The Solo 401(k): Great for Independent Physicians

Many physicians are classified as independent contractors. Perhaps you work part time and don’t receive any benefits. Or you’re an emergency medicine physician. Or maybe you do some locum tenens work.

One of the benefits of being an independent contractor is the type of retirement plan you set up. While many of you have SEP IRAs, you should strongly consider setting up a solo 401(k). The fact that it’s a 401(k) might discourage you, but I’m going to lay out the fundamentals of this great option and also discuss some advanced strategies.

T

he basics of a solo 401(k)

Like a hospital-sponsored profit-sharing or 401(k) plan, the solo 401(k) is a qualified retirement plan. This means it has to comply with the complex IRS rules and regulations to allow you to make contributions on a tax deferred basis.

While that seems daunting, if you open a “prototype” solo 401(k) at any of the major institutions (Fidelity, Vanguard, etc.) these plan documents are pre-packaged for you and have already been scrutinized and approved by the IRS — which means you don’t need to hire a retirement plan specialist to draft anything. Unlike a large employer, with a solo 401(k) only you and your spouse can be part of the plan.

Once you’ve got the plan document, the application to open a solo 401(k) consists of an adoption agreement (states that you’re adopting the plan), your personal information, the title of the plan (example: The Mazumdar Individual k Plan) and beneficiary designations. That’s basically it. While that’s more involved than opening a SEP IRA, it’s really not that bad.

You have to open the solo 401(k) by December 31 to contribute to it for that calendar year.

The solo 401(k) — like an employer sponsored profit sharing 401(k) plan — consists of two types of contributions. The first is the employee contribution (called an elective deferral) and the second is the employer contribution (called a discretionary contribution not a match). The maximum employee contribution for 2012 is $17,000, and the combined employee and employer contributions cannot exceed $50,000 for 2012. If you’re over age 50, you can make an additional $5,500 employee contribution (known as a catch up contribution). So if your income is high enough, you can contribute $55,500 total this year. That’s a pretty sweet deal.

At this point you might be wondering what the employer contribution refers to since it’s just you, but if you formed a corporation then the employer contribution comes from your corporation. Even if you’re a sole proprietor, you can still make an employer contribution.

Speaking of your classification as either a sole proprietor or a corporation, while there’s a maximum contribution limit, this also depends on your income, and that also depends on your classification as a sole proprietor or an employee of your corporation.

Let’s take an example to show you the difference.

Suppose you formed a corporation and you take a salary of $200,000 from it. You can contribute $17,000 as an employee contribution, but the rules limit your employer contribution to 25% of your salary — in this case $50,000. However the combined employer and employee contribution can’t exceed $50,000 total, so your employer contribution is limited to $33,000.

If you’re a sole proprietor (you don’t have a corporation), the rules are a bit different. You can still make the $17,000 employee contribution. Since you don’t have a salary, your employer contribution amount is based on the net income you make. This means that you take your gross physician income, subtract your business expenses, deduct half of your self-employment tax and then multiply that amount by 20%. So if your net income is $200,000 then your max employer contribution is $40,000. Again this is subject to the combined max of $50,000.

The deadlines for contributions are also different whether you’re a corporation or a sole proprietor. For a corporation your employee contribution deadline is generally January 15 of the following calendar year, and the employer contribution deadline is generally March 15 of the following calendar year. For a sole proprietor those deadlines are generally April 15.

So why is the solo 401(k) a good deal for you if you’ve got to comply with these rules? I’ll discuss some advanced strategies you can use with a solo 401(k) in my next article.