401(k)s for the Self-Employed

Every once in a while, I receive a stack of paper in the mail from Vanguard addressed to “Plan Administrator,” which gives me an undeserved sense of self-importance.

No, I didn’t select “Plan Administrator” from a drop-down list of salutations that also included “Dr.,” “Lord,” and “Marquis”; I am actually the administrator of a 401(k) plan. The plan has one participant. Guess who?

My plan is called an individual, or solo, 401(k). It’s been legal since 2001, but until a few years ago, practically nobody had heard of this type of plan and few investment companies offered one.

Now, the major players like Fidelity, E*TRADE, and Vanguard are all on board– and still, practically nobody has heard of it. Recently, I helped a friend set up an Individual 401(k), and her accountant had no idea what to do with it.

The individual 401(k) is great because it allows you to save more than other self-employed retirement plans. It puts independent contractors on par with employees.

Well, sort of: if you want to match your own contribution, the match will have to come out of your other pants pocket. For most self-employed people (including employees who get a W-2 from their boss but also run a business on the side), however, the individual 401(k) is better than other plans like the SEP IRA or Keogh.

Admittedly, many of you have no use for this cool retirement tool. Before you conclude that the individual 401(k) isn’t for you, however, read on: if you have any self-employment income at all and your business has no employees (other than your spouse), running your own 401(k) could reduce your taxes enormously.

If there’s anybody who doesn’t like the sound of that, please post a comment so we can see what a space alien looks like.

What’s so great about being a Plan Administrator?

The key feature of the solo 401(k) that makes it better than the other plans available to self-employed people is: you can contribute up to 100% of the first $17,000 your business makes.

This comes in handy in a couple of common situations and one uncommon one:

1. Your spouse works full time and contributes to a retirement plan at work. You work part-time for yourself and would like to save as much of your income as possible.

With other retirement accounts like a SEP-IRA or Roth IRA, you’ll quickly hit the maximum contribution and miss out on the bigger tax break you’d get from a 401(k).

2. You generally live off your self-employment income, but you receive an inheritance or other windfall. Now, all of a sudden, you have more money you’d like to save—and shelter from taxes.

An individual 401(k) can help: you can save $17,000 plus 20%-25% of your business’s profit (depending on whether the business is incorporated), up to a maximum of $50,000 (or $55,500 if you’re 50 or over).

3. You’re just super-frugal. A Spartan sole proprietor who makes $40,000 can save $8,000 in a SEP-IRA, $5000 in a Roth IRA, but over $21,000 in a solo 401(k).

Yes, these numbers are simplified; the actual IRS formulas are more complicated. Does this surprise anyone? And yes, I know people this frugal.

Last year I found myself in the first category, so I opened an individual 401(k). Incidentally, despite the name, an individual 401(k) can have two participants: you and your spouse, as long as your spouse works for your business and is paid a reasonable salary.

That is, you can’t pay your spouse $17,000 to take out the trash one day and call it a salary.

Who shouldn’t 401(k)?

If you don’t have more than $5,000 to contribute to an individual 401(k), just stick with a traditional or RothIRA.

If you contribute the maximum to a 401(k) at work, you can still open a solo 401(k), but you can’t contribute the $17,000, only the 25% of profits.

If you have a lucrative side gig, however, this could certainly be worth doing.

If you hire employees (not contractors, but real W-2 employees) other than your spouse, you’re no longer eligible for a solo 401(k) and have to convert it to a full 401(k).

Okay, sign me up!

To open an individual 401(k), you’ll need to fill out some paperwork—maybe a dozen pages. It’s not as easy as opening a Roth IRA, but it’s not hard, either.

I opened my 401(k) with Vanguard, and it took less than an hour, with a helpful phone representative walking me through it. After the initial application, everything can be done online.

If your solo 401(k) has more than $250,000 in it, you have to file an annual form with the IRS. Nice problem to have.

You don’t need to be incorporated to establish a solo 401(k), but if you’re not, you need a Federal Employer Identification Number (EIN), which you can get online from the IRS in a couple of minutes.

If you’re unincorporated, you’ll use your EIN for the 401(k) paperwork and enter it, along with your Social Security number, on Schedule C of your 1040.

That’s it—don’t use it for anything else unless you’re incorporated, or it confuses the IRS (I found this out the hard way).

Finally, all versions of TurboTax that support self-employment income (that is, Deluxe, Premier, and Home & Business) understand individual 401(k)s, so it won’t bite you at tax time. Unless you have to explain it to your accountant.

Matthew Amster-Burton is a personal finance columnist at Mint.com. Find him on Twitter @Mint_Mamster.