Self-employed individuals are allowed to fund an individual retirement account, but there are better options available. Owners of small businesses can maximize their retirement account contributions by establishing a solo 401(k) plan.
A solo 401(k) plan is similar to a regular 401(k) except that the solo plan is available only to self-employed individuals. The owner of a small business is considered to be both the employer and the employee for purposes of funding the plan. A key feature of a solo 401(k) plan is that the only allowable employee is the spouse of the business owner.
Deemed employee contribution
The annual contribution limits to a solo 401(k) plan are much higher than those for a traditional IRA or a Roth IRA. Deemed as an employee of your business, you can contribute up to $18,000 of your earnings each year to a solo 401(k). If you are at least age 50, you can contribute up to $24,000. As with a regular 401(k), contributions are tax-deferred.
Deemed employer contribution
Depending on how your small business is structured, you can also contribute to a solo 401(k) plan on behalf of the company. If your business pays income tax as a regular corporation, it may contribute up to 25 percent of your compensation to your solo 401(k). If income tax on the business is paid along with your personal tax return, an additional calculation is necessary to calculate how much your company can contribute.
The overall annual contribution limit to a 401(k) plan for an individual under age 50 is $53,000. For persons age 50 or older, the overall ceiling increases by $6,000. If the company does not pay tax as a regular corporation, your personal income tax return may include a deduction based on the amount of self-employment tax. If so, the additional calculation is necessary.
If the business is not a regular corporation, you must subtract both one-half of the self-employment tax and your own 401(k) contribution from the overall limit to determine the company contribution limit. Regardless of the calculated limit, the company can contribute no more than 25 percent of your compensation.
If the account balance in your solo 401(k) plan is at least $250,000 at the end of any year, you must file Form 5500-SF with the U.S. Department of Labor. If you anticipate adding employees aside from a spouse, there are other types of retirement plan options available. Contact a financial advisor for more information on retirement plans for small businesses.