By Rich Best

Business owners have several retirement plan options, each with specific rules, limitations and opportunities for maximizing contributions and saving personal taxes. The most popular option for many small business owners has been the Simplified Employee Pension (SEP) or the Savings Incentive Match Plan (SIMPLE) due primarily to their simplicity and low cost. But small business owners who want to maximize their deductible contributions may be much better off utilizing a Solo 401(k). It’s not quite as simple, and it may cost a bit more, but it can be more than offset by the additional tax savings.

What exactly is a Solo 401(k)?

A Solo 401(k), also known as an Individual 401(k), is a qualified retirement plan option available in situations where the business owner is the sole full-time employee. You can have part-time employees and still be eligible for a Solo 401(k) as long as they work less than 1,000 hours. Aside from that, a Solo 401(k) works similarly to the larger 401(k) plan in terms of contributions and limitations. And, like its larger version, the Solo 401(k) does require reporting and administration that is best provided by a third party administrator (TPA). While that can increase the cost of the plan, you will find that, due to the increasing demand for Solo plans, TPAs have become very competitive in their pricing.

Setting the cost of administration aside for the moment, here is a side-by-side comparison of the contribution limits for each type of plan:

Business Owner Retirement Plan Comparison

 

Solo 401(k)

SIMPLE IRA

SEP IRA

Who can contribute

Employee; employer optional

Employee & Employer

Employer only; must make uniform contributions on behalf of all eligible employees

Maximum employee contribution

$18,000 plus $6,000 catch up if over 50

$12,500 plus $3,000 catch up if over 50

NA

Employer contribution

Up to 25% of earnings capped at $53k ($58K if over 50) including profit sharing option

Must match 100% of first 3% of participating employee contributions or 2% of all eligible employee salaries

Employer-only contribution up to 25% of income or compensation with a $53K cap

Access to funds before 59½

Participant may take penalty-free loans; 10% penalty for early withdrawal

25% penalty for withdrawals within first two years of plan; 10% thereafter

10% penalty for early withdrawal

Vesting

Can have vested schedules that are as long as 6 years on employer contributions

Participants are 100% Vested on all contributions

Participants are 100% Vested on all contributions

Here is an example to highlight the advantage of the Solo 401(k). John is a 51-year old C-Corp business owner who earns $70,000 from the business.

Plan Option

Employee Salary Deferral

Employer Contribution

Total Contribution

Solo 401(k)

$24,000

$18,000

$42,000

SEP IRA

$0

$17,500

$17,500

SIMPLE

$15,500

$2,100

$17,600

John’s wife is employed by the business and earns $40,000. By adding her salary deferral of $18,000 plus an additional profit sharing contribution of $10,000, their combined contribution to the plan would be $70,000.

John would also have greater flexibility in modifying or even terminating the plan. With a SEP IRA or SIMPLE IRA, the contribution formulas and eligibility requirements are fixed. A Solo 401(k) allows the owner to adjust contributions, formulas and eligibility as the situation dictates. That all could change, should the business owner add full-time employees. But even then, if the age and income disparity between the owner and lower paid employees is big enough, the owner may want to consider another form of 401(k), called a Safe Harbor 401(k) plan.

For business owners, the 401(k) plan combined with a profit-sharing plan offers the best opportunity to maximize contributions for greater personal and business tax savings. As always, it is strongly recommended that you consult with a qualified plan expert and your CPA to thoroughly assess your needs and circumstances when selecting a retirement plan for your business, especially if you anticipate hiring new employees.

Rich Best has spent 28 years in the financial services industry, as an advisor, a managing partner, directors of training and marketing, and now as a consultant to the industry. Rich has written extensively on a broad range of personal finance topics and is published on several top financial sites. 

 


The information provided is presented for general informational purposes only and does not constitute tax, legal or business advice. Any views expressed in this article may not necessarily be those of Nevada State Bank, a division of ZB, N.A.