If you are self-employed or have any self-employment income, you’ve probably wondered about the different types of retirement accounts available to you. Three of the most common types of accounts are SEP IRAs, Simple IRAs, and the Solo or Individual 401(k) plan. This recent post I wrote gives more information on these three account types. Here, I’ll focus on the Individual 401(k) and why it might be right for you.
The Individual 401(k) plan is, in many cases, the better choice for self-employed people because of several key benefits that aren’t available with the SEP or Simple options.
First, for most individuals, the Individual 401(k) allows for a larger contribution to the retirement plan than a SEP or Simple IRA. For example, if you are a sole proprietor and make $100,000 per year, the employer contribution would be the same as a SEP IRA. However, because you can also make an employee contribution to an Individual 401(k), it would allow you to put in a much higher amount each year. The exact amount you would be able to contribute can be difficult to determine because it depends on how your business is structured, so it’s important to work with a knowledgeable CPA.
The Individual 401(k) can also work well for a couple where one person earns significantly more than the other. If one earns $20,000 and the other earns $200,000, and they want to save more money pre-tax, the Individual 401(k) will allow the lower-earning spouse to save almost all of his or her income. The SEP or Simple would allow for less savings in this situation.
Additionally, the Individual 401(k) could allow someone to either isolate after-tax IRA basis or to do a backdoor Roth IRA. This is a very powerful benefit that is often overlooked. For example, suppose you had $500,000 in an IRA account, and $50,000 of it was after-tax money (basis). While it would be nice to be able to convert just the $50,000 to a Roth, the IRS requires you to use a pro-rata rule which makes this less than ideal. Because the pro-rata rule also applies to the SEP and Simple IRAs, these retirement plans won’t give you the same flexibility. Luckily, there is an alternative.
Assuming you had self-employment income, you could instead open an Individual 401(k), which accepts only pre-tax dollars, and transfer the $450,000 into the individual 401(k), leaving only the $50,000 of basis left. Then, you could convert the $50,000 to a Roth without any tax consequences because it was only after-tax money. In addition, in each year going forward, you could make a non-deductible IRA contribution and then immediately convert it to a Roth, which is discussed here.
The planning can be difficult, and it requires a lot of moving parts to make sure it happens properly. There also are some very important reporting requirements that need to be followed closely. However, with the right CPA and advisor, I’ve found this to be a great solution for many of my self-employed clients.
For further information about SEP, Simple, and qualified plans, refer to this IRS publication.