Posted on: Thursday, December 18, 2003

Individual 401(k) smart move for self-employed

By Sandra Block
USA Today

If you own your business setting up a retirement plan before year's end can shrink your tax bill and boost your savings.

Self-employed workers have several savings alternatives, but if you're interested in saving a lot of money, consider individual 401(k) plans, also known as solo 401(k)s or one-person 401(k)s. Depending on your income, you can invest up to $40,000 in an individual 401(k) this year. Because of the new "catch-up" contributions for older workers, self-employed workers who are 50 or older can save up to $42,000. Contributions are pretax, so putting money in an individual 401(k) will reduce your taxes.

If you're short on cash at the moment, don't worry. As long as you set up your plan by Dec. 31, you can wait until you file your 2003 taxes to make a contribution, says Anthony Luciano, vice president of retirement products for Fidelity Investments. In most cases, that means you have until April 15, 2004.

Provisions in the 2001 tax cut bill made individual 401(k) plans possible. Initially only a few financial firms offered them, but the number of companies offering solo 401(k) plans has mushroomed. The Web site www.401khelpcenter.com lists more than 70 providers.

Individual 401(k) plans permit higher contributions than other types of retirement savings plans because they let self-employed entrepreneurs wear two hats: employer and employee. As the employee, you're allowed to contribute up to $12,000 of your self-employment income, or $14,000 if you're 50 or older. As the employer, you're allowed to contribute up to 25 percent of your compensation to the 401(k).

The combined contributions can't exceed $40,000 this year, or $42,000 if you're eligible for catch-up contributions.

Other advantages of individual 401(k) plans:

• Loans. You can borrow from an individual 401(k), an option that's not available for other types of self-employed retirement plans, says Christopher Guarino, president of Bisys Retirement Services.

However, not all financial services companies that provide individual 401(k) plans offer that feature.

• Rollovers. You can usually roll over money in an SEP-IRA or other self-employed savings plan into your individual 401(k). If you have money in a former employer's 401(k), you can roll that over, too.

A rollover will let you consolidate your savings and increase the amount you can borrow, assuming your plan offers that option.

• Flexibility. Unlike some other types of retirement plans for self-employed workers, you don't have to make annual contributions to your individual 401(k) plan, Luciano says. That's a nice benefit if your annual income fluctuates.

Some business owners are still better off with traditional retirement savings plans. An individual 401(k) plan isn't a good choice for you if:

• You plan to expand. Don't set up an individual 401(k) plan if you expect to hire anyone other than your spouse, says Elise Pilkington, an assistant director at Principal Financial. If you add full-time workers, you'll have to make the plan available to them, too.

You'll be required to comply with federal requirements that may limit how much you can contribute and increase your administrative costs. The rules kick in even if you hire just one full-time employee.

• You're a high-earner. The main advantage of an individual 401(k) is that it allows you to save more than traditional retirement savings plans, such as the SEP-IRA. But the individual 401(k) loses its edge after net business profits top about $208,000 for an unincorporated business or $160,000 of W-2 wages if incorporated, Luciano says.

At those levels, you may decide to opt for the SEP-IRA, because it's generally easier and less expensive to administer. When you set up an individual 401(k) plan, you must comply with federal recordkeeping and tax-filing rules, or pay someone else to do it for you.