Solo 401(k) Plans explained

These days, many folks are self-employed. Many stayed on with their employers after retirement as consultants. Many others work full time and have a business on the side. With income coming in from employment, pensions, and Social Security, these self-employed persons may not need the extra cash for living expenses and are scrambling for ways to keep income taxes down. For them, the answer may be the Single-Person (or Solo) 401K Plan which came into being in 2001 with the Economic Growth and Tax Relief Reconciliation Act (EGTRRA).

It is easy to qualify for opening a Solo 401K and easy to manage one. For starters, the self-employed persons must have no full-time workers other than their spouse. Their self-employed income can come from any form of business, such as sole proprietorship (schedule C), limited liability company, partnership, or C/S – Corporation.

Why should you even consider opening a Solo 401K Plan? To save significantly more on current income taxes and to sock away money for the future. Even those over 70 ½ who are self-employed but are taking annual required minimum distributions (RMD's) from their other retirement accounts can sock away money into Solo 401K Plans at the same time.

A Solo 401K plan can be easily established through a bank, broker, or other financial institution. There are two basic types of Solo 401k's: Self-Directed and Brokerage Plans. The Self-Directed is a bit more flexible, with features such as checking, loans, and Roth sub accounts.

Solo 401K plans work just like the big company ones, only simpler and with almost no red tape. To grasp the concept for a single person, it is good to think of yourself as serving in two different roles simultaneously: that of employer and that of employee. The Solo 401K combines the contributions of these two components into one because; in fact, that is what the self-employed person really embodies. The IRS refers to the employer portion of contributions as "profit-sharing" and the employee contribution as "salary deferred".

Here's how much income a self-employed person (Sole Proprietor or Single-Member LLC) can stash away into a Solo 401K:

1. Profit Sharing:
• Up to 20% of earned income (maximum of $53,000) $33,000
(technically 25%, but netting to 20%)
• Catch up for those over 50 6,000
2. Salary Deferral Maximum: 18,000
Total possible contribution $67,000

For some, this reduction in taxable income can affect other eligibility aspects as well, such as Medicare. And there is no requirement to make these 401K contributions every year. Once your Solo 401(K) account is opened, you can wait until filing your tax return next year to see what your tax picture looks like and, also, how much cash is available at that time to make your contribution for the prior year.

Let's say you are 70 and earn $50,000 from self-employment as a consultant (sole proprietor). You could potentially contribute the following to your Solo 401K:

Profit Sharing: 20% x $50,000 $10,000
Catch up 6,000
Salary Deferred: Maximum 18,000
Total Maximum Contribution $34,000

This would mean that your self-employed income on your tax return would only be $16,000 ($50,000-$34,000 401K contributions).

Those who are still employed and are still eligible to contribute to the company 401K plan must take care not to exceed the maximum. Those maximum amounts apply to all 401K Plans for which the individual is eligible to contribute.

If your Solo 401(K) account is opened with a discount broker, investing the cash in that account is easy. Just liked your IRA's or other investment accounts, you can select from the universe of high-quality mutual funds in that one account.

If you are considering a SEP-IRA or a Solo 401K, here are some features of a 401K that are not allowed with a SEP-IRA:

• Employee salary contributions of $18,000 plus catch-up of $6,000.
• Roth contributions regardless of income levels.
• You can borrow up to $50,000.

If you have self-employed income and are looking for more tax shelter, it would be well to open a Solo 401(K) prior to December 31. There is not a lot of paperwork required to open the account nor in the reporting. Probably the best place to choose is a discount broker, like TD Ameritrade or Vanguard. Once the account is opened (with zero balance), you have until April 15, 2017 (or October 15, with an extension) to figure out the tax effects of different contribution amounts and, also, how much cash you'd have available to sock away into your Solo 401(K) for tax year 2016. These accounts are great tax planning opportunities for those who seek tax shelter.