A good retirement savings option for the self-employed

Solo 401(k) plans are worth considering, due to their relatively high contribution limits, flexible investments and the ability to make after-tax Roth contributions.

Jacob Turcotte/Staff/File
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Whether you’re a new entrepreneur or an experienced business owner, self-employment brings its own set of challenges. One of the key challenges is saving for retirement. In a traditional job, you might have an entire human resources department looking after your retirement planning, but it’s a different ballgame when choosing a plan for yourself.

Among the available retirement options, Solo 401(k) plans are worth considering, due to their relatively high contribution limits, flexible investments and the ability to make after-tax Roth contributions.

Here are some reasons self-employed business owners should consider Solo 401(k) plans.

Higher limits

Because the self-employed professional wears the dual hat of the employer as well as the employee of the business, the contribution limits for a Solo 401(k) include both employee deferral (up to $18,000 annually, plus up to $6,000 in catch-up contributions for those over 50) and profit-sharing employer contributions (up to 25% of business income, depending upon the structure or type of business).

Combining these two, the Solo 401(k) limits for 2016 are $53,000, plus a $6,000 catch-up contribution for professionals 50 or older for a total of $59,000.

Under an alternative retirement savings plan for business owners, the Simplified Employee Pension (SEP) IRA, the contributions are limited to the lesser of 25% of the business income or $53,000 for 2016. The absence of elective salary deferrals or catch-up contributions restricts the overall contribution limits of a SEP-IRA when compared with a Solo 401(k) plan.

Here’s an example of how the Solo 401(k) leads to higher limits: Let’s say you had a business income of $100,000. With a Solo 401(k), you can make profit-sharing contributions of up to $25,000 along with employee-deferral contributions of $18,000, totaling $43,000. On the other hand, a SEP-IRA would allow you to make only a profit-sharing contribution of $25,000, hence limiting retirement savings.

Alternative investment options

A self-directed Solo 401(k) retirement plan offers alternative investments, including real estate, tax liens, tax deeds, mortgage notes, private equity, personal lending, precious metals, and the traditional stock or bond investments. These alternative investments help you diversify your portfolio while achieving competitive returns.

However, these investment vehicles and alternatives require an understanding of their core operating principles. Make sure to educate yourself before investing in them and, if necessary, get an expert opinion before investing.

Tax-deferred growth

Like all 401(k) plans, with a Solo 401(k) plan your retirement savings enjoy tax-deferred growth. Thanks to compound interest and the steady rise of equities over time, this should be a solid investment. Compound interest is one of the key factors that decide the size of your retirement fund. In the purported words of Albert Einstein, “The strongest force in the universe is compound interest.”

Roth savings option

You can opt for the Roth feature in your self-directed Solo 401(k) retirement plan, which allows you to diversify your tax strategy with after-tax investments that will not be taxed when you withdraw your funds in retirement.

And unlike the regular Roth IRA, there are no income phaseout limits in a Roth Solo 401(k) plan. Under a Roth IRA, a single filer over 50 making less than $117,000 can contribute up to $6,500 in 2016 ($5,500 under 50), but as the salary grows, eligible contributions decrease proportionately. If you make $132,000 or more, you will be ineligible to contribute to a Roth IRA in 2016. A Roth Solo 401(k) has no such phaseout.

If you want to benefit from the higher contribution limits of a Solo 401(k) plan in 2016, set up your retirement plan before Dec. 31, 2016. You can make actual contributions for 2016 until the regular tax-filing deadline, but an account has to be set up before the year’s end.

Dmitriy Fomichenko is president and founder of Sense Financial, a provider of self-directed retirement accounts. Learn more about Dmitriy on NerdWallet’s Ask an Advisor.

This article first appeared in NerdWallet

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