Solo 401k and Individualk Plans for the Sole Proprietor

by : Richard G Keir

Retirement planning for the sole proprietor has an unfortunate tendency to kind of fade into the background under the press of seemingly more urgent concerns. When the issue does come up, it seems that, for entrepreneurs, the 401K is not a strong contender despite the existence of the Solo 401K and IndividualK plans. It is often believed that 401Ks have relatively low limits on contributions and are, in any case, really only suitable for larger businesses.

However, changes to the original legislation made by the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) have made the adoption of a Solo 401K or IndividualK plan a highly valuable addition to your retirement funding as well as a means to significantly reduce your income taxes as a self-employed person.

Unless you are careful in your fact checking you may find yourself expecting that the 401K maximum contribution for 2007 is $15,500 (plus the catch up contribution of $5000 for those over 50). This is not the full story. As you may know, a company can also make a contribution to a 401K on behalf of an employee. However, it may not be clear how this can work for you as an entrepreneur.

The base contribution that you make yourself, as an employee, is called an "elective salary deferral." Beyond the salary deferral, as an incorporated business you can give yourself a "profit-sharing" contribution at the maximum rate of 25% of eligible pay. And there is no deduction for the amount of the salary deferral. If you are unincorporated, the rule is slightly less favorable and limits you to a 25% profit-sharing contribution on net self-employment income which means the $15,500 (plus, if applicable the additional $5000) salary deferral would reduce your net income.

Whichever case applies to your business, a Solo 401K can help you put away a significant part of your earnings. Since the contributions and the interest or other earnings from the 401K are not taxed until withdrawn, you also can substantially reduce your tax liability.

The $15,500 elective salary deferral limit for 2007 and 2008 is known as the 402g limit. This limit, as well as the catchup limit, are indexed to inflation and increase in $500 steps. The overall total limit is set in section 415 and for 2007 is the lesser of 100% of salary or $45,000 plus the catchup contribution. This maximum of $45,000 is the sum of the elective salary deferral and the profit-sharing contribution and does not include the catchup contribution. So for 2007 the maximum possible contribution would be $50,000. The 415 limit increases to $46,000 for 2008.

Since Solo 401K or IndividualK plans can be structured as self-directed 401Ks, they permit investment in almost anything from tax liens, real estate and mortgages to stocks, bonds and CDs. With the potential for making fairly sizable tax free contributions and the investment latitude permitted, any self-employed person would do well to look into how a Solo 401K or an IndividualK plan would fit into their retirement planning.