Self-Employed 401(k) Plans for Small Business Owners

How the Solo 401(k) / Self-Employed 401(k) Let You Save $50,000 or More Per Year

Small biz owners
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If you are one of the many Americans who own a small business and you're looking to start investing some of your earnings for retirement, you may have an advantage over other investors. You already have a mindset on business-like investing, and the fruits of your hard work can be put into a 401(k) especially geared toward small business owners, which lets you sock away a large amount of money each year.

Data consistently shows that 50% of American millionaires are business owners or self-employed in some capacity. Believe it or not, about 1 in 25 Americans is a millionaire, and many made their money by investing in their own company, often starting with nothing more than work ethic, their savings and a little help from family and friends.

In a world where a large portion of the population exists on less than $2 a day, that is a staggering success rate, even though the road is sometimes fraught with risk and danger, as you may hear if you ever talk to a business owner who has ad a business fail and been forced into bankruptcy.

High Contribution Limits

Limited liability companies and limited partnerships are two of the best ways to own your family business. However, another option that isn't discussed as much is a so-called Solo 401(k) or Self-Employed 401(k). With this type of account, unlike an ordinarily Roth 401(k), a business owner is both the employer and the employee. As a result, for the tax year 2019, business owners can contribute a staggering $56,000 to their 401(k) plan this year, wiping all of that off their income taxes!

It gets even better for business owners aged 50 and older because they're allowed to contribute "catch-up" funds for a total allowable investment of $62,000 in tax-sheltered funds each year.

The Details of Self-Employed 401(k) and Solo 401(k) Plans

A self-employed 401(k) or solo 401(k) only works if you are running a business by yourself or with your spouse, because the plan's rules dictate that all employees must be treated equally. If you were to hire someone else, you would be forced to offer them the same retirement plan, which might not be possible for a small business.

Either way, for some types of small business investments, these retirement plans can be very effective ways to set aside a large amount of money for your golden years, which you can then invest in stocks, bonds, and even real estate, especially for a married couple. A married couple could put away a hefty $98,000 per year in retirement savings, keeping that money protected from income taxes for decades.

An Investment Example

Say a husband and wife launch their own small business. By the time they are 35 years old, they pay themselves salaries totaling $500,000 per year before taxes from the company. This could be a business such as owning a mid-tier hotel franchise like a Hampton Inn or a Holiday Inn Express in a city of, say, 50,000 to 100,000 people. This doesn't yet get them on the radar of Wall Street and private equity fund radars, but they're within the so-called capitalist class.

The couple decides to set up a separate limited liability company to serve as the controlling investor in their small business. They are the only employees of the holding company, so they can put $98,000 a year into the 401(k) plan they've established at the parent-company level.

This would lower the couples' taxable income from %500,000 per year to $402,000. In addition, if they continued to work for 30 to 40 more years, all of that money would stay within the protected confines of the 401(k) account, earning dividends, interest, capital gains, and profits without having to pay any income taxes until the money was withdrawn. That means far more money working and compounding for them over a long period of time.

In fact, if the couple earned 8% on their money and continued to invest for 35 years until age 70, their combined 401(k) accounts would have more than $16,887,046 waiting to fund their retirement. When the couple withdraws money, they will pay income tax on the funds as they would on normal income.

No one outside of their family will likely ever know the names of these successful business owners, and they would live in an ordinary town and go completely unnoticed. Of course, many millionaire business owners never make anywhere near $500,000 per year. More likely, they make between $50,000 and $100,000, live within their means, and work hard to build the value of their business. Over time, their effort and savings stars to amount to something much greater. That is the nature of how investing works.

It's important to discuss your plans for a Solo 401(k) or Self Employed 401(k) plan with a qualified, respected accountant to make sure you don't violate any rules and that you are eligible. 

The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.