Part of the beauty of having your business in the United States is that you have a great deal of leeway when it comes to selecting retirement accounts for self-employed people. And ever since individual 401k plans became available, more and more business owners have taken advantage of this option. Let’s see if an individual 401k plan is right for you.
What is an individual 401k plan?
Think of this as a meld between a 401k and a profit sharing-plan. That’s what makes this plan so appealing. You get the benefits of both. The only hitch is that you can only open this type of small business retirement plan if you are self-employed and have no full time employees (other than your spouse).
What makes individual 401k plans so great?
First, you can contribute up to $17,000 to the plan – or $22,500 if you are 50 years old or older. And that is just the 401k segment of the plan. You can still contribute more.
Keep in mind that a profit-sharing plan allows you to sock away up to 25% of your income – and the amount you put aside under the 401k element doesn’t count against you. The total contribution can’t be greater than $50,000 or 100% of your total pay. Again, if you are age 50 or better, you can contribute up to $55,500.
Let’s say you are 40 years old. You own and operate a private detective agency. You make $100,000 in 2012 and set up an individual 401k plan. How much are you allowed to contribute to your plan?
$25,000 for the profit-sharing element –25% of compensation
$17,000 for the 401k element of the plan
$42,000 is the total. Since it’s below the threshold of $50,000, you are in good shape.
If you qualify, these are fantastic plans. They are very simple to operate and inexpensive to administer. Most IRA custodians have off-the-shelf plans you can adopt so you don’t have to pay an arm and a leg to get your plan documents created.
Keep in mind that you aren’t ever forced to contribute to the plan. If business is slow, you don’t ever have to contribute to the plan. And you can borrow from the plan if you need to, but I don’t recommend it.
If this isn’t good enough, let me sweeten the pot a little more. You can even set up the plan so that some or all of your contributions get deposited into a Roth 401k. Of course you won’t get an immediate tax deduction, but when you eventually withdraw money from the account it will be on a tax-free basis.
What to Look Out for Before You Open an Individual 401k Plan
First, make sure you qualify. The restrictions are very clear. You can only open these accounts if you are self-employed and have no employees other than your spouse.
Next, if you do qualify, make sure you select the right retirement account custodian. The “free” accounts offered by mutual fund companies and insurance companies offer very limited investment choices, and even those have very high costs. This is just one of the ways these companies get you to pay high 401k fees without knowing it.
If you are making a lot of coinage, these plans may not be the best fit. You can only sock away
$50,000 using this plan. Other small business retirement plans may be more appropriate.
Last, if you have a successful business, it’s probably going to grow. That means you may end up with more staff. At that point, the individual 401k plan won’t work anymore.
The bottom line is that the individual 401k plan is a fit for you if:
a. You qualify;
b. You are pretty sure you’ll continue to qualify; and
c. You don’t want to put more than $50,000 into your retirement account each year.
If this seems like a fit, you can even take your existing IRA, SEP or old 401k and roll those accounts to your new individual 401k plan.
If you are self-employed, what kind of retirement plan are you using? Why?
One other potential benefit of the Individual 401(k) – Once set up, you can request to transfer any and all pretax IRA money into it. This would then leave only post tax money (in the case of those who were above the income level for deducting this) which can then convert to a Roth with no tax due. In following years, the IRA deposit can be converted immediately after deposit.
Neal Frankle says
That is a fantastic benefit and one I have not heard any discussion about. Thanks for bringing it up sir.