21 Feb The Solo 401(k) – a Small Business Retirement Plan
Most people have heard of 401(k) plans- a tax advantaged way for employees of larger companies to save for their retirement. As traditional employer-paid pension plans have declined in usage, 401(k)s have become one of the most popular retirement benefit choices. A Solo 401(k) (also known as an Individual 401k or a uni-401k) is very similar to a 401(k) that you would find at a larger company but is designed for self-employed business owners.
Solo 401(k)s carry all the advantages of qualified plans such as higher deferral amounts and robust creditor protection, but unlike a 401(k), solo 401(k)s are exempt from the nondiscrimination rules that apply to the 401(k)s used by larger companies. This is a huge advantage for small business owners because it is these administrative costs that makes 401(k)s more expensive to maintain than other types of retirement plans. The biggest caveat to using a solo 401(k) is that you cannot have any employees. There are only two exceptions to this rule: 1) your business is legally structured as a partnership and the only employees are the partners or 2) the only employee is a spouse of the owner.
Solo 401(k) contributions work in the same manner as a traditional 401(k). There are still employee contributions (known as elective deferrals) and employer contributions but in the case of the solo 401(k), the owner wears both hats. The maximum employee deferral amount is $19,000 in 2019. The total annual contribution (elective deferrals plus employer contributions) is limited to $56,000 per employee. If the employee is over age 50, an additional catch-up amount of $6000 is available bringing the maximum to a hefty $62,000 per year.
The solo 401(k) plan document can be tailored to meet the needs of each individual business. It’s important to work with an advisor you trust to ensure that they understand your goals and objectives of the plan including flexibility so that the plan is written in the best way to benefit you and your business.
Employee and Employer Contributions
The calculation of employee and employer contributions differs based on the type of business entity and how it is taxed. Because these calculations can be complicated, we recommend asking your CPA or tax professional for assistance in the calculation.
Pass-through Organizations Taxed as Sole Proprietors
Sole proprietorships, partnerships and LLCs are generally pass-through organizations. When the business is formed, the owner elects to either be taxed as a sole proprietor or as a corporation. For those who elect to be treated as sole proprietors, the contributions are based on “net earnings”. Net earnings are calculated by taking net profit from schedule C and subtracting the deduction for self-employment tax.
The employee contribution, or salary deferral, is based on net earnings. The owner can contribute 100% of these profits up to a maximum of $19,000 (2019) or $25,000 if age 50 or older.
An employer contribution or profit sharing can be made up to 20% of the net earnings. Keep in mind that total annual contributions cannot exceed $56,000 for 2019 ($62,000 for employees over age 50).
Taxed as a Corporation
The calculation of contributions for a business structured as an S-Corp, C-Corp or an LLC that is taxed as a corporation will be based on the W-2 wages that the owner takes. This simplifies the calculations but does allow for some strategic planning relative to how much the owner chooses to take in wages vs. dividend income.
The employee contribution is based on W-2 income. The owner can contribute 100% of W-2 earnings up to the maximum of $19,000 (2019) or $25,000 if age 50 or older.
The employer contribution can be made up to 25% of W-2 earnings.
This can be something to think about when deciding how much to pay yourself in salary. You may avoid FICA taxes by taking a lower salary and taking the rest of your income in distributions, but you are decreasing the amount you can contribute to your retirement account, which also saves you on taxes. It’s important to work with a CFP® and/or CPA when making these decisions. A good team will look at your goals for the plan, your personal and business finances and help you avoid pitfalls.
For example, if you receive a salary of $100,000 in W-2 income from your S-Corp you can contribute $19,000 as an employee contribution and up to $25,000 in employer contributions (25% of $100,000). This would give you a total annual contribution of $44,000. If your goal was to max out the annual contribution of $56,000 you would need to receive $148,000 in W-2 income.
Catch Up Contributions
Solo 401(k) plans allow for catch up contributions for those 50 or over. The catch-up contribution amount for 2019 is an additional $6,000. The catch-up contribution must come from the elective employee deferral portion of your annual contribution but does allow for a greater overall annual contribution.
Business owners that we have spoken to often steer away from 401(k) plans because of their complexity. Traditional 401(k) plans require a third-party administrator to perform annual testing to ensure there is no discrimination of lower level employees in favor of highly compensated or key employees. The good news is that non-discrimination testing is not required for a Solo 401(k). This makes Solo 401(k) plans cheaper to maintain and easier to administer than a traditional 401(k) while maintaining all the benefits of qualified plans.
Solo 401(k)s allow for a Roth option as well as the traditional tax deferred option. Roth contributions will not lower your current taxable income, but when you withdraw funds from the Roth portion of your 401(k) in retirement you will not pay any taxes on those distributions, nor on investment gains. Roth contributions are only allowed on employee salary deferrals, not employer contributions.
Required Minimum Distributions are required from Roth 401(k)s but can be avoided if rolled over to a Roth IRA at retirement. Roth contributions can be a great way to gain flexibility in retirement with both taxes and distributions. Whether or not they are right for you depends on a few different factors including current and projected marginal tax rates. Always partner with your CERTIFIED FINANCIAL PLANNER™ before deciding if Roth contributions or conversions make sense for you.
Is your business a side hustle?
For the budding entrepreneur who is working for an employer while starting their own business, the Solo 401(k) is a great option. Think of it as the side hustlers’ bonus retirement account. Many people view their side business income as “extra money” they don’t need for living expenses; why not shelter some of it from taxation now and help set yourself up for retirement? If the two businesses have no affiliated or legal relationship, then you can contribute to two retirement plans. The maximum contribution amount is $56,000 per business. Note that the employee contributions are aggregated across all plans (and capped at $19,000 or $25,000 if age 50+) but the employer contributions are separately calculated.
Having an additional solo 401(k) can help you reach the maximum annual contribution and save on taxes, just be careful not to over contribute. Another consideration is to make sure you are receiving the full match from your employer before contributing to the solo 401(k); you don’t want to lose “free money” from your employer for the sake of making contributions to your solo 401(k).
When would I want to use a solo 401(k)?
If you own a small business with no employees or where the only employees are either 1) your spouse or 2) a business partner and the business is structured as a partnership and you have good cash flow.
When would I not want to use a solo 401(k)?
If your business has employees who receive W2s (other than your spouse) or you don’t have enough cash flow in your business.
Can I use a solo 401(k) if my workers are all independent contractors (all workers receive a 1099, not a W2)?
Yes- if you don’t have any employees who receive W-2s, you can use a solo 401(k).
I am a contract worker receiving 1099. Can I use a solo 401(k)?
Do I need to work full-time in a self-employed capacity to be eligible for a solo 401(k)?
No! This is one of the things that makes the solo 401(k) so advantageous to those with side gigs.
What is a good source for more information?
The IRS has some good information available here: Solo 401(k) Information.