A Solo 401K Plan, also called an Individual 401K or Self Directed 401K Plan is a qualified retirement plan designed specifically for the self-employed or small business owner. The Solo 401K Plan provides a number of significant advantages generally not available through a traditional retirement plan, such as a SEP or SIMPLE IRA.
The Solo 401K Plan was created specifically for the self-employed in order to provide the small business owner with a low cost and easy administrative retirement option. The Solo 401K Plan has many of the same advantages of a conventional 401K Plan sponsored by companies with multiple employees. The one major advantage of the Solo 401(k) Plan is the high contribution limitations. The Solo 401K Plan was essentially designed to maximize contributions.
In general, the annual Solo 401k contribution calculation consists of two parts, an employee salary deferral contribution and an employer profit sharing contribution. In 2011 the total contribution limit for a Solo 401k is $49,000 or $54,500 for those age 50 or older. The total allowable contribution limits are combined to get the maximum Solo 401k contribution limit.
For the employee deferral contribution limitation, a Solo 401K Plan participant is able to contribute $16,500. An additional catch-up contribution of $5,500 can be contributed for individuals over the age 50. Unlike a SEP IRA, which is a percentage of the employee’s compensation, with respect to a Solo 401(k) Plan, the employee deferral contributions can be equal to 100% of the participant’s self-employment compensation. For example, if one earned $16,500 in annual compensation from a business that has adopted a Solo 401K Plan, the individual can contribute the entire amount – $16,500 to the Plan. In addition, that employee deferral contribution amount can be in pre-tax or Roth. The difference between a pre-tax contribution and a Roth contribution, is a pre-tax contribution is tax-deductible but is subject to tax when a distribution is taken, whereas, a Roth contribution goes in after tax (no tax deduction), but goes out tax-free as long as the Roth 401K account has been open at least 5 years and the individual is over the age of 59/12 when the distribution was taken.
The second part of the Solo 401K contribution calculation is the employer profit sharing contribution. Even though it’s called a profit sharing contribution, the employer contribution is still based off the participant’s total annual compensation. The profit sharing contribution is made by the employer and not the plan participant. Through the role of employer, an additional contribution can be made to the plan in an amount up to 25% of the participant’s self- employment compensation. The 25% is the maximum number and not the required amount. The employer profits sharing contribution can be made at a lower percentage. Note – if an employer profit sharing contribution is made, the contribution must be made on behalf of all the Solo 401K Plan participants (i.e. husband and wife).