Individual 401k Plan Benefits

The Individual 401k plan has several benefits for small business owners and the self employed.

• Higher Contribution Limits
• Tax Deductible Contributions
• Tax Deferred Growth
• Contribution Flexibility
• Access to Tax Free Loans
• Cost Effective Administration
• Retirement Plan Consolidation

Individual 401k Contribution Limits

Compared to other retirement plans you may be able to make greater contributions at identical income levels, therefore maximizing retirement contributions and valuable tax deductions.

In 2008, the Individual 401k contribution limit is $46,000 or $51,000 if age 50 or older. The annual Individual 401k contribution consists of 2 parts a salary deferral contribution and a profit sharing contribution. The total allowable contribution adds these 2 parts together to get to the maximum Individual 401k contribution limit.

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

• Salary Deferral Contribution
  In 2008, 100% of W-2 earnings up to the maximum of $15,500 or $20,500 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
  Although the term salary deferral is used, these businesses do not provide a W-2 salary to the business owner. For businesses of this type, the salary deferral contribution is based on net adjusted business profit. 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. In 2008, 100% of net adjusted business profits income up to the maximum of $15,500 or $20,500 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. You will want to ask your tax professional for assistance with this calculation.

Roth Individual 401k

Individual 401k salary deferral contributions can be made as Roth 401k (after tax) or Traditional 401k (pre-tax). The basic difference between a Roth 401k and a Traditional 401k is that the Roth 401k is funded with after-tax contributions while the Traditional 401k is funded with pre-tax contributions. In other words, with a Roth 401k you pay taxes today in return for a tax-free withdrawals in retirement. Traditional 401k contributions are tax deductible and are made pre-tax so you save taxes today, but withdrawals are taxed in retirement.

Learn more about a Roth Individual 401k.

Individual 401k Calculator

To determine the annual retirement contribution you could make based on your income use the Individual 401k calculator.

Tax Deductible Contributions

Individual 401k retirement plans may provide significant tax savings because in general, you can deduct 100% of contributions made into an individual 401k from your taxable income. Incorporated businesses can generally deduct the salary deferral contribution from W-2 earnings and the profit sharing contribution as a business expense. Unincorporated businesses such as sole proprietors can generally deduct contributions made to an individual 401k from personal income.

Tax Deferred Growth of Investment Earnings

Assets in an Individual 401k grow tax-deferred, meaning you won't pay taxes on the dividends and investment earnings until you withdraw the assets. Tax deferred earnings growth can have a powerful effect over time. Money can be withdrawn after age 59 1/2 without penalty. When money is withdrawn after age 59 1/2 income taxes will be paid only on the amount that is withdrawn and the remaining balance in the Individual 401k continues to go tax deferred. If you should withdraw money prior to age 59 1/2, you will pay income taxes and it's likely that you will incur an additional 10% IRS penalty for a premature withdrawal.

For some self employed investors, saving in a tax advantaged retirement plan such as an Individual 401k provides a significant benefit. Investors are able to make tax deductible contributions during their working years and are able to earn many years of tax deferred growth on the dividends and investment earnings. Once retired and potentially in a lower tax bracket, you can withdraw the money as needed from your Individual 401k.

Contribution Flexibility

Each year the funding of your individual 401k retirement plan is completely discretionary. You can increase or decrease your salary deferral and/or profit sharing contributions depending on the profitability of your business.

Individual 401k Loan - Access to Tax Free Loans

An Individual 401k loan is permitted at any time using the accumulated balance of the 401k as collateral for the loan. Individual loans are permitted up to 1/2 of the total balance of the 401k up to a maximum of $50,000. A loan from an Individual 401k is received tax free and penalty free. There are no penalties or taxes due provided loan payments are paid on time.

Generally, Individual 401k loans have a 5 year maximum repayment term. Individual 401k 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. Failure to repay the loan according to these terms may result in a loan default causing taxes as well as IRS penalties. Loans are not permitted with Traditional or Roth IRAs, SEP IRAs, or Keogh (Money Purchase/Profit Sharing Plans).

Loan payments are made monthly or quarterly. Loan payments of principal and interest are repaid back into your own Individual 401k. Because of this an Individual 401k loan may be a favorable option compared to other loans where interest is paid to the bank or lending institution.

The proceeds from an Individual 401k loan can be used for any purpose and there are no income or credit qualifications to receive the loan. The ease of an Individual 401k loan is attractive because start up businesses and self employed business owners often run into difficulties with qualifying for a self employed loan through banks and lending institutions.

Learn more about an Individual 401k loan.

Cost Effective Administration

Compared to traditional 401k's, the Individual 401k plan is easy, flexible and inexpensive to maintain because administration is minimal, and complex discrimination tests are not required. Fees vary depending on the level of administrative services provided by the Individual 401k administrator. Loans may have an additional administrative fee. If an Individual 401k is greater than $250,000 IRS form 5500 needs to be filed and the administrator may charge a fee for its completion or you could elect to complete the form yourself.

Retirement Plan Consolidation

An important feature of the Individual 401k plan is the opportunity to consolidate retirement assets into one account. This includes Traditional IRAs, SEP IRA Plans, 401k Plans, Money Purchase Plans, SIMPLE IRAs, Profit Sharing Plans, Defined Benefit Plans, 403b Plans and IRA Rollovers. Consolidating retirement accounts is particularly important if you would like to use the loan provision. Other advantages of rolling over and consolidating your retirement plans into your individual 401k are improved financial organization and ease of monitoring your retirement portfolio.

Individual 401k Eligibility

Learn more about who is eligible to establish an Individual 401k.

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Disclosures:

* The information on this page is for informational purposes only and does not constitute, and should not be construed as, professional, legal or tax advice. To determine your individual tax situation and specific needs, please consult a professional tax advisor.

* Information contained in these sections merely highlight some benefits. There are risks involved with all investments that could include tax penalties and risk/loss of principal.