Solo 401k: My Favorite Retirement Plan for the Self-Employed

The great thing about being self-employed (yes, independent contractors, that means you) is unlimited freedom, control, and upside potential. The trade-off is no pension, benefits, or company-sponsored retirement plans. Most self-employed individuals understand this and are motivated to sock money away so they can become financially independent one day. The question is: What’s the best savings vehicle? There are so many to choose from such as the IRA, SEP IRA, Simple IRA, 401k, personal pension, rental real estate, and individual savings/brokerage accounts. In my opinion, the Solo 401k is the single greatest savings vehicle for the self-employed.

The first thing to understand is the Solo 401k is an option only for business owners who do not have employees (note the word “solo” in Solo 401k). Your spouse or business partner (in a partnership) are the only exceptions to the no employee rule. You will need to use a different retirement plan if you have W-2 employees who are over 21 years old and work more than 1,000 hours a year (e.g., Traditional 401k, Simple IRA, or SEP IRA).

What’s so great about the Solo 401k?

The key factors in choosing a retirement plan are:

1) Ease of setup and administration.

2) The amount you can contribute (tax-deferred) each year for a given level of income.

The Solo 401k is hard to beat on those two factors. No other retirement plan offers such large tax-deductible contribution limits, ease of setup and maintenance, and the flexibility to contribute some years and not others.

How do you set up a Solo 401k (also known as a personal 401k, Uni-k, or Single K)?

A Solo 401k can be set up at most major custodians, such as TD Ameritrade, Schwab, or Fidelity. It is just like opening any other account and does not entail any additional costs to set up or administer. This is very different from a traditional 401k, where you have W-2 employees and need a Third-Party Administrator (TPA), which adds cost and complexity.

How much can you contribute each year?

The Solo 401k allows you to contribute $57,000 if you are under 50 or $63,500 if you are 50 or over in 2020. Other qualified retirement plans, such as the SEP IRA, have identical contribution limits, but the difference is you can “max out” your contribution to the Solo 401k at lower levels of income.

For example: A business owner, who is taxed as a corporation, could contribute the maximum $57,000 if they are under age 50, or $63,500 at age 50 or over to their Solo 401k if they paid themselves W-2 wages of $150,000. The same business owner, with the same level of income, could only contribute $37,500 to a SEP IRA, $21,000 to a Simple IRA, or $7,000 to a traditional or Roth IRA.

Now do you see why business owners love the Solo 401k?

How much do I need to earn to contribute the maximum?

There are two contribution limits: a salary-deferral contribution and a profit-sharing contribution. Both contributions are tax-deductible.

Salary-Deferral Contribution:

You can contribute up to 100% of your personal compensation for the salary-deferral portion, up to a maximum of $19,500 if you are under 50, or $26,000 if age 50 or older. Your compensation is considered to be your W-2 wages, assuming your business is taxed as a corporation. Compensation is based on “net-adjusted business profits” if your business is taxed as a sole proprietorship. Net-adjusted business profit is calculated by taking your business revenues, minus business expenses, and then also subtracting 50% of your self-employment taxes (FICA and Medicare).

Profit-Sharing Contribution:

A profit-sharing contribution can also be made. The profit-sharing contribution is limited to 25% of W-2 wages if your business is taxed as a corporation. For sole proprietorships, your profit-sharing contribution is limited to 20% of net-adjusted business profits (defined above).

Can I borrow from my Solo 401k?

Yes, you can. However, borrowing from your retirement plan should be a last resort, meaning after you have exhausted your emergency fund. Nevertheless, 401k loans are permitted by the IRS up to 50% of your account value, with a $50,000 maximum loan amount. This is another potential advantage over other retirement plans such as a SEP IRA, Keogh plan, or SIMPLE IRA, which do not allow loans.

Who is eligible to set up and participate in a Solo 401k?

A business owner, their spouse, and business partner (in a partnership) are eligible. The business entity can be a sole proprietor, LLC, Corporation (S or C), or partnership. Your business becomes ineligible for this type of plan once it has W-2 employees who are over age 21 and work 1,000 hours or more.

What types of investments can I use in my Solo 401k?

Most Solo 401k plans are brokerage accounts held at large, well-known custodians (Schwab, Fidelity, TD Ameritrade) where the participants invest in stocks, bonds, mutual funds, and REITs. Some specialty 401k custodians are designed for “self-directed” investors who want to hold physical real estate, gold, shares in their own company, and other alternative investments. These self-directed plans can get complex and be expensive to administer, and they are more likely to run into trouble with the IRS.

How do I learn more?

Contact us and a Surevest financial advisor will be happy to answer your questions.

Have a great week.