If you are self-employed, it's hard to feel like a real business. There are no corporate mugs, no paid vacation days, and no fancy 401(k) retirement plans. Oh wait, there is a fancy 401(k) plan for the self-employed. It's called an individual 401(k) or a solo 401(k), and if you work for yourself without employees, an individual 401(k) plan can be a real boon to your retirement. Here's how an individual 401(k) plan works in 2013.
Solo 401(k) Contribution Limits 2013
Like a traditional 401(k) plan, a solo 401(k) is a tax-deferred investment account. You can contribute a certain amount per year before taxes. In 2013, you can contribute up to $17,500 to a solo 401(k) plan. That's an increase from the 2012 limit of $17,000. You can contribute an extra $5,500 if you are age 50 or older, bringing your total limit to $23,000 for 2013. It's known as a catch-up contribution, and it's designed to help those people nearing retirement, well, catch up.
Limits on a solo 401(k) plan really jump if you give yourself an employer match. When you work at a company with a traditional 401(k), your employer can match your contributions. If you are self-employed with solo a 401(k), you can match your own contributions, up to between 20% and 25% of salary. Just as long as your total contributions do not exceed $51,000 in 2013. Or $56,500 with a catch-up contribution.
How a Solo 401(k) Works
If you have had a traditional 401(k), then you know how a solo 401(k) works. Contributions go in pre-tax, so you can take it off the top of your taxable income. The investments made in the 401(k) grow tax-deferred until retirement. Retirement in this case can begin at age 59 1/2 but no later than age 70 1/2. Take the money out before then and you'll pay taxes and you'll likely pay a penalty charge as well.
Or you can do a Roth solo 401(k). It's like a Roth 401(k), where the contributions you make go in after tax. There's no additional tax deduction, but the investments in a Roth generally grow without ever being taxed again. It's kind of the opposite of a traditional 401(k). With a traditional 401(k), you defer taxes now and pay them in retirement (the idea is that your income will be lower then). With a Roth, you pay taxes now so you don't have to pay them in the future. But you can't match Roth solo 401(k) contributions. The limit for Roth solo 401(k)s is $17,500 in 2013 (up from $17,000 in 2012). You can also add a $5,500 catch-up contribution in 2013.
Solo 401(k)s vs. Other Self-Employed Options
When you consider the matching potential, the contribution limits on solo 401(k)s can't be beat. Plus, you can also loan yourself money from your solo 401(k), as you might through an employer's 401(k) plan. But you must pay it back, with interest, within a period of five years.
One of the biggest differences with a solo 401(k) compared to other self-employed retirement plan options is when you can open one. With an IRA, a SEP IRA or a SIMPLE IRA, you have until tax time of the following year to open and contribute for a given tax year. So if you want to open a SIMPLE IRA in 2013, you have until April 15, 2014 (or October, if you file an extension) to set up an account and make your contribution. With a solo 401(k), you must set up the account by the end of the year in which you want the tax treatment. But you have until you file income taxes for that year to fund your solo 401(k).
The other difference is price. A solo 401(k) may not be as cost-efficient as other self-employed retirement plans. Learn the differences before deciding which plan is right for you.
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