If you’re self-employed, you have several retirement plan options available to you as an individual or small business owner. The best retirement plan for the self-employed, though, is probably the Solo 401(k).
Also called an individual 401(k), it has similar advantages to the traditional, employer-sponsored 401(k) plans available to large companies. However, it brings with it more benefits because you’re self-employed.
How a Solo 401(k) Plan Works
A Solo 401(k) plan is essentially a 401(k) for a self-employed individual. But there are several features of the plan that distinguish it from the larger, employer-based 401(k) plans. These include:
- Since you are the business owner, you act as both employer and employee on the plan.
- A Solo 401(k) plan is just for the owner of the business and the owner’s spouse; it is not available for employees of the business.
- The amount you can contribute to a Solo 401(k) are generally more generous than they will be for an employee participant in typical large company 401(k) plans.
- You can set up a Solo 401(k) even if you are an independent contractor or a freelancer.
Solo 401k Contribution Limits
As an employee of the business, contribution limits to a solo 401(k) plan are exactly the same as they are for a traditional 401(k) plan. You can contribute up to 100% of your salary or up to the contribution limit, whichever is greater. The current contribution limit for 2017 is $18,000 of your salary, or up to $24,000 if you’re age 50 or older.
It’s here that being the employer comes in handy.But since you are also the employer in the solo plan, you can also contribute as much as 25% of your net income to the plan as a profit-sharing contribution. (See IRS examples of the
As an employer, you can also contribute as much as 25% of your net income to the plan as a profit-sharing contribution. (See IRS examples of the employer matching contribution — it varies by business entity.)
Solo 401k Contribution Deadline
One other important point about the solo 401(k) plan is that you must make your contributions to the plan no later than the end of the calendar year. That means that you must make your contribution no later than December 31 in order for the contribution to be deductible for the tax year in question.
This is unlike contributions to IRA plans, which allow you to make deductions up until the filing deadline for the preceding tax year.
One of the biggest advantages of a Solo 401(k) is that you can essentially set it up similar to a self-directed IRA. That means that you are free to choose your investment trustee. You can also select a discount investment broker. This will provide you with an opportunity for unlimited investments and very low fees.
This is unlike many traditional 401(k) plans, which often limit your investment options to a few mutual funds and charge high plan fees.
Very Generous Contributions
As I noted above, with the Solo 401(k) you can make both employee and employer contributions. So, let’s say you’re self-employed as a sole proprietor and report your income and expenses on Schedule C of your income tax return. If your net income from the business is $100,000, you can contribute $18,000 as an employee. But then you can also contribute 25% of the net profit as the employer.
This means that your total contribution could reach $43,000!
That’s an enormous retirement contribution based on a $100,000 income. If you are in the 25% federal tax bracket, for example, a $43,000 contribution could result in a tax savings of $10,750 (although it’s important to consult a tax expert to be sure).
This is much more generous than other types of self-employed retirement plans. For example, let’s take the contribution scenario above. In it, you are contributing 43% of your income to your retirement plan using the Solo 401(k).
Under a SEP IRA, your contribution would be limited to 20% of the same income, or $20,000. (The SEP IRA provides for a deduction equal to 25% of your net income, after the deduction for the contribution is removed from your income... That means that the net contribution to a SEP IRA is effectively limited to 20% of your income.)
Under a SIMPLE IRA, your contribution limit is even lower. The maximum contribution that you can make as an employee is $12,500. (This bumps up to $15,500 if you are age 50 or older.) SIMPLE IRAs also provide for an employer match. As the employer in the business, you can provide either a 3% matching contribution, or a 2% non-elective contribution (up to $5,000). That means that your total contribution to the plan is limited to a total maximum of $20,500 per year.
And, of course, a traditional IRA or a Roth IRA limits your annual contribution to $5,500, or $6,500 if you are 50 or older.
The maximum contribution to any and all tax-sheltered retirement plans, including the Solo 401(k) plan, is $54,000 for 2017. However, with a Solo 401(k) plan, you can reach that maximum much more quickly than you can with other self-employed retirement plans.
There is one important limitation pertaining to S corporations: distributions paid from an S corporation are considered dividends, and are therefore not considered earned income. For this reason, you cannot make contributions to a Solo 401(k) plan that include your distributions from the S Corp.
You Can Add a Solo Roth 401(k) to the Mix
Just as with a traditional 401(k), you can allocate part of the plan to a Solo Roth 401(k) plan. That will enable you to allocate up to $5,500 of your employee contribution to the Roth portion. If you are age 50 or older, up to $6,500 can go toward the Roth portion. The remainder of your allowed contribution will go into the regular portion of your Solo 401(k) plan.
The employer matching portion can only go into the regular part of your Solo 401(k), and not the Roth portion.
You Can Include Your Spouse
An owner cannot add employees to a Solo 401(k) plan. He or she can, however, add a spouse. Your spouse can make contributions based on his or her earnings from the business.
For example, let’s say that you have an S corporation. You take a salary of $50,000 per year, and your spouse takes an equal amount. You can each make a contribution of up to $18,000 on your respective salaries. As an employer, you can then match up to 25% of the same amount.
Converting the Solo 401(k) to a Traditional 401(k)
Many businesses start out as one-person afairs. The owner starts out working for himself and only adds employees as the business grows.
A Solo 401(k) plan really shines when you hire employees. Why? Because you can convert these plans to a traditional 401(k) plan as soon as you begin adding employees.
When you start adding staff, you can easily convert your Solo 401(k) to a traditional plan. As you do, you can enable your employees to participate in the plan. That’s a big advantage because offering a 401(k) plan — particularly as a small business — is an attractive advantage for drawing potential talent. Many employees prefer to work in a business that offers a retirement plan. With the Solo 401(k), you will already have a plan in place when that day comes.
As with all things related to retirement plans, be sure to consult a tax expert before making any decisions.
If you’re self-employed, do you use the Solo 401(k)? How would it change the way you save for retirement?