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401K for sole proprietors

© December 2005 Tony Lawrence

In the U.S., many employers offer 401K plans, but until recently, a sole proprietor could not set up their own tax deferred plan without a fair amount of complication and paperwork. That's changed, but there are still many resources on the web that will tell you that you can't have a 401K without incorporating. You can.

There are two basic plans: SEP and Solo 401K. These are very similar. SEP allows employees (who you have to cover, with some exceptions); the other does not (although there are certain types of employees allowed).

You may be able to contribute as much as $49,000 a year to this kind of plan. There are potential negatives: if you plan on hiring employees later, you will want to think carefully about this because you'll be required to expand this to include the employees. Of course anything like this should be discussed with your tax advisors before jumping in. However, if the plan fits, this is a simple way for the unincorporated sole proprietor to put aside tax deferred money. The intention of the law was probably to encourage profit sharing; as it doesn't exclude those of us with no employees, we benefit by being able to defer larger amounts than we could with IRA's.

In 2010 and 2011, you might be able to sock away as much as $54,500 (that's if you are over 50). It's limited to 25% of income (or 20% of net profit), though, so you'd have to be doing pretty well to reach that limit.

The other important thing is that you aren't locked into any particular amount - even if you have employees. You decide each year how much to contribute and that can be a nice round figure of zero if you've had a bad year.

There are no special reporting requirements - it's a tax deduction, but no complicated forms are required.

You can withdraw money at any time after 59 1/2 and before with a 10% penalty - but there are exceptions that waive that penalty. IRS rules do not permit loans with a SEP IRA.

Finally, yes, you (and your employees) can roll a SEP into some other plan later if circumstances change.

Like other retirement plans, at age 70 1/2 , you have to start withdrawing (and paying tax, of course).

Overall, these are great plans for a sole proprietor and small business, incorporated or not.

Be careful though: even though these plans have been legal for some time now, I have still found so-called financial advisors who either don't know about them or who have misunderstandings. Read up and ask tough questions.

Got something to add? Send me email.

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