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

January 25, 2014 | By | Reply More

taxesAre you looking for ways to save on your taxes? If you are running a one-person business, fret no more: you can cut down your taxes while at the same time save for your retirement with the Self Employment 401(K). Once the exclusive enclave of employees of larger businesses, a special type of 401(K) plan is now available to self-employed individuals and owner-owned businesses.

What is the Self Employment 401(K), otherwise known as Solo 401(K) plan or One Participant K plan?

The Self Employment 401(K) plan allows a self-employed individual or business owners with no employees other than a spouse to open and contribute to a Self-Employed 401(k) plan and receive a tax break from the contributions. The plan was established by the Tax Relief Act of 2001 of the Bush Administration, and has become a great tax saving and retirement tool for one-person businesses, owners of mom-and-pop companies, even people who own a side business while working full-time. As long as you do not have any employees other than your spouse — whether you are running a sole proprietorship, LLC, partnership, or corporation — you are qualified to open a Self-Employment 401(K) plan.

Like other retirement plans, the Self-Employment 401(K) plan is a tax-deferred retirement plan, which means that you get a tax deduction or credit now when you deposit the money, but will be taxed on those monies when you taken them out (there’s really no running away from Uncle Sam!). But what makes the Self-Employment 401(K) plan different from other retirement plans?

Benefits of a Self-Employed 401(k)

The Self-Employed 401(k) offers the following benefits:

1. It allows you to substantially reduce your current income taxes

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.

2. 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).

3. 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 2013 and 2014, you can make tax-deductible 401(k) salary deferrals to the plan of up to $17,500, plus an additional catch-up salary deferral contribution up to $23,000 if you are 50 or older.

You can also make tax-deductible profit sharing contributions of up to 25% of compensation, up to the annual maximum allowed for the year. The total of salary deferrals and profit sharing contributions cannot exceed $51,000 for 2013 and $52,000 for the 2014 plan year.

4. 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 $250,000.

It includes catch-up provisions for those 50 and above. Individuals aged 50 or older may defer up to $23,000 in 2013 and 2014 subject to the combined deferral and employer contribution limit.

5. 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.

Note, however, that not all Self-Employed 401(K) providers allow this investment option. If this is something that you are interested in, check with a provider if they allow this option before signing up with them.

6. 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.

7. 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.

Caveat to Consider

One important caveat to consider:  before signing up, think carefully about possible early withdrawal of funds and its tax implications. Some providers charge 10% early withdrawal penalty if you are under 59 1/2 years of age in addition to the taxes that will be applied to the withdrawal. Fidelity Investments, for example, that minimum required distributions without the early withdrawal penalty starts at age 70 1/2. If you will need the money before you are 70 1/2 years old, consider the withdrawal costs and taxes to be applied before investing your money in a Self Employed 401(K) plan.

The Self-Employed 401(K) plan can greatly benefit you as a one-person business owner in terms of your personal and company taxes while allowing you to save more for your retirement.  Be aware, though that each Self-Employed 401(K) plan must be setup no later than December 31 of the calendar year to be eligible for tax deductions in that tax year.

Talk with your accountant, tax or financial adviser to help you understand the financial and tax impact of a Self-Employed 401K plan and whether it is right for you. Read the IRS guidelines on Self-Employed or One-Participant 401(K) Plans.

Recommended Books on Retirement for Small Business Owners:


George Rodriguez

George Rodriguez is a writer for An entrepreneur with experience in running several businesses, he writes on various topics on entrepreneurship and small business.

Self-Employed 401K: A Retirement and Tax Savings Tool for Small Businesses
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Self-Employed 401K: A Retirement and Tax Savings Tool for Small Businesses
Are you looking for ways to save on your taxes? If you are running a one-person business, fret no more: you can cut down your taxes while at the same time save for your retirement with the Self Employment 401(K).
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