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Solo 401k Plan

This article is directed towards the owners of a business, who are willing and able to establish a 401 (k) plan. The solo 401 (k) plan is the opportunity given to "one-person" business owners to allocate money for their retirement years.

The solo 401(k) plan experienced serious transformations during the Bush legislation, the most important of which is the increase in the amount that can be contributed each year. This is advantageous in itself since the amount of your tax-deferred assets is greatly increased and allows for the reduction in the annual income tax bills.

Some of the traditional retirement plans directed toward small businesses are:

  • SEP
  • Keogh
  • Profit-sharing plan

They allow for 25% percent deductible contributions from your yearly salary. This is in case you are governing a business that falls in the corporation category. In case you are a sole proprietor, you are allowed 20% deductible contributions from your annual income. The maximum dollar cap for the latter is $42,000 for the year 2005. In case you are above the age of 50, this dollar cap is increased to $46,000.

To gain a clearer view of this, let's consider the case of John who owns a corporation and enjoys a $90,000 annual salary. As a result he will be allowed to contribute to his retirement plan up to $22,500 annually, which represents 25% of $90,000 (his annual salary). On the other hand, his wife Mary is a sole proprietor and her annual salary is again $90,000. As a result she will be able to make deductible contributions of $18,000 each year, which represents 20% of the $90,000 (her annual salary).

Both of them are not satisfied with the annual deductible contributions they make, since they can afford to allocate a greater amount. This will not only provide them with more resources for their retirement years, but also will lower their tax bills.

The Solo 401 (k) Benefits

The better option for both John and Mary may be the solo 401k plan. In this way they will be able to maximize the contributions to their retirement accounts. This is so since the solo 401k plan constitutes of two parts.

Part 1

The first contribution part includes the possibility of allocating 100% of the first $14,000 of the compensations or self-employment income you have acquired during 2005. An exception is made for those who are above the age of 50 at the end of the year and the corresponding amount is $18,000. For the years to come this amount will be increased to $15,000, whereas for those above the age of 50 it will be changed to $20,000.

Part 2

The second contribution part represents the contribution and deduction of additional 25% of the compensation income or 20% for the self-employed income. These contributions and deductions are similar to the ones you can execute under a traditional retirement plan for small businesses.

In order to build a clearer view of how exactly the solo 401k plan's parts work together consider the extended example about John and Mary.

John still gets his $90,000 salary from his corporation. Therefore John will get $14,000 (Part 1) plus the traditional 25% of $90,000 (Part 2), which amounts to a total of $36,500. As you can see John will enjoy further $14,000 in terms of contributions each year (under the traditional retirement plan he can contribute up to $22,500).

Mary also continues to earn $90,000 each year from her sole proprietorship. Therefore, Mary will get $14,000 (Part 1) plus the additional 20% of $90,000 (Part 2), which amounts to a total of $32,000. Again, as you can see Mary will benefit additional $14,000 in terms of contributions each year (under the traditional retirement plan she contributed up to $18,000).

We have done the previous calculations on the basis of the assumption that both Mary and John are under the age of 50. If they were beyond this age the corresponding contributions would have been $40,500 for John, which represents 25% of his annual salary added by the Part1 contributions of $18,000. As for Mary, her contributions would have been $36,000, which represents 20% of her annual salary added to the Part 1 contributions of $18,000. These calculations are made on the basis of 2005 limits.

In the years to come both Mary and John will experience further increases in their contribution limits, since the Part 1 amounts are expected to increase.

Even if your income is larger than those of both Mary and John, you can make bigger contributions, but not exceeding the established cap of $42,000 for the year 2005. If you're above the age of 50, the dollar cap you should not exceed is $46,000. Both these limits are subject to change in the years to come.

Solo 401k plans provide additional benefits in terms of taxes. You decide on the amount you want to invest in your 401k solo plan when the year is good, which provides you with tax savings opportunities. Additionally, you are not required to contribute more than you can afford in lean years.

The Solo 401k Plan Disadvantages

Unfortunately, solo 401k plan is not deprived of any drawbacks.

Disadvantage 1

 In case you employ other people in your enterprise, by law you are required to make contributions to their accounts as well. Therefore, you should consider the possibility of hiring an experienced and qualified retirement plan professional to manage these issues. However, this requirement is not limited only to solo 401k plans, since the traditional 401k plans also require for such employee contributions.

Disadvantage 2

As with all retirement plans, the establishment and management of solo 401k plans is surrounded by paper work you should deal with. However, solo 401k plans eliminate many of the documents you should manage since you are handling only your plan. If you still find it difficult to administer the required paperwork, hire a professional to do this in return to a minimal fee.

Disadvantage 3

There is a deadline you should keep in mind when deciding to open a solo 401k plan. It is December 31 for the corresponding year. You should take the necessary actions before this date in order to be able to claim the yearly tax deductions.

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