Employers have embraced the 401(k) plan as a way to help their employees save for retirement. 401(k) plans not only provide a convenient and easy way for employees to save, they also allow employers to contribute to employees’ accounts. Together, this can result in a considerably higher amount saved for retirement each year than by saving through an IRA alone.
But what if you're a sole proprietor with no employees – are you stuck without a way to save those higher dollar amounts in a tax-qualified retirement plan? No. You actually have two options to set up an employer-sponsored retirement savings plan. You can save a significant amount of money through a SEP IRA, up to $56,000 in 2019. Or, you can establish a solo 401(k) plan (also known as an Individual(k) plan) and put away as much as $62,000 for retirement in 2019, with some additional benefits.
Benefits of an Individual Plan
A Solo(k) or Individual(k) plan is a retirement plan designed for business owners (and their spouses) with no employees. It follows many of the same rules and requirements as other 401(k) plans, but combines the benefits of a 401(k) plan with the flexibility of a self-directed IRA:
- The business sponsoring the plan can be structured as a sole proprietorship, partnership or corporation, although the structure might impact the maximum amount of potential yearly savings.
- Savings can be invested in mutual funds or other investments offered by the plan. Depending on how you set up the plan, your investment options can go far beyond the mutual funds typically found in a corporate 401(k) plan. With an alternative asset custodian, you may be able to include investments such as Real Estate Investment Trusts (REITs), promissory notes, and private equity funds.
- Each business owner can make “salary deferrals” on either a pre-tax or after-tax (Roth) basis up to $19,000 for 2019 (and up to $25,000 if age 50 or older).
- The business can make – and deduct – a profit sharing contribution for yourself (and other owners) up to 25% of compensation each.
- You may be able to take a loan from your Individual(k) plan account, depending on the plan document.
- Contributing to an Individual(k) plan does not prohibit you from making annual IRA contributions. (As with participation in any employer-sponsored retirement plan, however, your level of income may impact the tax deductibility of a traditional IRA contribution and your eligibility to make a Roth IRA contribution.)
- Nondiscrimination testing is an ongoing and potentially large expense for 401(k) plan sponsors with employees, but Individual(k) plans do not require such testing because there are no employees. In addition, an Individual(k) plan is not required to file an annual Form 5500-EZ or Form 5500-SF report until it has $250,000 or more in assets. (If the business ends up hiring employees, all the regular 401(k) rules, like nondiscrimination testing and Form 5500, will apply.)
How the Employee/Employer Contribution Works
Individual(k) plans have a unique feature that allows business owners to make much larger annual contributions to their own account than is often possible under traditional 401(k) plans because there are no other employees to share the employer contribution. Since all contributions made as both the employer and employee are going into one account, the savings can add up quickly! However, the maximum amount that you will be permitted to put away each year is dependent on your self-employment or W-2 income.
Under this structure, business owners can make an elective salary deferral to the plan for themselves as an employee and profit share with themselves as an employer. Elective deferrals can be 100% of compensation up to the current annual contribution limits. And, depending on the structure of the business, employers can make nonelective contributions of up to 20% of "earned income" (business income minus half their self-employment tax and nonelective contributions) for unincorporated sole-proprietorships or 25% of W-2 income for single owner corporations. Such discretionary "profit sharing" contributions allow a business owner to accumulate much more on a yearly basis when they are able, but contributions are not required in years when profits aren’t as favorable.
Easy to Set Up
You must use a written plan document approved by the IRS to establish an Individual(k) plan, but most providers, including Mainstar Trust, offer a plan document that has been pre-approved. You must sign the plan document by the last day of your tax year to make contributions for that year.
Calculating Your Contributions
Calculating your earned income (including self-employment tax), allowable contribution rate, and tax deduction for an Individual(k) plan can be complex. It is recommended that you consult an accountant to make sure these amounts are calculated accurately to avoid costly corrections. However, there are some useful tools that can assist the "do it yourself" business owner:
To maximize both retirement savings and tax benefits, business owners should balance how much is saved through salary deferrals vs. nonelective profit sharing contributions.
For more information:
Visit Mainstar Trust to find FAQs about Individual 401(k) plans, and explore the plan documents used to establish a plan. If you have any questions, please contact the Mainstar Trust team at 1-800-521-9897 or customerservice@mainstartrust.com.