Catch-up On Savings With A Solo 401(k) If You’re A One Person Business

If you have a profitable one-person business, then consider setting up a Solo 401(k) for more pre-tax contributions to your savings. I.e. more than either a SEP or SIMPLE can offer you. Here’s how the numbers work in 2012…

*Solo 401(k) – what it is and what you can contribute:

A solo 401(k) plan is the same as the regular 401(k) plan. But the rules are more relaxed for the ‘solo’ since it can only be set up for an individual owner with no employees other than a spouse. That reduces some of the paperwork.

Your savings contributions to it will be composed of two parts: The first part is the regular annual salary tax-deferral contribution limit of any 401(k). For 2012, that’s $ 17,000 plus an extra $ 5,500 if you’re 50 or older. The second part is from your business. It can also make a maximum tax-deductible contribution to the plan – as with a traditional profit-sharing plan – of up to 25 percent of your compensation or 20% of your net business income if you are a sole proprietor or unincorporated.

Realize that the amount of compensation deferred as part of your 401(k) plan does not count toward the 25 percent limit. So you, as an owner-employee, can defer the maximum amount of compensation under the 401(k) plan, yet still contribute up to 25 percent of total compensation to the profit-sharing plan on your own behalf.

But the total plan contributions for 2012 cannot, however, exceed the lesser of $ 50,000 or 100 percent of your compensation.

*Here’s a quick example to make those points:

Bill is 57 and sole owner of an incorporated business. His compensation for 2012 is $ 100,000. He sets up a solo 401(k) plan for his retirement.

Bill’s solo 401(k) plan can have a tax-deductible business contribution of $ 25,000 (25 percent of $ 100,000), plus his 401(k) elective deferral contribution of $ 22,500 (i.e. $ 17,000 plus the extra $ 5,500 because he’s passed 50). So, total contributions for Bill’s savings equal $ 47,500. That’s just under the 50,000 limit (i.e. the lesser of $ 50,000 or 100 percent of his compensation).

*Comparing SEP and SIMPLE Contributions with the Solo 401(k):

With both a SEP IRA and a SIMPLE IRA, you can contribute up to 20% of your net adjusted business profit (or 25% of W-2 earnings in a corporation) as “profit sharing.” The SEP IRA, however, has no provision for either salary deferrals like the $ 17,000 maximum in 2012 in other plans or catch-up contributions. SIMPLE IRAs, meanwhile, allow an $ 11,500 salary deferral and up to just 3% of your business profit or compensation, plus a $ 2,500 catch-up contribution for eligible participants. Thus, in most cases, the solo 401(k) allows you to save the most.

As an example, let’s take a person under 50 years old who is self-employed with a $ 60,000 net business income. In this case the solo 401(k) would allow deferral of $ 17,000 and profit sharing of $ 12,000 to give total savings of $ 29,000.

Comparatively, the SEP IRA has no salary deferral but does allow $ 12,000 (i.e. 20% of $ 60,000) of profit sharing which produces a total savings of only $ 12,000.

The SIMPLE IRA allows him $ 11,500 of deferred salary and only $ 1,800 (i.e. 3% of $ 60,000) for profit sharing. That gives only $ 13,300 for his total savings.

You can see that the solo 401(k) offers him, by far, the most savings per year.
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