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Going It Alone
For small business owners, it’s often more difficult because of additional limits on tax-deferred profit sharing. However, recent changes in tax laws have given some small business owners a distinct edge in saving for retirement.
Under the previous laws, small business owners had to lump together all the sources for their tax-deferred savings, subject to a relatively low contribution cap, namely $30,000.
“It was not practical to combine a 401(k) and a profit-sharing plan, because 401(k) deferrals reduced the amount that you could contribute to a profit-sharing plan, and you could get to the maximum with just the profit-sharing plan,” said Brian Moore, a financial and trust adviser with Legacy Trust, a
As such, there is suddenly a new market for business owners who previously had no incentive to start a 401(k) plan, as opposed to participating in other tax-deferred plans such as SEPs and SIMPLEs, or just using traditional IRAs.
“The challenge there is, you hit the maximums much quicker,”
Changes in the Internal Revenue Code starting in 2002 increased the maximum amount of a business owner’s compensation that could be contributed to a profit-sharing plan and deducted from taxable income from 15 to 25 percent. At the same time, because of the “decoupling”
Of course, the number of people who are able to set aside nearly $100,000 each year for retirement is quite small. That does not mean that a solo 401(k) is not a good choice for lower-income business owners.
“Your salary isn’t assumed paid until the end of the year. Even if you’re taking those regular draws from the business, those are not necessarily considered paid salary until the end of the year when you know what your profit is,” he said.
In a poor year, a solo 401(k) participant could contribute nothing. In a good year, the business owner could contribute up to the maximum. The true flexibility comes in being able to wait until the year is over to make that decision.
“So you could take a big lump sum and plop it into the plan at that point. You don’t really have to pre-plan as long as you get your plan in place by Dec. 31,”
The rules are slightly different for corporations. For incorporated business owners, the contributions would be more formal and regular, like those made in traditional 401(k)s in larger corporations, and there is no ability to wait until the end of the year to determine contributions.
Although the rules regarding solo 401(k)s are different from a taxation standpoint, the actual investments are the same as traditional 401(k) funds.
The idea of an individual 401(k) might seem too good to be true. That’s not the case, but they are not necessarily right — or available — for everyone. To qualify for a solo 401(k), a business can’t have any common-law employees that qualify for the plan. That still allows the owner and the owner’s spouse to participate. The business can have other employees, but there are certain restrictions they must meet in order to be considered ineligible for participation.
“People are saying, ‘I am going to take these skills that I have accumulated during my pri