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Editor's note: This article appears in Kiplinger's special issue Retirement Planning.
Setting out to work for yourself can be a liberating experience. You can set your own hours, pick your own dress code and run the business the way you want. And here’s one more advantage: You may be able to sock away more money in tax-deferred retirement accounts than you could if you worked for someone else.
Consider the savings power of the individual 401(k), also known as a solo 401(k) or independent 401(k). This powerful vehicle is available only to the smallest businesses—you as sole employee (and your spouse, if employed by the business). You may contribute up to $15,000 this year as an employee. Plus, your business can kick in another 20% of your self-employment income (which is total business income minus half of your self-employment tax)—or 25% of your compensation if your business is incorporated—for a combined maximum contribution of $44,000 in 2006. Not only will you put your retirement savings on a fast track, but your contributions reduce your taxable income dollar for dollar.
Those maximum contribution caps are the same as for a traditional workplace 401(k). But when you work for yourself, you don’t run up against plan restrictions imposed by your employer. Some employers, for example, may deposit extra cash in your account through a matching contribution or profit-sharing feature, but the amount may not measure up to the 401(k)’s full potential. And an employer may limit employee contributions to a percentage of your income, resulting in a maximum level that’s far below the $15,000 threshold.
Say, for example, your employer limited your contributions to only 10% of your salary and chipped in a 25-cent match for every dollar you contributed. If you made $100,000, you would be able to sock away only $12,500 per year ($10,000 of your own money and $2,500 of your employer’s). But if you make $100,000 working for yourself, you may stash up to $40,000. That’s $15,000 as the employee, plus $25,000—or 25% of $100,000—as the incorporated business.
The superior savings power isn’t lost on Jonathan Sargent, who runs his own motion design and animation business in Atlanta. From his first job out of college, Sargent contributed to company 401(k)s. “When I went out on my own,” he says, “I knew I had to keep doing this.” When he started his business in 1999, the solo 401(k) was not yet available. He opened a SEP IRA and contributed as much as he could, but “the limits were brutal.” A SEP, which stand for Simplified Employee Pension, currently allows you to kick in only 20% of your income, and you don’t get that sweet, $15,000 employee-contribution component. The limits were even lower back then, “but at the time the SEP was better than nothing.”
When the solo 401(k) debuted in 2002, Sargent jumped at the chance to sign up for a new plan called the Single(k) from Decimal (www.single-k.com), a financial-services provider. “Saving the most money possible is my A-number-one priority,” says Sargent, “and the Single(k) raised the roof by a long shot.”
