by Matthew Bandyk
Even sole proprietors without employees can get in on 401(k)’s to plan retirement
Running a small business can be a life-consuming process, so sometimes small-business owners miss the forest for the trees. Maybe that’s why only about 16 percent of businesses with fewer than 50 employees in the United States have 401(k) plans. Small-business owners are so focused on developing their businesses that some do not realize that those assets can grow at a much faster rate for their retirement under the right plan. An October survey by ING DIRECT’s ShareBuilder401k, which designs 401(k) plans for small businesses, found that “not enough employees” was the top reason cited by small-business owners as to why they do not have a 401(k) plan. That’s despite the fact that even sole proprietorships with no other employees can have 401(k)’s.
Of course, that’s not to say that small-business owners can’t use other retirement plans like IRAs. But there are some unique benefits to 401(k)’s. In 2001, Congress changed the laws in a way that allowed self-employed people to put more money into their 401(k)’s. Today, a business owner under 50 with a 401(k) can invest up to $46,000 a year into the account, with up to $15,500 ($20,500 if over 50) coming from his or her own income, and then up to 25 percent of the business’s profits under the “profit sharing” provision. Regardless of the size of the profits, the total amount cannot exceed $46,000 (or $51,000 if you’re over 50), but that can make a huge difference. That $46,000 “can drop you a tax bracket,” says Stuart Robertson, general manager of Sharebuilder401k. “That is a great tax shelter for these folks.”
But if, like many small-business owners, you’re not very familiar with 401(k)’s, what do you need to know before you get your own plan started?
Know the difference if you have any employees. If you’re in business all by yourself, you’re blessed with a simpler 401(k). First, if you have no employees and less than $250,000 in assets in your 401(k), you don’t have to fill out compliance paperwork. Congress upped this limit from $100,000 “to make it easy for small-business owners not to get hung up on the IRS,” says Eric Wikstrom of Integrated Wealth Strategies LLC. Having employees also means the proprietor must pay a higher administrative burden for the plan. That’s because 401(k)’s are regulated so that they can’t be “top-heavy”—the benefits of the plan cannot be too weighted in
favor of the company’s top brass.
Carefully consider the array of investment options. Speaking of those administrative costs, if you use a financial institution, broker, or consultant to design your 401(k) plan, be careful about what they may be charging you. Some offer a “closed” menu of funds or other investments for you to put your money. Not only does that limit your options, but sometimes the mutual fund is paying the third party for the favored treatment. That means as a shareholder in that fund, you’re footing that bill, which means less money for retirement. Look for brokers who are “open” and do not have such restrictions on what funds are available.
Make sure a third party is experienced. If you’re using a someone else to set up your 401(k), make sure they know what they’re doing. They may not be particularly focused on 401(k)’s, so ask just how many they have set up before. If it’s just a few, I wouldn’t want to deal with them,” says Richard Meigs, president of 401khelpcenter.com.
Understand the Roth account. You can put all, or none, of your $15,500 (or $20,500 if you’re over 50) into a Roth 401(k). The difference between the regular 401(k) and the Roth account is that the traditional account holds money that is tax-deferred; it comes from your pretax income, and is taxed only when the money is distributed upon retirement. The Roth account is tax-free—the money comes from your after-tax income, and is not taxed again. The fact that tax rates are historically quite low today has made the Roth account much more attractive, because the expectation is that taxes will be higher in the future, says Meigs. But that doesn’t mean you have to put everything in the Roth. “If you think taxes are going to increase, or if you think you’re going to be in a higher tax bracket, I would put some in your Roth and some in your traditional, as a hedge,” explains Robertson.
Ask yourself how much control you want. For some entrepreneurs, the traditional 401(k) may be too limiting. “There are lots of financial institutions that will let you set up [a 401(k)], but you have to invest in just the vanilla options—mutual funds, stocks, bonds,” says Wikstrom. “In my opinion, they don’t offer true self-direction.” Some people choose to pursue a “selfdirected” 401(k), which lets you invest your money in almost anything you choose, such as real estate. That’s one you set up yourself, which can make things difficult for a novice investor but offers you more freedom.