A Solo 401(k) Plan is an IRS approved retirement plan, which is suited for business owners who do not have any employees other than themselves and perhaps their spouse. The “one-participant 401(k) Plan” or individual 401(k) Plan is not a new type of plan. It is a traditional 401k Plan covering only one employee. Unlike a Traditional IRA, which only allows an individual to contribute $5500 annually or $6500 if the individual is over the age of 50, a Solo 401k Plan offers the Plan participant the ability to contribute up to $56,500 each year. Before the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) became effective in 2002, there was no compelling reason for an owner-only business to establish a Solo 401(k) Plan because the business owner could generally receive the same benefits by adopting a profit sharing plan or a SEP IRA. After 2002, EGTRRA paved the way for an owner-only business to put more money aside for retirement and to operate a more cost-effective retirement plan than a Traditional IRA or 401(k) Plan.
There are a number of options that are specific to Solo 401k Plans that make the Solo 401k Plan a far more attractive retirement option for a self-employed individual than a Traditional IRA for a self-employed individual.
1. Reach your Maximum Contribution Amount Quicker: A Solo 401(k) Plan includes both an employee and profit sharing contribution option, whereas, a Traditional IRA has a very low annual contribution limit.
Under the 2013 new Solo 401(k) contribution rules, a plan participant under the age of 50 can make a maximum employee deferral contribution in the amount of $17,500. That amount can be made in pre-tax or after-tax (Roth). On the profit sharing side, the business can make a 25% (20% in the case of a sole proprietorship or single member LLC) profit sharing contribution up to a combined maximum, including the employee deferral, of $51,000, an increase of $1,000 from 2012.
For plan participants over the age of 50, an individual can make a maximum employee deferral contribution in the amount of $23,000. That amount can be made in pre-tax or after-tax (Roth). On the profit sharing side, the business can make a 25% (20% in the case of a sole proprietorship or single member LLC) profit sharing contribution up to a combined maximum, including the employee deferral, of $56,500, an increase of $1,000 from 2012.
Whereas, a Traditional Self-Directed IRA would only allow an individual with earned income during the year to contribute up to $5500, $6500 if the individual is over the age of 50.
For example, Joe, who is 60 years old, owns 100% of an S Corporation with no full time employees. Joe earned $100,000 in self-employment W-2 wages for 2013. If Joe had a Solo 401(k) Plan established for 2013, Joe would be able to defer approximately $48,000 for 2013 (a $23,000 employee deferral, which could be pre-tax or Roth, and 25% of his compensation giving him $48,000 for the year). Whereas, if Joe established a Traditional Self-Directed IRA, Joe would only be able to defer approximately $6,500 for 2013.
2. No Roth Feature: A Solo 401k Plan can be made in pre-tax or Roth (after-tax) format. Whereas, in the case of a Traditional Self-Directed IRA, contributions can only be made in pre-tax format. In addition, a contribution of $17,500 ($23,00, if the plan participant is over the age of 50) can be made to a Solo 401(k) Roth account.
3. Tax-Free Loan Option: With a Solo 401K Plan, you can borrow up to $50,000 or 50% of your account value, what ever is less. The loan can be used for any purpose. With a Traditional Self-Directed IRA, the IRA holder is not permitted to borrow even $1 dollar from the IRA without triggering a prohibited transaction.
4. Use Non-recourse Leverage and Pay No Tax: With a Solo 401(k) Plan, you can make a real estate investment using non-recourse funds without triggering the Unrelated Debt Financed Income Rules and the Unrelated Business Taxable Income (UBTI or UBIT) tax (IRC 514). However, the non-recourse leverage exception found in IRC 514 is only applicable to 401(k) qualified retirement plans and does not apply to IRAs. In other words, using a Self-Directed SEP IRA to make a real estate investment (Self Directed Real Estate IRA) involving non-recourse financing would trigger the UBTI tax.
5. Open the Account at Any Local Bank: With a Solo 401k Plan, the 401k bank account can be opened at any local bank or trust company. However, in the case of a Traditional Self Directed IRA, a special IRA custodian is required to hold the IRA funds.
6. No Need for the Cost of an LLC: With a Solo 401(k) Plan, the plan itself can make real estate and other investments without the need for an LLC, which, depending on the state of formation, could prove costly. Since a 401(k) Plan is a trust, the trustee on behalf of the trust can take title to a real estate asset without the need for an LLC.
7. Better Creditor Protection: In general, a Solo 401(k) Plan offers greater creditor protection than a Traditional IRA. The 2005 Bankruptcy Act generally protects all 401(k) Plan assets from creditor attack in a bankruptcy proceeding. In addition, most states offer greater creditor protection to a Solo 401(k) qualified retirement plan than a Traditional Self-Directed IRA outside of bankruptcy.
The Solo 401k plan is unique and so popular because it is designed explicitly for small, owner-only business. The many features of the Solo 401k plan discussed above is why the Solo 401k Plan or Individual 401k Plan it so appealing and popular among self-employed business owners.