The individual 401(k) - also known as the solo 401(k), works much the same as traditional 401(k) plans offered by large companies, as well as SEP IRAs designed for the self-employed.
Unlike other retirement plans, though, an individual 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).
The individual 401(k) comes in both a traditional and Roth version, just like IRAs. With the traditional individual 401(k), you put away money on a pretax basis and it grows tax-deferred. Your money is taxed when you withdraw it, in a future that may well include higher tax rates.
If you opt for the Roth version, you put in after-tax dollars and your money grows tax-free - which means it is not taxed upon withdrawal. You can split your contributions between the two types of accounts. One other point: Unlike SEP IRAs, solo 401(k)s allow you to borrow against your savings.
When are individual 401(k)s a good deal?
These plans are ideal if you intend to sock away large sums. An individual 401(k) allows you to save for retirement both as an employer and an employee, often enabling you to contribute more than would be possible with other retirement plans.
Here's how: As an employee, you can stash away as much as $16,500. As the boss, you can contribute an additional 25% of compensation, up to a maximum of $49,000, 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 $98,000. And if you are both 50 or older and eligible for catch-up contributions of $5,500 each, the total climbs to $109,000.
Who can contribute to one?
An individual 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).
When can I get access to the money?
Typically you need to keep the money invested in the retirement account until you reach age 59 ½. Withdraw money before then and you'll be hit with a 10% early withdrawal penalty, on top of the income taxes you'll pay on the withdrawal.
There are a few exceptions to the early withdrawal rule. Each plan's rules vary, but you may be able take money out of your retirement account penalty-free before age 59 ½ if you use it for:
- Purchasing your first home
- Expenses after the onset of a sudden disability
- Higher education expenses
- Payments you make to prevent eviction or foreclosure.
What if I need the money before retirement?
In general, the best solution is to take out an individual 401(k) loan, which uses the accumulated balance of the account as collateral. You can borrow up to half of the total balance on your solo 401(k), as long as the loan doesn't exceed $50,000. The remainder of your balance is still invested in your individual 401(k), with tax-deferred investment earnings growth. Loan payment plans vary by provider.
The alternative is to simply withdraw money from your individual 401(k). If you choose to do so before you are at least 59 ½, you'll typically owe a 10% early withdrawal penalty. You'll also owe income tax on the withdrawal - even if you hold a Roth 401(k). There are exceptions, however. The IRS allows the 10% penalty to be waived for certain "hardship withdrawals" such as permanent disability or large out-of-pocket medical expenses.
How should I invest the money?
When investing for a long-term goal such as retirement, you typically want to emphasize stocks, which have the best chance to generate returns that outpace inflation. Adding some bonds or cash to your mix can help reduce the overall volatility of your holdings.
How do my withdrawals get taxed in retirement?
If you go with the regular individual 401(k) and put away money on a pretax basis, your money grows tax-deferred - but it is taxed as income when you withdraw it. If you choose to invest in an individual Roth 401(k), you put in after-tax dollars now but your money grows tax-free, so that you pay no taxes upon withdrawal.
The Roth version might make sense if you expect your tax bracket to rise sharply by the time you are making withdrawals. But the choice between a traditional 401(k) and a Roth 401(k) can be tricky, so get help if you need it.
Does an individual 401(k) plan make sense for me?
These plans are appealing if you intend to sock away large sums. But 401(k) plans require more paperwork than SEP IRAs. If your account balance exceeds a certain amount, you have to file a special tax return for the plan, which can add slightly to tax-preparation costs and hassles.
In addition, many of the firms that will help you set up a solo 401(k) account levy setup charges (typically $100 to $375, depending on the level of service and the size of your account) as well as annual fees of $10 to $250.
Who can help me set up and administer a plan?
Here's some advice to consider as you shop for a plan provider:
- Check out investment options. Unlike corporate 401(k)s, which often offer dozens of funds from multiple fund families, many solo 401(k) providers restrict you to one fund group.
- Keep a lid on costs. Fees vary widely among 401(k) providers. Set-up charges and annual fees depend on the amount of advice offered. Many firms will waive some expenses for larger accounts.
- Consider your borrowing needs. Although the law allows you to borrow as much as 50% of the assets in your individual 401(k) (up to a loan limit of $50,000), not every provider offers a loan option. While it's certainly not advisable to raid your retirement plan for cash, you may want the financial safety net that a loan feature provides.
Fidelity is a good choice for many people, visit Fidelity Self-Employed 401(K) Center for more information.