Self-employed individuals mostly have fewer options when looking for a retirement plan. Their choices are mostly limited to IRAs like SEP, SIMPLE, Roth etc or the Individual 401(k) plan. However most of these plans (except Roth) are made of tax deferred contributions where the money is taxed on making a withdrawal. Roth IRAs provide employee to invest after-tax dollars in the account where the investments and earnings from these grow tax-free and are tax-free on making a qualified withdrawal as well. However(,) contributions to Roth IRA are limited to $5,000 a year if the employee is below the age of 50 and $6,000 if the employee is above the age of 50. Individual 401(k) plans have higher contribution limits; however, the contributions made to these plans are tax-deferred.
The individual Roth 401(k) plan (also known as solo Roth 401(k) plan) for the self-employed provides individuals with the combined benefits of a Roth IRA and a traditional 401(k) plan. Individuals can make after-tax contributions to their Roth 401(k) account where the funds and returns from the investments made from these funds, grow tax free. Also, the funds are not taxed upon withdrawal. The plans provide greater advantage for individuals who want to contribute more to their Roth IRAs but are unable to contribute more due to the smaller contribution limits.
Anyone can opt for a Roth Individual 401(k) and make contributions to the plan regardless of their income bracket. However, one cannot make profit sharing contributions to Roth individual 401(k) as such contributions are pre-tax in nature. Contribution limits for individual Roth 401(k) are same as that of individual 401(k) account. For the year 2010, one can contribute fully up to $16,500 if they are below the age of 50 and $22,000 if they are above the age of 50. These contributions are calculated as being in conjunction to other individual 401(k) accounts. This means that the limit applies cumulatively to both accounts. If one contributes $10,000 to individual Roth 401(k), then they can contribute only $6,500 to individual 401(k) and vice versa (if the individual is below the age of 50). There is one exception though; individuals whose income exceeds $167,000, when filing jointly with their spouse and $105,000 when filing individually cannot contribute completely just to a Roth 401(k) account. Such individuals should work out the details with their plan providers.
It should be noted that the contributions made to this account are irrevocable; funds once put in this account cannot be transferred to an individual 401(k) account. And since the contributions are after-tax, they are subject federal as well as state (and local if applicable) taxes.
Unlike individual 401(k) accounts, with an individual Roth 401(k), one is not needed to take required minimum distributions when they reach the age of 70 ½. Qualified withdrawals can be made from the account when the individual reaches the age of 59 ½ provided the account has been opened for at least 5 years. And as specified, these withdrawals will not incur any income tax. Also, upon retirement, the funds from individual Roth 401(k) account can be rolled over into a Roth IRA.
There are more benefits the individual Roth 401(k) plan can offer a self employed individual, however due to the required intensive administrative work, individuals have not been so keen on taking up these plans.