Self-Employed 401K: A Retirement and Tax Savings Tool for Small Businesses

• It allows you to substantially reduce your current income taxes because generally, you can deduct the entire amount of your plan contributions from your taxable income each year. You can deduct contributions for yourself from your personal income if your business is unincorporated, while you can generally deduct contributions as a business expense business is incorporated.

• It provides complete contribution flexibility. While the law sets the maximum amount you can contribute every year, the plan does not set any minimum. In fact, you can decide each year whether to contribute and how much to contribute. You can even skip contributing in one year, although your investment advisor may tell you that Uncle Sam frowns upon sporadic yearly contributions (e.g. contribute one year then skip two years).

• It sets higher contribution limits relative to other types of retirement plans. One of the key benefits of the Self-Employed 401(K) is that it allows you to put more money into your retirement relative to other 401(K) plans. For 2007 or 2008, you can make tax-deductible 401(k) salary deferrals to the plan of up to $15,500, plus an additional catch-up salary deferral contribution of $5,000 if you are 50 or older.
  
  You can also make tax-deductible profit sharing contributions of up to 25% of compensation (maximum compensation on which contributions can be based is $225,000 for 2007). The total of salary deferrals and profit sharing contributions cannot exceed $45,000 for 2007 (or $50,000 if age 50 or older) or $46,000 for the 2008 plan year.
   
• It allows your earnings to grow tax-deferred. Plus, the plan can help you defer more money to retirement by allowing the consolidation of your assets from your traditional IRAs or other retirement plans. You have to file an IRS Form 5500 when plan assets exceed $100,000.

• It includes catch-up provisions for those 50 and above. Individuals aged 50 or older may defer up to $16,000 in 2004 subject to the combined deferral and employer contribution limit.

• It allows for greater flexibility in investment. Unlike other retirement plans, a Self-Employed 401(K) plan allows a wider range of investment, even including real estate. The law allows investing into various types of real estate, such as condos, single family rentals, mobile homes, raw land and second mortgages – provided that the property is considered a business investment. This means that all profit from the property must be flowed back into the plan and that you or your immediate family, including children, parents and spouses (no mention though of siblings) cannot live in the property.

• The plan is easy to set-up and inexpensive to maintain. Setting up a Self-Employed 401(K) plan is a breeze relative to other larger 401(k) plans. Many providers, mostly mutual fund companies, offer easy administrative requirements – without any voluminous paperwork involved. Fees for establishing and maintaining the Self-Employed 401(K) plan vary by the different providers, often based on the features offered. Plans that allow investment in assets such as real estate usually charge higher fees as well as those that offers loan feature. Some providers such as Fidelity Investments, while not charging any set-up or administrative fees, do not offer the real estate investment option nor allow enrollees to get a loan from their contributions.

• Some providers allow access to cash via the 401(k) loan option. Unlike other retirement plans, you may be able to use your 401(K) assets before the allowed distribution age through a loan program. Some -- but not all providers -- allow you to get a loan of up to the lesser of $50,000 or one-half of your Self-Employed 401(k) account balance. There are no restrictions on how you can use the loan amount. Plus, it is tax-free and penalty-free (unlike other retirement plans where you will pay a hefty penalty fee to the IRS) provided you repay the loan back on time. If this is an option you think you may use, check with your provider if their plan offers this feature.