The Many Pluses of a Solo 401(k)

One isn't necessarily a lonely number when it comes to saving big for retirement

KIPLINGER'S PERSONAL FINANCE, "Retirement Planning: Your Guide to Securing Your Dreams"
FALL 2005

By Mary Beth Franklin

Entrepreneurs have established about 80,000 solo 401(k) plans since they first became available in 2002 and have poured about $3 billion into their nest eggs in just three years, says Chris Brown, director of retirement market research for Financial Research Corp., in Boston. The rapid growth is expected to continue, with the number of new solo-401(k) plans – also known as single(k) plans and independent (k)s – expected to double by the end of this year. “It has substantially enhanced the retirement-savings opportunity for small businesses,” says Brown.

Dona Baker, a hairdresser in Aurora, Ill., was among the early converts. Designed for business owners with no employees (other than a spouse), the plan allows her to contribute up to $14,000 this year as an employee. Plus Baker’s business, which is incorporated, can contribute as much as 25% of her compensation – up to a combined maximum of $42,000 for 2005. Contributions to a solo 401(k) reduce taxable income dollar for dollar. If you business is not incorporated, you can contribute up to 20% of self-employment income in addition to the $14,000 employee pay-in – up to the same combined maximum of $42,000.

For example, if you earn $100,000 this year and your business is incorporated, you could contribute $39,000 to your solo 401(k) - $14,000 as the employee and $25,000 as the company’s kick-in (25% of that $100,000 income). If your business is not incorporated, your maximum contribution on $100,000 earnings in 2005 would be $32,639 - $14,000 plus 20% of your self-employment income (which in this calculation is total business income minus half of your self-employment tax).

“I try to sock away as much as I can,” says Baker, 38, who opened the salon in 2003 after working for other people for 16 years. By maxing out her solo 401(k), Baker will not only save about $13,000 in federal and state taxes on her 2005 return, she will be on track to retire from full-time work by age 50.

Solo 401(k)s can offer tremendous advantages over traditional small-business retirement plans, such as SEPs (Simplified Employee Pensions) and Keoghs. Those plans allow owners to contribute up to 20% of self-employment income (up to the same $42,000 maximum) but don’t include that sweet $14,000 “employee” contribution component. Consequently, small-business owners with traditional retirement plans need higher incomes to contribute the maximum to their plans and to qualify for the biggest tax savings.

For example, solo 401(k) participants with an incorporated business can qualify for the maximum $42,000 contribution with as little as $112,000 of income. For an unincorporated business, the owner would need about $148,000 in income to max out. But a small business owner with a SEP or Keogh would need to earn at least $168,000 with an incorporated business and $219,000 with an unincorporated business to squirrel away the full $42,000.

Sole proprietors age 50 and older can also take advantage of “catch-up” contributions, adding up to $4,000 to that $14,000 salary-deferral portion, boosting total solo 401(k) contributions to $46,000 for 2005. Neither Keoghs nor SEPs allow catch-ups. You can compare potential tax deferred contribution limits for solo 401(k) and other retirement plans at www.401khelpcenter.com. Click on “small business channel” and then “solo k calculator ”

The tax savings offered by individual 401(k)s are substantial. “When we looked at our existing small-business-plan customers, we found that approximately one-third could benefit from the higher contribution limits associated with an individual 401(k) plan,” says David Hueser, marketing manager for T. Rowe Price, in Baltimore.

For example, an unincorporated small-business owner with net business income of $150,000 in 2005 would pay approximately $37,300 in federal taxes (assuming he or she is married filing jointly, with two children) if no contributions to the individual 401(k) plan by contributing $42,000, federal taxes could be reduced to $26,800 – a tax savings of $10,500.

In addition to tax savings, maximizing contributions to a solo 401(k) can build a glorious retirement war chest. Annual contributions of $42,000 a year to a solo 401(k) over 20 years would grow to more than $2 million, assuming an average of 8% annual return.

When solo 401(k)s debuted, it was hard to find a company to administer a plan. But the landscape is rapidly changing. As of January 2005, 401k-helpcenter.com listed 100 individual 401(k) providers, ranging from mutual fund giants Fidelity and T. Rowe Price and discount broker Charles Schwab to traditional retirement-plan administrators including the Principal Financial Group and Wachovia Securities. Setting up a plan is easy. Some firms charge a set-up fee of up to $300. Others, like T. Rowe Price, will get you going for free. Most charge annual maintenance fees based on your investment options and the types of services you need, such as record keeping and filing annual 5500 forms with the IRS.

Mark Larsen, who owns Leaderspeak, a management consulting firm in Algonquin, Ill., searched long and hard to find a solo-401(k) provider that met his needs. He chose Decimal (www.theonline401k.com) of San Francisco. “Their plan was the only one I could find that allowed you the full benefits of a 401(k) including a loan provision.”

Although IRS rules allow 401(k) participants to borrow up to half of their loan balance, up to a maximum of $50,000, most solo-401(k) plans do not include a loan feature. Larsen, 41, had a six figure 401k from an earlier job to roll over into an individual plan.

With his Decimal Single(k), he can take full advantage of the loan provisions – an important feature for small businesses that sometimes face cash flow problems. By maximizing his annual contributions, Larsen hopes to reduce his taxes substantially while building a retirement nest egg over the next 15 to 20 years.

Chad Parks, president of Decimal, says many of his clients like the convenience of rolling over retirement balances from former jobs into their solo 401(k). It allows them to consolidate all of their retirement money and to borrow the maximum amount from their account if needed. Decimal charges a $149 annual fee but has no set-up fee.

What’s the best retirement plan for someone who works for an employer plus operates a business on the side? Assuming you max out your 401(k) at your day job, you can take advantage of that $14,000 limit again with a solo 401(k). You get only one bite at that apple.

So you may want to open a SEP IRA for your side business, allowing you to save up to 20% of your self employment income (or 25% of your gross compensation if your business is incorporated) while reducing taxes. SEP IRAs are readily available from banks, mutual funds and brokerage firms. They generally involve no set-up fees and have only minimal annual maintenance fees. SEPs do not allow loans.

Small business owners can also choose a SIMPLE IRA, which stands for Savings Incentive Match Plan for Employees. SIMPLE IRAs limit your contribution to a set dollar amount instead of a percentage of your income. In 2005, you can save up to $10,000 dollars of self-employment income, plus your business can kick in another 3%. People age 50 and older can tack on an extra $2,000 in catch-up contributions. For example, if you earn $30,000, you can set aside $10,812 in a SIMPLE ($10,000 of your earnings plus $812 in employee matching money) or $12,812 if you’re age 50 or older by the end of the year.