anything other than the usual profit sharing plan, a Keogh or SEP IRA, for its easy administration and high level of deductible contributions.

With a SEP IRA, individuals can contribute a whopping 25 percent of W-2 income received from their business or 20 percent of self-employment income, net of half the self-employment tax, up to a maximum of $49,000. Not a bad way to contribute towards retirement while deducting from your adjusted gross income. Unfortunately, for entrepreneurs to see the IRS maximum retirement contribution of $49,000, they have to make $196,000 a year. As many have realized, the catch to a SEP IRA is the need to continually increase your taxable income in order to increase your contributions. Doing so may come at the expense of higher employment taxes and possible phased out deductions.

The Solo 401k quietly entered the scene offering a two faceted approach and unique calculation on retirement contributions creating a higher maximum deferral on a smaller sum of money. Similar to a 401k, one can contribute the first $16,500 of taxable wages or self-employment income plus a $5,500 catch-up contribution if age 50 or older ($22,000 total). Additionally, the opportunity exists to contribute the equivalent of 25 percent of one’s overall compensation or 20 percent of self-employment income similar to a SEP IRA.

For example, a 50-year-old business owner pays himself $60,000 through his incorporated business and would like to contribute the highest amount possible to his retirement. Using a SEP IRA the maximum would be $15,000 (25 percent of $60,000). With a Solo 401k the business owner could defer $16,500 plus the $5,500 catch-up contribution ($22,000). Then he could contribute the 25 percent employer portion of the $60,000 to make his overall deductible retirement contribution $37,000. That is almost two and a half times as much as the SEP IRA.

Yet, sole proprietors may be hesitant to fully utilize a retirement plan as a primary strategy to lower their taxes because they are unable to touch the money until age 59 1/2 years old. With a Solo 401k, participants are permitted loans up to 1/2 their total value to a maximum $50,000. The loan interest is actually paid back to your account, not the financial institution. Yet, I would only endorse a loan against your retirement as a final level of emergency safety.

Going it alone, entrepreneurs need to be intentional with every dollar spent and strategy implemented. Proper advice can make a substantial difference in what one pockets at the end of the day. In the case of choosing a retirement plan, running a single-person company may provide considerable advantages. In my opinion, the Solo 401k is substantially under utilized by the self employed and those running side businesses.

Griffin Dalrymple, wealth manager with Opinicus Wealth Management, can be reached at (941) 847-0035, ext. 222 or griffin.dalrymple@lpl.com.