Used to be, you had to give up either savings or flexibility to create a tax-deferred nest egg. Not any more.
Building your retirement plan while you’re also trying to build your business can be tough. Many retirement plans don’t allow entrepreneurs to put much money away, or if the plans do provide for large contributions, they don’t offer the flexibility a business owner needs to manage uncertain cash flow needs. But there is, finally, one retirement plan that does both. It’s called a solo 401(k).
You qualify for a solo 401(k) if you’re the only employee in your business (the solo part), or if you and your spouse are the only two employees. A solo 401(k) allows you to defer up to $17,000 a year in wages if you’re under age 50 and $22,500 if older. Plus, because it’s a 401(k), it also has a profit-sharing feature, which means that in addition to your 401(k) “salary deferral,” you can also make an employer contribution out of “profits” that could take your total contribution upwards of $50,000 for a year. You can even set up your solo 401(k) to allow for Roth 401(k) contributions, which means you can build a nice tax-free (as opposed to tax-deferred) balance.
Here are a few examples of how a solo 401(k) can help build retirement assets but also respond to business cash flow needs.
Let’s say you’re 40 years old and starting your own consulting firm, but your spouse has a regular job and a healthy income. In your first year, you generate $50,000 of net income and you’d like to shelter as much as you can. You could contribute $17,000 of that income into your solo 401(k) plan. You can then make a profit sharing contribution of roughly 20% of your net self-employment income, which roughly amounts to another $9,000, for a total of about $26,000, or a little over a 50 percent contribution. Compare that with an IRA, where you’d be limited to $5,000, or an SEP IRA, where you’d be stuck at 20 percent of $50,000, or about $10,000.
Now, let’s assume next year you net $100,000. You can now make the $17,000 401(k) deferral and about another $18,000 in profit sharing, for a total of about $35,000. Or, if you decide that next year you want cash for expansion, you can contribute $0 to the 401(k), or $5,000 or whatever you want.
Remember, if your spouse also works in the business, you can essentially split the contributions. That means with limits of about $50,000 per person, you could be looking at a $100,000 contribution and a $100,000 tax deduction.
You also have the ability to borrow from your solo 401(k) plan. Generally, you can borrow up to 50 percent of the account balance, up to a maximum of $50,000. This may come in pretty handy if your bank tightens up your credit line.
Most large brokerage firms and many mutual fund companies support solo 401(k)s and can provide you the basic documents. But remember: These plans are more technical than an IRA or SEP IRA, and I’ve only provided you with a summary of some basic options. That means you’re going to want to work with a tax professional. For instance, contribution limits are calculated differently for sole proprietors or pass-through entities like S corporations and LLCs, than they are for C corps. As you can imagine with the tax code, every situation is unique, so make sure you get the guidance you need before starting a solo 401(k). It may cost a few bucks to get your solo 401(k) established, but the tax savings and flexibility are generally more than worth it.
CHARLES FARRELL is a principal with Denver-based Northstar Investment Advisors and the author of the book Your Money Ratios: 8 Simple Tools for Financial Security. The Wall Street Journal called it “one of the best financial books to cross our desks.”