If you have income from self-employment, establishing and funding an Individual 401(k) (also known as a Solo 401(k)) may be one of the best ways to both cut your tax bill and rapidly build your retirement nest egg.  But the December 31 deadline to establish this plan can come up too quickly for some us amid other year-end obligations and festivities.  Not too worry, if you missed the deadline, you do have options.

First, what is a Solo 401(k) and is it better than a SEP-IRA?

A SEP-IRA:

• Can be established and funded until your tax-filing deadline, which is April 15^th for most people
• Allows you to contribute 25% of profits, with a 2016 contribution limit of $53,000

An Individual 401(k):

• Must be established by December 31 of the year you want to contribute (funding can come later)
• Allows you to contribute 25% of profits, with a 2016 contribution limit of $53,000.  This includes a $18,000 “salary deferral” contribution
• Includes an additional $6,000 “catch-up” contribution if you are over 50 for a total of $59,000

Because you can usually make a significantly larger contribution to an Individual 401(k) than to a SEP-IRA, theIndividual 401(k) is usually a superior choice for self-employed individuals with no employees. Higher contributions mean more tax savings and faster growth of your retirement account.

The relative advantage of an Individual 401(k) over a SEP-IRA is most stark for individuals at lower income levels. Let’s look at an example under both plans: 

• Someone earning $50,000 of income from self-employment could contribute $12,500 to a SEP.  
• This same person, however, would be able to contribute $30,500 to an Individual 401(k) – $12,500 plus $18,000 of salary deferral.  Thus, at lower levels of self-employment income, the Individual 401(k) offers much better tax-savings potential.

So if you missed the deadline, what should you do?

If you would be better off using an Individual 401(k) to build your retirement nest egg but missed the December 31 deadline to establish one, you can take two steps:

1. Establish a SEP-IRA before your 2016 tax filing deadline and make the maximum contribution for 2016.  
2. Then, for 2017, establish an Individual 401(k) and roll the assets from the SEP into the new 401(k).

Please contact us if you would like to us to offer our views on how, for your particular circumstances, you can best cut your tax bill while saving for retirement. 

If you earn over $100,000 in self-employment income, read more about what we consider the most powerful retirement plan, called a defined benefit plan.