Solo 401(k) plan

If you are a self-employed individual or a business owner with no employees other than a spouse, you may qualify to establish an Individual 401k plan. You can qualify if your business is organized as a sole proprietorship, a partnership, or a corporation (including both subchapter S and C corporations). The Individual 401k plan was enacted by the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA). As a qualified plan, salary deferrals and matching payments are made with pre-tax earnings, and invested funds are tax-deferred until they are withdrawn. Beginning in 2006, Individual 401k plans were permitted to offer designated Roth accounts which could accept designated Roth contributions. Designated Roth contributions are made with after-tax contributions and withdrawals are generally tax free. As with all qualified plans withdrawals prior to age 59 1/2 (age 55 if you are terminated) are subject to a 10% penalty tax, and required minimum distributions must begin at age 70 1/2 for retired individuals. Currently a growing number of investment firms are offering Individual 401k plans to self-employed individuals.

Contribution Limits
An Individual 401k contribution consists of two parts, a salary deferral contribution and a profit sharing contribution (the company match). In 2009 the maximum allowable salary deferral contribution is $16,500 (not to exceed 100% of pay and no more than $245,000 of pay can be taken into account). If one is age 50 or older one can make a maximum $5,500 catch up contribution. Depending on how the business is organized, 20% or 25% of business earnings can be used for matching payments. In 2009 the combined maximum contribution limit is $49,000 or $54,500 if age 50 or older. Both salary deferrals and profit sharing distributions are discretionary, so contribution levels can be adjusted to the fluctuations of business income.

Individual 401k Contribution Calculation - for a S or C corporation or a LLC taxed as a corporation


 * Salary Deferral Contribution: In 2009, 100% of W-2 earnings up to the maximum of $16,500 or $22,000 if age 50 or older can be contributed to an Individual 401k.
 * Profit Sharing Contribution: A profit sharing contribution up to 25% of W-2 earnings can be contributed into an Individual 401k.

Individual 401k Contribution Calculation - for a sole proprietorship, partnership or a LLC taxed as a sole proprietorship
 * Salary Deferral Contribution: These business organizations do not provide a W-2 salary to the business owner. The salary deferral contribution is calculated by taking gross self employment income and then subtracting business expenses and then subtracting 1/2 of the self employment tax (this is termed net adjusted business profit). In 2009, 100% of net adjusted business profits income up to the maximum of $16,500 or $22,000 if age 50 or older can be contributed in salary deferrals into an Individual 401k.
 * Profit Sharing Contribution: A profit sharing contribution can be made up to 20% of net adjusted businesses profits. Net adjusted business profit is calculated by taking gross self employment income and then subtracting business expenses and then subtracting 1/2 of the self employment tax.

Loan Provisions
If the 401k plan document has a loan provision you can take a loan from the plan. Loans are limited up to 50% of the total 401k value up to a maximum of $50,000. Generally, Individual 401k loans have a 5 year maximum repayment term although loans used for the purchase of a primary residence may extend the loan repayment term up to 10-15 years. Loans must be repaid according to the terms of the loan amortization schedule which is provided when a loan is initiated. Generally, the loan interest rate charged is the Prime Rate or Prime plus 1% or 2%. The interest rate depends on the Individual 401k provider. Failure to pay the loan according to the loan terms can trigger taxes and early withdrawal penalties, since the IRS deems the unpaid loan as an early distribution from the retirement account.

Account Rollovers
An Individual 401k can accept rollovers and transfers from  traditional IRA, SEP, Qualified Plans or  Keoghs (Profit Sharing, Money Purchase Pension, Defined Benefit), 401k, 403-b and governmental 457 plans. SIMPLE IRAs are eligible for rollover after two year holding period is met. . A "traditional" Individual 401k plan can be rolled over to another "traditional" 401k plan and into Traditional IRA and rollover IRAs. An Individual Roth 401k plan can be rolled over to a Roth 401k plan or a Roth IRA.

Roth 401k Designated Accounts
If your plan allows designated Roth 401k salary deferrals you can make after tax contributions to the Individual 401k plan and take tax free distribution of contributions and qualified earnings upon withdrawal. Keep the following features of an Individual 401k Designated Roth IRA Account:
 * The Individual 401k Roth is not subject to the income limitations which apply to qualifying for a personal Roth IRA. The Individual 401k Roth makes it possible for high income self-employed individuals to contribute to a Roth IRA.
 * Unlike a personal Roth IRA, the Individual 401k Roth is subject to required minimum distributions at age 70 1/2. This rule can be mitigated by executing a trustee-to-trustee rollover to a personal Roth IRA upon retirement.
 * The Designated Roth 401k Account is forbidden from taking employer matching contributions. These contributions must be made to the pre-tax Individual 401k Account.
 * Ordering rules for Roth IRA distributions do not apply to Designated Roth 401k Accounts. Any distribution from the account is prorated according to the proportion of account basis and earnings in the account.
 * Withdrawals of earnings from a Designated Roth Account are subject to a penalty tax if they are taken prior to age 59 1/2 and if the account has not passed a five year holding period. The five year holding period does not carryover to a personal Roth IRA rollover. A rollover to a first time Roth IRA begins the holding period for the rollover. A rollover into an existing Roth IRA will receive the tenure of the existing IRA.

Individual 401k Advantages
Individuals who qualify for the Individual 401k have the following advantages:
 * The potential to shelter more earnings in the the Individual 401k than in a SEP or SIMPLE IRA.
 * The Individual 401k can allow for loan provisions.
 * The Individual 401k can provide a Designated Roth 401k account.

Individual 401k Caveats
Individuals considering an Individual 401k should keep in mind the following:
 * . Complexity and Costs: Although an Individual 401k plan is much simpler and less expensive than most standard 401k plans, careful consideration of costs and administrative burdens are critical factors to consider. The addition of plan options, such as loan provisions and designated Roth options may increase plan costs. Individuals will usually bear the following administrative tasks with the Individual 401k plan:
 * You must maintain accurate records, including beneficiary files for plan participants, and submit all required reports and notices to participants, the IRS (including 5500 reporting), and the Department of Labor.
 * You must determine when employees are entitled to benefits under the plan.
 * You must instruct the investment custodian regarding plan contributions and distributions.
 * Potential Individual 401k participants come from two basic groups: individual sole proprietors of businesses, and business employees who have outside consulting contracts or freelance earnings that are reported on IRS schedule C returns. These individuals may be contributing to their company's 401k plan. The annual contributory limits apply to all 401k contributions, so if you are maxing out your employer plan there is very little utility in opening an Individual 401k plan.
 * . If your business is likely to expand and require the addition of employees, the Individual 401k plan must become a full fledged standard 401k plan.

You may find this Individual 401k FAQ to be helpful.

Links

 * 401khelpcenter.com
 * Individual 401k Beacon Capital Management Advisors
 * Vanguard Individual 401k Plan
 * The Single-Participant 401(k), Juliette Fairley and Peter D. Fleming, Journal of Accountancy, March 2003.