How a Self-Employed Worker Can Get a Good 401(k)

A 401(k) is a company-sponsored retirement plan that allows employees to surrender a portion of their salaries to be invested in a tax-efficient manner. All funds paid into a 401(k) plan are retained on a tax-free basis until the holder reaches age 65 and withdraws money from the plan. Employees can contribute up to $16,500 into such a plan annually (as of 2011). Employers can make contributions for employees, too.

Federal legislation passed in 2001 enables self-employed people to contribute to a different form of 401(k) plan. The self-employed 401(k)-also called a solo 401(k) or individual 401(k)-allows business owners to pay into a tax-efficient plan. By combining salary and profit sharing (as both the employee and the employer) self-employed workers can make significantly higher contributions to their 401(k) plan than their employed peers can. As of 2011, the combined annual limit is $49,000 (or $54,500, if the individual is age 50 or older). Other benefits and conditions of the plan remain the same: Savings are retained interest-free, subject to a 10 percent penalty on withdrawals before age 65.

Benefits to the self-employed

Solo 401(k) plans offer a number of advantages to self-employed people. Aside from the higher contribution limits, plan-holders can borrow tax-free loans against the plan, up to a maximum of $50,000. The combination of salary and profit-sharing contributions is more tax-efficient for the business overall (an annual savings of about $8,000 on net profits of $100,000). The solo 401(k) is a much less expensive plan to administer compared to the employer plan. Requirements for complicated tests to prevent discrimination are not required, and IRS paperwork doesn't need to be filed until the plan accumulates $250,000.

Notably, business owners who retain a regular, employed role can pay into both a 401(k) plan and a different self-employed plan.

Tax adviser can help you choose

If you want to start a self-employed 401(k), it's wise to look into the various options on the market. Although plans are offered by a number of different providers, legislation largely dictates the benefits and terms-so you don't need to compare and contrast based on these terms.

Self-employed 401(k) plans are not, however, the only option open to business owners. A SEP IRA, Simple IRA or profit-sharing plan are other choices, any of which could be the most tax-efficient option, depending on your type of business, net income and age. Your tax adviser can help you get the best retirement plan, including the various 401(k)s.

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