Finally a 401(k) plan just for one

The owners of the smallest businesses enjoy more flexibility than ever when it comes to saving for retirement. Here's why.

By Penelope Wang, FSB Magazine

(FSB Magazine) -- Launching a business was Ryan McBryde's first priority, but a close second was finding the best way to save for retirement. Specifically, the 38-year-old professional land surveyor - and now owner of Ryan McBryde Land Surveying & Planning in Southern Pines, N.C.- sought a savings plan geared to his needs as a sole proprietor.

His solution: the solo 401(k), which offers benefits similar to those of a traditional 401(k), but lets you put away far more money.

The solo 401(k) has become more attractive since last year, when it began offering sole proprietors a flexible-funding feature, which allows them to choose whether to avoid taxes on current income or on withdrawals they will take later, in retirement.

A dedicated saver, McBryde set up a solo 401(k) last year, soon after launching his business. It so far holds about $30,000 in after-tax funds, all of it in a Roth account. "As my business grows, I know I can put away a lot more," says McBryde. "And I'll never have to pay taxes when I withdraw the Roth money."

The solo 401(k), also known as the solo k, the individual 401(k), or uni-k, first came on the market in 2001. It works much the same as traditional 401(k) plans offered by large companies, as well as SEP IRAs designed for the self-employed.

But unlike other retirement plans, a solo 401(k) is strictly for sole proprietors who have no employees (although your spouse may contribute if he or she earns income from your business). With this plan, you can choose whether to invest pretax or after-tax dollars.

If you put away money on a pretax basis, it grows tax-deferred, but it is taxed when you withdraw it, in a future that may well include higher tax rates. If you opt for a Roth option, you put in after-tax dollars and your money grows tax-free, i.e., it is not taxed upon withdrawal. You can also split your contributions between the two types of accounts. And unlike SEPs, solo 401(k)s allow you to borrow against your savings.

These plans are ideal for those who intend to sock away large sums. "With an individual 401(k), you save both as an employee and as an employer," says Kristen Luby, senior marketing manager at fund group T. Rowe Price. "That feature allows the typical business owner to put away more than in most other retirement plans."

Here's how: As an employee, you can stash away as much as $15,500 in 2007. As the boss, you can contribute an additional 25 percent of compensation, up to a maximum of $45,000, including your employee contribution. These contributions are discretionary, so you can save the maximum in flush years and nothing in tougher times. If you and your spouse are both in the plan and enjoy a banner year, you could save a total of $90,000. And if you are both 50 or older and eligible for catch-up contributions of $5,000 each, the total climbs to $100,000.

By contrast, a SEP IRA would let you sock away 25 percent of your business income up to the $45,000 max. But you can't make the additional employee contributions of as much as $15,500 (a critical feature if 25 percent of your income is not sufficient to get you to the $45,000 ceiling), nor can you add the $5,000 catch-up contributions.

In a traditional 401(k), you could put in no more than the $15,500 annual limit, plus the $5,000 catch-up, and many companies set contribution limits below that amount. Entrepreneurs are catching on to the advantages - some 104,000 solo 401(k) plans have opened and collectively hold $5.4 billion, up from $3.1 billion in 76,000 accounts in 2005, according to Financial Research Corp. (frcnet.com), a financial industry research firm based in Boston.

Those figures are expected to continue to climb with the introduction of the solo Roth 401(k) savings option. Financial advisors have long recommended that investors build nest eggs in both tax-free and tax-deferred accounts.

"With savings in a tax-free plan such as a Roth IRA or Roth 401(k), you don't have to pay taxes on those distributions," says Ed Slott, a certified public accountant in Rockville Centre, N.Y. "And since you don't know what tax rates you will face in the future, having both tax-deferred and tax-free accounts to draw on gives you flexibility in managing your tax bills in retirement."

There are a few drawbacks to these plans, however. Solo 401(k)s require more paperwork than SEP IRAs. Those whose accounts grow to $100,000 or more must file a special tax return for the plan, which can add slightly to tax-preparation costs and hassles. In addition, many providers of solo 401(k) accounts levy setup charges, which typically run from $100 to $375, depending on the level of service and the size of your account, and annual fees of $10 to $250.

To find out more about individual 401(k)s, go to 401khelpcenter.com, an industry Web site that publishes a list of more than 100 plan providers. Only a few of the major firms have begun to offer the Roth option, but AllianceBernstein, Pioneer, and T. Rowe Price are three that do. Or ask your accountant or financial advisor for recommendations.

Are you a sole proprietor? Do you have a solo 401(k) account? How do you save for your retirement as a small business owner? Post your thoughts on the FSB blog.  Top of page

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Market indexes are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer LIBOR Warning: Neither BBA Enterprises Limited, nor the BBA LIBOR Contributor Banks, nor Reuters, can be held liable for any irregularity or inaccuracy of BBA LIBOR. Disclaimer. Morningstar: © 2014 Morningstar, Inc. All Rights Reserved. Disclaimer The Dow Jones IndexesSM are proprietary to and distributed by Dow Jones & Company, Inc. and have been licensed for use. All content of the Dow Jones IndexesSM © 2014 is proprietary to Dow Jones & Company, Inc. Chicago Mercantile Association. The market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved. FactSet Research Systems Inc. 2014. All rights reserved. Most stock quote data provided by BATS.