What are the benefits of setting up and Individual 401(k) plan if you own a small business? In the right circumstances, it can be the best option available due to its high contribution limits, low costs if you use the right custodian, availability of a loan from the plan, and the fact that it isn’t an IRA. Some custodians even let you do a Roth option on this plan for the employee contribution portion!
An Individual 401(k) plan (or Solo 401(k) plan, as it is sometimes called) is very similar to a 401(k) that you might find at most large companies these days. The biggest difference is the restriction that it can only be used at a business that involves the owner and his/her spouse. If you have employees in the business, you can’t use an Individual 401(k), you would need to look at a SEP IRA or a Simple IRA. 1099 employees don’t count as employees, nor do employees age 21 or younger, or part-time employees working less than 1,000 hours per year.
For a successful self-employed individual, the biggest benefit of having an individual 401(k) plan is the contribution limit, and the ability to contribute up to $18,000 for tax year 2016 ($24,000 if you are over 50) as an employee contribution. That means that as long as your business earns at least $18,000 in net income, you can contribute every dollar of that to an Individual 401(k) plan. This is not the case with a SEP or Simple IRA. With a SEP IRA, you are limited to contributing 25% of your total net income from your business. At $18,000 of net income, you could only contribute $4,500 to your SEP IRA. At $100,000 of net income, you would be able to contribute $43,000 to an Individual 401(k) plan, and only $25,000 to a SEP IRA. Both the I401(k) and the SEP have the same maximum contribution limit of $53,000 for 2016, but with the I401(k) you only have to earn $140,000 to make that contribution. With a SEP, you would have to earn $212,000 to make the maximum contribution.
One thing that keeps people from using the I401(k) plan is the costs of setting up the plan. However, in this day and age of competition from brokerage houses and custodians, this plan shouldn’t have any additional costs if you shop around for the right custodian. Our custodian, Charles Schwab, does not charge anything to our clients for using the I401(k). I am not sure if this is true on the retail side, but if you go through a financial advisor like us, that is the case.
Another benefit of the I401(k) that is not available with a SEP IRA is the loan option. If you find yourself in a bind and need to withdraw money from a retirement account prior to age 59.5, you will almost certainly incur a penalty on top of the taxes you owe. However, if you take a loan from your plan and pay it back within 5 years, there are no tax consequences to you. The loan has a maximum amount of either half your plan value or up to $50,000. You will pay interest on the loan, but the best part about that is you are paying the interest to yourself!
A SEP IRA can be converted to a Roth IRA, but there is no Roth option on a SEP. Some I401(k) plans do allow for a Roth option, but only for the employee contribution potion. That means you could potentially put $18,000 per year into a Roth. Compare that to the traditional Roth IRA contribution limit of $5,500 ($6,500 if over age 50), and that is a great way to supercharge your tax-free money in retirement.
One less commonly known feature of the I401(k) plan is that it isn’t an IRA. You may be wondering how that is a benefit, but if you plan on making back door Roth contributions, this is important. A back door Roth contribution is when you contribute money to a non-deductible IRA and then do a Roth conversion. Usually the reason for this transaction is that you make too much money to contribute directly to a Roth. The problem with this strategy is that under the IRA aggregation rule, all of your IRAs are treated as one IRA. Therefore, if you have both a traditional IRA and a non-deductible IRA, you can’t simply convert the non-deductible IRA to a Roth. The IRS will look at it as a percentage of your total IRA balance, and the percentage that you hold in the traditional IRA will be taxable. For instance, if you have $80k in a traditional IRA, and $20k in a non-deductible IRA and do a $5k Roth conversion, 80% of that, or $4k, will be taxed as ordinary income to you. However, you can avoid all this by using an individual 401(k)! Simply roll your traditional IRA money into your I401(k), do the conversion, and 100% of it will be treated as coming from your non-deductible IRA.