Launch a Solo 401(K) Plan by Karla Hopkins

Most limits for retirement plans have not increased in years. However, small business owners can take matters into their own hands and create higher tax deferred deductions by setting up a solo 401(K) plan.

With the usual self employed retirement plans (SEP), the maximum deferral is the lesser of $49,000 or 25% of your net compensation. The maximum compensation that can be taken into account however is $245,000.

In contrast, an employee can make elective deferrals within annual limits and the employer may match part of the employee’s contribution. Therefore, a solo 401(K) plan offers even more.

Under a 401(K) plan, you can elect to defer up to $16,500 annually (or $22,000 if you are over 50). The key to the 401(K) plan is that the elective deferrals don't count towards the 25% cap as described above. So you can combine the employer contribution with an employee deferral for greater savings.

Here's an example. Let's say your wages are $125,000. The maximum SEP you can deduct is $31,250 (25% of your wages). If you had a solo 401(K) plan you could defer $16,500 in addition to the employer match of 25% of your salary ($125,000 x .25) or $31,250 for a total contribution of $47,750 (still below the $49,000 overall limit described above).

For a sole proprietor the 25% is reduced to 20% so that in the example above the total contribution allowed would be $41,500 ($16,500 plus $25,000).

A solo 401(K) plan can also be set up to allow loans and hardship withdrawals in the event you have a casualty. You can also roll over funds from other previous employer plans into your own 401(K) plan. Contributions are discretionary so that if you business is having a bad year, you can skip contributing entirely.

While this is a great tax planning tip, it is not a free ride; there are some downsides to a 401(K) plan. If the business has other employees, they may have to be covered by the plan too. There are moderate costs for running the plan that are generally paid to plan administrators. In the large investment companies like Fidelity, a small plan my be charged a one time setup cost of $100 and annual fees ranging from $50 to $250.

Even with the fees, it is a good option for long term retirement savings, especially if you do not have employees.