It’s hard to believe that the end of the year is rapidly approaching. With this in mind, it would be prudent for self-employed individuals and sole proprietors to consider establishing a solo or individual 401(k), if they haven’t done so already.
The Self-Employed Retirement Dilemma
Many companies nowadays have retirement plans such as a 401(k) where the employer contributes a percentage to the plan. But what is a self-employed individual to do to save for retirement? Until recently, self-employed individuals did not have a lot of options aside from contributing to a profit-sharing plan, SEP-IRA or Keogh plan. However, these plans did not have the same benefits afforded to 401(k) plans, such as employee deferral.
The retirement saving options for self-employed people changed in 2001 when Congress passed the Economic Growth and Tax Relief Reconciliation Act (EGTRRA). The act created the individual 401(k) for self-employed individuals who do not have employees other than a spouse or child. The self-employed individual can contribute to the plan as both employer and employee. As the IRS explains, “The business owner wears two hats in a 401(k) plan: employee and employer. Contributions can be made to the plan in both capacities.” IRS rules state that the plan must be established by the end of the employer’s tax year.
The individual 401(k) is an excellent option for saving for retirement and reducing taxable income; and establishing one comes with some key benefits.
One of the benefits of an individual 401(k) is the high maximum contributions that are allowed. For example, the self-employed individual can make elective deferrals (employee contributions) up to 100% of compensation, or earned income, up to the annual contribution limit of $17,500 in 2014, plus an additional $5,500 catch-up contribution for individuals age 50 or older, for a total employee deferral of $23,000.
In addition, the self-employed individual can make employer contributions up to 25% of net business profits (subject to adjustments for Self-Employment tax; see www.irs.gov/Retirement-Plans/One-Participant-401(k)-Plans). The total contributions to the individual 401(k), excluding the catch-up contributions, cannot exceed $52,000 for 2014. Contributing a total of $52,000 reduces taxable income and could drop the self-employed individual into a lower tax bracket.
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Setting Up an Individual 401(k)
Another benefit of the individual 401(k) is that it is easy to open and maintain. For example, there is no discrimination testing for the Employee Retirement Income Security Act of 1974 (ERISA) since there are no employees who could potentially be discriminated against in favor of highly compensated employees. In addition, custodians such as TD Ameritrade, Schwab and Fidelity have a standard form that can be filled out to establish the individual 401(k), which simplifies the process of setting up an account. Regulatory or administrative requirements are not a burden with the individual 401(k) until the account balance exceeds $250,000, at which time Form 5500-SF will need to be filed.
Just as with corporate 401(k) plans, most custodians offer the individual Roth 401(k) as well. An individual Roth 401(k) allows larger contributions than the standard Roth IRA. Roth IRA contributions are $5,500 in 2014 plus an additional $1,000 catch-up for individuals 50 or over. Also, the individual Roth 401(k) does not have income limitations, a perk for those whose income disqualifies them from contributing to a Roth IRA.
Another advantage of an individual 401(k) for a self-employed individual is the ability to choose from a wide array of investment options. In contrast, the standard corporate 401(k) tends to have more limited investment options.
In addition, if you haven’t saved enough for retirement, are 45 or older, and are a high earner, you can take advantage of the defined benefit plan in addition to the individual 401(k). A defined benefit plan, more commonly referred to as a pension, promises to pay the self-employed individual a specific dollar amount in retirement based on a target amount the self-employed individual would like to receive. One will need to work with an actuary to determine the contribution amounts, which will involve the following factors:
- Retirement age (typically five years from the adoption of the plan)
- Investment performance
In 2014 the annual benefit payable in retirement is $210,000. There are advantages to the defined benefit plan, such as making tax deductible contributions in excess of the individual 401(k) limits and significant future retirement income.
The disadvantages are that setup and maintenance of the defined benefit plan are expensive and the annual funding requirements are mandatory.
In short, if you are self-employed, it would be prudent to put tax deferral on your Christmas list by opening an individual 401(k) by New Year’s Eve. Also, consult with your financial advisor to determine if the defined benefit plan makes sense for your situation as it, too, needs to be set up by December 31 or the end of your fiscal year.