When it comes to funding retirement, a vast array of choices face America's 19.5 million self-employed individuals. Yesterday's retirement savings primer from Foolish colleague Mary Dalrymple gave you a brief overview of all of these choices.
If you're after more specific information about some of these options, you've arrived at the right place. On Wednesday, we studied the SEP IRA, which stands for Simplified Employee Pension. Today, we're moving on to the Solo 401(k).
But before we do, here's a SEP refresher: The SEP is a profit-sharing plan that allows free agents like me to fund their retirement with business income. Up to 25% of your profits can be socked away and invested in just about anything, including top growth stocks like Sykes Enterprises (NASDAQ:SYKE) and ISTA Pharmaceuticals (NASDAQ:ISTA).
Solo 401(k)s -- regular and Roth
You can do the same with a Solo 401(k). So, what's the difference between the two? Unlike the SEP, the Solo 401(k) includes a salary deferral component that isn't indexed to business income, up to $15,000 for 2006 and $15,500 for 2007. Profit-sharing is then added to that base, up to a total deferral of $44,000 for 2006 and $45,000 for 2007.
That's pretty impressive, and it could save you a lot of money on taxes. But let's get back to that. First, I want to also introduce you to the new Solo Roth 401(k). Here's how Investopedia defines it:
"A new employer-sponsored investment savings account that is funded with after-tax money. After the investor reaches age 59.5, withdrawals of any money from the account (including investment gains) are tax-free. Unlike the Roth IRA, the Roth 401(k) has no income limitations for those investors who want to participate -- anyone, no matter what his/her income, is allowed to invest up to the contribution limit into the plan." [Emphasis mine.]
How awesome is that? Sure, you'll pay more in taxes now, but you'll be able to invest in anything -- including dynamic dividend payers like American Capital Strategies (NASDAQ:ACAS) and Collectors Universe (NASDAQ:CLCT) -- and then collect your gains tax-free. Even if you're only a modestly successful investor, that could add up to millions by retirement.
Big tax savings
But you may want to save on taxes now. If so, the Solo 401(k) is a pretty sweet deal. Assuming you run a business that produced $100,000 in net income in 2006, and you're the only employee, you'd be eligible to sock away up to $18,587. Mix in a $7,065 deduction for one-half of self-employment tax and the maximum $15,000 salary deferral, and your taxable income would fall from $92,935 to $59,348. Talk about a steal.
If there's a problem with the Solo 401(k), it's that it can be more restrictive than SEP IRAs. For example, Fidelity and Schwab, two brokers that offer the plans, don't usually allow for loans against Solo 401(k)s. And in some cases there are no hardship withdrawals, such as using funds for a down payment on a house. The lesson? Don't plan on using your Solo 401(k) as an emergency fund.
Still interested? Here's a list of discount brokers that offer the Solo 401(k):
And for more on the Roth 401(k), check out IRS Publication 4530 (downloads a PDF file).
You can learn more about these and other accounts in our Broker Center. Need more retirement advice? Consider our Rule Your Retirement newsletter. Editor Robert Brokamp is hosting an open house all week. Through March 12, you can check it out free of charge -- including stock and fund recommendations, interviews, and our online seminar, "How to Plan the Perfect Retirement." Getting started on the road to retirement security is just a click away.
Fool contributor Tim Beyers, who is ranked 1,515 out of more than 24,000 in our Motley Fool CAPS investor intelligence database, writes weekly about personal finance and investing basics. Have a Foolish money tip? Tell him.
Tim didn't own shares in any of the companies mentioned in this story at the time of publication. All of Tim's portfolio holdings can be found at his Fool profile. His thoughts on retirement, Foolishness, and investing in general may be found in his blog. American Capital Strategies is an Income Investor recommendation. The Motley Fool's disclosure policy sees you on a beach sipping pina coladas in a few years.
