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Self-Employed 401k

In some cases, this plan enables sole proprietors to shelter up to 100% of their income from taxes, as long as they do not hire employees.

By David Fisher

(LifeWire) - Thanks to a bit of federal legislation passed in 2001, self-employed people now have a powerful tool for sheltering savings - a lot of savings - from the tax collector.

The self-employed 401k, also known as a solo 401k or Individual 401k, lets self-employed business owners sock away as much as $51,000 a year (under 2008 limits) into a personal 401k account.

As with a regular 401k, money goes into a self-employed 401k tax-free and grows tax-deferred until it is taken out, with the usual 10% penalty imposed on anything withdrawn before age 59 1/2 unless it qualifies as one of the exceptions. Beyond that, though, similarities to the regular 401k, with its expensive management fees and ponderous administrative duties, are few.

Unlike the traditional version, the self-employed 401k is inexpensive to create and administer. There are no requirements for complicated discrimination tests, and IRS Form 5500 doesn't have to be filed until the account contains $250,000.

Adding a Profit-Sharing Component

As with the regular 401k, pre-tax contributions of salary are capped - at $15,500 in 2008, or at $20,500 for anyone 50 and older. Those amounts are scheduled to rise with inflation in subsequent years. Unlike the traditional 401k, the self-employed 401k allows owners to contribute up to 25% of their annual pay to themselves in the form of profit-sharing. For most people, the two forms of contributions can add up to a maximum of $46,000 a year, under 2008 rules, although people aged 50 and over are allowed to put away as much as $51,000 a year. Perhaps the best part: In combination, the two forms of contributions can add up to 100% of an owner's income if they fall under these limits.

This retirement plan has a few other perks. These accounts can be set up to allow for pre-retirement loans, and they can be set up in the form of a self-employed Roth 401k, which reverses the tax flow: Money is taxed as income when it goes in, but it grows tax-free and is tax-free upon withdrawal.

Business owners who keep their day jobs can contribute to their regular 401k at work and to their own self-employed 401k, as long as their income contributions don't exceed the $15,500 or $20,500 caps and their total contributions to both plans don't exceed the $46,000 or $51,000 caps.

Most businesses that would qualify for a self-employed 401k plan would also qualify to take a tax credit of up to $500 to cover up to half the cost of setting up and administering the plan in each of its first three years.


Why single out small-business owners for these benefits? The US Labor Department figures that only about 34% of people who work for small firms are covered by a retirement plan, compared with nearly two-thirds of workers for large and mid-sized businesses.

Created by the Economic Growth and Tax Relief Reconciliation Act of 2001, or EGTRRA, the self-employed 401k was designed specifically to give lone-wolf entrepreneurs a better shot at joining the world of tax-deferred retirement savings. Thus, its restrictions.

A self-employed 401k is basically limited to companies with one employee - the owner - although spouses can also contribute to the plan. Partners or shareholders can be included in the plan as well. In some cases, the company can have part-time employees who are excluded from the plan, as long as they work less than 1,000 hours a year, or (under certain circumstances) belong to a union or are non-resident aliens. But as a rule of thumb, as soon as the company takes on full-time employees who aren't married to the boss (or bosses), the self-employed 401k will have to be converted to a cumbersome traditional 401k plan.

That said, the self-employed 401k is not limited to any particular type of ownership structure - sole proprietorships, partnerships, Subchapter S corporations and regular corporations all qualify.

A Higher Cap

The self-employed 401k allows considerably higher contributions than a pair of popular alternatives, the SIMPLE IRA and the SIMPLE 401k, both of which carried contribution caps of $10,500 plus an employer match of up to 3% of salary in 2008, with a $2,500 catch-up allowance for anyone over 50. (SIMPLE is an acronym for Savings Incentive Match Plan.)

One key difference: A SIMPLE plan allows for the inclusion of employees, as do SEP IRAs. An SEP, which stands for Simplified Employee Pension, allows employer contributions of up to 25% of net earnings or $46,000, whichever is less. Unlike SIMPLE plans or self-employed 401(k)s, SEP contributions must be the same for each participant.

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