On this road to financial freedom, I continue to find ways to alleviate our tax burden year after year. Since I own my own business, I have the ability to take advantage of something called an individual 401(k), or solo 401(k). This will eventually be a place we can dump large sums of tax deferred money into every year. What I really like about the individual 401(k) is that I can choose the funds in the plan, unlike the company you might work for, where someone else sets up the funds for you (which most of them might not be in you best financial interest).
Advantages of an individual 401(k)
The number one advantage of the solo 401(k) is that you can contribute as both an employee and and employer. Like all 401(k) plans, the contribution limit per year as an employee (2017) is $18,000. As an employer, I can match an additional 25% of the compensation up to $53,000 per year. Basically, every penny I make can go into this account and grow tax deferred. Since I am the only employee of my business, that limits me to $73,000 per year I could contribute.
The second advantage over your typical 401(k) plan is that you get to choose which funds are included in your plan. I like this idea better than contributing to Lou’s 401(k) plan only because I get to actually choose the funds in my plan, which, if you can guess, would all be Vanguard index funds.
The third advantage of an individual 401(k) is that you’re spouse could contribute to the plan as well (only if they earned income from your business). Individual 401(k)’s are strictly for sole proprietors, so in order for your spouse to contribute, you would have to show and prove that you paid them as an employee. The IRS does not play games when it comes to that, and the last thing you want is them looking closely at your situation. So be careful!
Does it make sense for you?
Question of the day. Only you can know if opening a solo 401(k) is right for you. Jeremy over at GoCurryCracker.com often gives me some really good advice (thanks Jeremy!!), and I once asked him in what order should we be contributing our money?
He told me this:
3. Traditional IRA (if deductible)
4. 401k to max
5. Brokerage account
Now, the closer you get to retirement age, this might change a bit. For us looking to retire at 45ish, we would need to build up enough money in our brokerage account to float us until we can start making withdrawals from our retirement accounts. We would also be supplementing our income with a really nice Roth conversion ladder.
Currently we sit in the 28% tax bracket. In retirement, I hope to have that close to 0%. So I can already see that we are going to be in a much lower tax bracket during retirement, which is why we will not be using a Roth IRA until later. This is why we need to maximize contributions now in our tax advantaged accounts like a 401(k) and IRA’s. Our savings in tax should be substantial, and I plan on showing just how much we saved by maxing out these accounts.
Roth vs. Traditional
The difference between a Roth and Traditional IRA is that money contributed to a Roth IRA is after-tax, meaning, you pay taxes on the money before it goes into the account. When you withdraw the funds in retirement, you will have already paid the taxes on that money. That’s nice if you can see that you will be in a higher tax bracket during retirement.
On the other hand, the contributions to a traditional IRA are pre-tax, meaning, you won’t pay taxes on the money now, however, you will be required to pay taxes on the money you withdraw during retirement. Both Roth and Traditional IRA’s have advantages, but you have to look into your own situation to make the decision that is best for you.
The same goes for Roth and Traditional 401(k)’s. Lou’s 401(k) is a traditional 401(k), and I will be opening up a traditional solo 401(k) next year.
All of the accounts listed above by Jeremy are accounts that require us to wait until retirement age to make withdrawals, except the brokerage account. Like I said, that will be the account we live off of in early retirement until we can start to make withdrawals from our tax advantaged accounts.
That last statement is almost true, until I came across a very helpful article from the Mad Fientist. Let me direct you to his site because he is a financial genius, and for that, I tip my hat to you sir!
What if I don’t have a small business?
You might have a small business and not even know it. Do you have a ton of NKOTB stuff lying around in your closet you could sell? Post it online and start selling. If you can prove income for 3 years, the IRS will consider that a business and not a hobby. Also, if you start a business with a profit motive, but suffer losses in your first years, you can still be considered a small business.
If you don’t have access to to 401(k) through an employer or through your small business individual 401(k), you can still open up an IRA and make contributions. Though the limits to your contributions are substantially lower, it’s better than no contributions at all.
One major advantage of having a small business is having access to an individual 401(k). Not only do you get to contribute to it as an employee, but also as an employer too. That’s a potential $73,000 per year for a sole proprietor, all pre-tax. If you have access to a 401(k) through your employer, then I highly suggest maxing out contributions when you are financially able to.