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September 19, 2011

Behold, the Solo 401(k) – Good for Self-Employed Individuals

Filed under: investment — Tags: , — admin @ 12:41 pm

Ready to be your own boss? If you are, you might want to look over the fundamentals one more time. Now, we’re not trying to tell you that you haven’t thought about everything there is when it comes to freeing yourself from that pesky J-O-B and getting to be your own boss, setting your own schedule and planning for retirement. Oops, did we say that last part out loud? Unfortunately, a lot of people don’t stop to really think about their own retirement plans, thinking that they’re going to want to run their business all the way up until their deaths. That does happen from time to time, but may more people dream about a traditional retirement where they aren’t working. You have to decide for yourself what type of retirement makes sense to you. All things considered, you’re going to want to make sure that you can take control of your finances, and there’s no better way to really cap this process than to really think about retirement even as a self employed professional.

If you had a 401(k) from work, you can roll it over into a solo 401(k), which is actually the subject of this article.

Just what is a solo 401(k)? Well, it describes the type of retirement plan to a T — instead of the 401(k) you have at your old job, you will have a retirement plan just for you and you alone. This is perfect for self-employed professionals that aren’t taking on employees. So the solitary lawyer running his own one-man show is eligible, but the man dreaming about hiring a team of lawyers would do better with another retirement plan.

The obvious benefit of a solo 401(k) over other self employment-oriented retirement plans is that you can sock away a lot more money. If you haven’t heard of the solo 401(k) or the Individual 401(k), don’t beat yourself up. It’s actually quite new in terms of tax laws — established in 2001, which means that it’s only been around for about a decade.

At the time of this writing, you can contribute up to 49,000 a year, which is also tax-deductible. These tax-deductible contributions can definitely grow, and that means that you’ll be able to let more of your money grow without tax interference.

However, before you jump right into the new 401(k) fun, it’s important to understand a few more things. First and foremost, the big 49,000 (54,500 if you’re over 50) number is actually composed of two parts: the salary deferral contribution plus the profit sharing contribution. This will be different for different business structures.

Let’s cover the sole proprietorship, one of the simplest businesses around. It’s not a separate legal entity, which means that it exposes the owner to a lot of liability. Still, this is the one that requires the least amount of paperwork, and that’s definitely a good thing. In the case of a sole proprietorship, you will need to calculate the net adjusted business profit. This is simply the gross revenue that you brought in for the year and then subjecting all of your business expenses, plus half of the self employment tax (you are paying yourself employment taxes, right?). This number is held at a maximum of $16,500.

The profit sharing component comes into play where you can make up to 20% of the net adjusted business profits. So essentially, that makes up the other half of the $49,000. If you’re not sure how this plays out in real life, you will need to ask your tax professional of choice for assistance in order to make sure that you got this number correct.

For a regular corporation, you can just refer back to the W-2 issued out. You can contribute up to 100% of W-2 earnings, and then 25% of W-2 earnings for the profit sharing contribution.

Keep in mind that the assets you put into a solo 401(k) will grow tax-deferred, which does mean that you won’t pay taxes on any dividends or investment earnings until you withdraw the assets themselves. You can withdraw the money after 59 1/2 without penalty. If you decide to withdraw the money before then, you will end up paying income taxes as well as a 10% penalty for the privilege.

However, what if you need the money really badly and you don’t have any other choice? Consider tapping the other benefit of this retirement plan — tax-free loans. You will be able to get a loan for half of the total balance, up to $50,000. The loan repayment schedule is usually done over the course of 5 years, though the purchase of a primary residence can extend this to 15 years. You will get your money from an individual 401(k) tax free as well as penalty free, but this is provided that you pay back the loan on time. You really don’t want to miss a payment — you will default on the loan and have to pay a lot in taxes as well as IRS penalties, as it’ll be counted as an invalid withdrawal just like if you had withdrawn the money before 59 1/2 under other circumstances.

Even though you will have to pay back the money with interest, you will get to put the money back into your retirement account as well as the interest. That’s something that isn’t offered with SEP IRAs or Roth IRAs.

Overall, if you’re really ready to take things to the next level, you really need to stop and get yourself a good retirement plan like the Solo 401(k). Since the rise of the Internet has caused a new revolution for the world of finance, you will want to make sure that you go online to open up your Solo 401(k) account. You won’t have to worry that the investment advisors won’t be able to answer your questions. After being around for a decade or so, this is a plan that accountants and other tax professionals are now familiar with, and they can help you get started in the right direction. The other benefit of managing your money online is that you can actually watch it grow and get reports — even text and email alerts sent to your phone and email address, respectively.

With so many benefits waiting for you, there’s no reason not to save for retirement with a Solo 401(k) plan — even when you’re self employed!

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