Most limits for retirement plans haven’t budged an inch in 2011. They’re exactly the same as they were last year. But some small business owners can take matters into their own hands.
Strategy: Set up a “solo 401(k) plan.” If you qualify, you can effectively benefit from both “employee” and “employer” contributions to your account.
Usually, this dual tax winner can’t be beat because it often allows you to sock away more money than virtually any other type of retirement plan.
Here’s the whole story: With the usual defined contribution plan used by small business owners—such as a Simplified Employee Pension (SEP) or garden-variety profit sharing plan—the employer’s deductible contribution for 2011 is capped at the lesser of 25% of compensation or $49,000 ($54,500 if you’re age 50 or older). The maximum compensation that may be taken into account for these purposes is $245,000 for 2011. But that’s as far as it goes.
In contrast, an employee participating in a traditional 401(k) plan can make an elective deferral contribution to the plan within the annual limits, and the employer may match part of the contribution, usually up to a single-digit percentage of your salary.
A solo 401(k) offers even more. For 2011, you may defer up to $16,500 of compensation to your account, plus an extra catch-up contribution of $5,500 is allowed if you’re age 50 or older—the same as with elective deferrals to a traditional 401(k). Of course, the limits on deductible employer contributions still apply, but here’s the kicker: Elective deferrals to a solo 401(k) don’t count toward the 25% cap. So you can combine an employer contribution with an employee deferral for greater savings.
Example: Let’s say you’re the sole employee of your company, you’re under age 50 and you receive an annual wage of $125,000. The maximum deductible amount you may contribute to a SEP in 2011 is $31,250 (the lesser of 25% of compensation or $49,000). If you set up a solo 401(k) plan instead, you can defer $16,500 to the account in addition to keeping the maximum $31,250 employer contribution. That gives you a total contribution of $47,750 (below the $49,000 limit). And, since you’re the only employee of the company, you don’t have to worry about making contributions for anybody else.
The contributions to a solo 401(k) grow tax-deferred until you’re ready to make withdrawals. For simplicity, suppose you contribute $47,750 to your account each year for the next 20 years until you retire. If you earn 8% a year, you will have accumulated a nest egg worth $2,359,944!
Conversely, if you contribute $31,250 to a SEP for 20 years instead and invest it at the same 8% rate, you will accumulate $1,544,466 before retirement—or $815,478 less.
If the business isn’t incorporated, the 25%-of-compensation cap on employer contributions is reduced to 20% because of the way contributions are calculated for self-employed individuals. But that still leaves you with plenty of room to maneuver. For instance, if your net self-employment income is $125,000, you can stash away up to $41,500 ($16,500 deferral and $25,000 employer contribution) in the account this year. Plus, contributions can be boosted at age 50.
Note that a solo 401(k) may offer other advantages. For instance, the plan can be set up to allow loans and hardship withdrawals. Also, you might roll over funds tax-free from another qualified plan if you previously worked somewhere else.
Tip: Contributions are discretionary. Therefore, you can cut back on your annual contribution—or skip it entirely in a bad year.
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