Solo 401k's: The Secret Weapon of the Self Employed
Are you self employed? If so, you might be passing up a powerful opportunity to make “big time” savings for retirement while potentially dodging thousands and thousands of dollars in taxes in the process! With a solo 401(k), eligible participants can save up to $61,000 in 2022 ($67,500 if age 50+) towards retirement. What’s more, you can also save to a Roth Solo 401(k) which is a big opportunity for anyone whose income is too high to be able to contribute to a Roth IRA (or wants to be able to save more to a Roth plan than the $6,000 Roth IRA contribution limit allows). Even if you don’t plan to save anywhere near that limit for retirement this year, the solo 401(k) is one of the most powerful retirement plans out there. If you’re self employed, this is a retirement plan that you don’t want to ignore!
What is a Solo 401(k)?
A Solo 401(k) is a retirement plan for one person businesses who have no employees (i.e. freelancers, contractors, and other small businesses). It’s not a widely known option since one person businesses are a smaller portion of the population. What it is, however, is one of the most powerful retirement savings plans out there. Not having the help of an employer to save for retirement (setting up a plan for you, giving matching contributions, etc) makes retirement savings tougher. To help with this, the Solo 401(k) was created to help one person businesses by allowing them to save more for retirement than many of their “employee peers” typically can who have Traditional 401(k)’s and even their “self employed peers who have employees” can who use SEP IRA’s.
Do you qualify for a solo 401(k)?
To qualify you must:
Be a one person business with no “full time employees”
“Part time employees” (those who work 1000 hours or less per year) won’t disqualify you. Neither will hiring 1099 contractors.
A couple running a business together also qualifies as a “one person business”.
You must have “self employment income” (after expenses) from the business. How much you can save is limited to your net self employment income.
The Pros of a Solo 401(k)
Sky High Contribution Limit: You can save as both the “employee” and the “employer” in a solo 401(k) plan.
Employee Portion: You can save up to $20,500 for the 2022 tax year, or $27,000 if you are age 50 or older.
Employer Portion: You can save up to 25% of your net self employment income (20% if you are a sole proprietorship, partnership, or an LLC taxed as a sole proprietorship). This calculation can be a little tricky, speak with your accountant first if you intend to save the maximum amount.
Maximum “All In” Contribution: Cannot exceed $61,000/year (or $67,500/year if age 50 or older) for the 2022 tax year.
Save More Than a Traditional 401(k):
Your “employee” peers typically may be able to save $20,500 to their 401(k) plus let’s say a 3% employer match. You with a solo 401(k) can not only save $20,500 like they can, but your “employer contribution” can be way higher than what your employee peers are limited to!
Save More Than a SEP IRA:
SEP IRA’s allow you to save up to 20% of your net self employment income (for sole proprietorship, partnership, or LLC taxed as a sole proprietorship) or 25% if you are a corporation. This is the same as the “employer” portion of the Solo 401(k). However, the Solo 401(k) let’s you also save the employee portion as well! (another $20,500/year for 2022 above what a SEP IRA may allow).
Take Advantage of a Solo Roth 401(k):
Certain Solo 401(k)’s also allow you to save the up to $20,500/year (the “employee portion”) as a Roth contribution, or $27,000 if you are age 50 or older. This is a great option for those who want to save more than $6,000/year to a Roth IRA (or for those who can’t contribute to a Roth IRA since their incomes are too high)!
Mega Backdoor Roth Contributions:
Certain Solo 401(k)’s also allow you to take advantage of the Mega Backdoor Roth Contribution strategy which could allow you to potentially save up to an additional $40,500/year to a Solo Roth 401(k). This strategy involves multiple steps, professional oversight is recommended.
Note: Roth isn’t always the best approach. For folks in higher tax brackets, a traditional solo 401(k) can be a great option to defer paying tax until your “lower tax bracket” retirement years.
Typically more investment options than the Traditional 401(k) plans your “employee” counterparts have access to.
You can take loans against a solo 401(k). It should be a last resort measure but this feature does provide some flexibility.
The Cons of a Solo 401(k)
You lose eligibility once you have an employee who loses part time status (>1,000 hours worked in a year).
The IRS requires contributions to a Solo 401(k) to be “recurring and substantial.” In general, this means you must make contributions somewhat regularly for the account to remain active.
Minimal administration costs may apply to setup or maintain the solo 401(k) but there are low cost/free options out there.
Is a Solo 401(k) right for you?
In general, the benefits of a solo 401(k) vastly outweigh the negatives. The primary challenge with the solo 401(k) is eligibility (not just today but in the longer run if you ever hire a full time employee who isn’t your spouse). Regardless, nothing is stopping you from taking advantage of a solo 401(k) plan today if you are eligible. The Solo 401(k) is a powerful savings vehicle for any eligible solo business owner who wants to save a lot for retirement and potentially save thousands of dollars in taxes in the process!
Other Retirement Plan Options for the Self Employed
SEP IRA: An easy, flexible option for small businesses with employees. The “all in” contribution limits are the same as the Solo 401(k) at $61,000 for 2022. However, your contribution cannot exceed 25% of your net self employment income. which may not be adequate for your goals. Simply put, the solo 401(k) allows you to contribute a higher percentage of your income to the plan (for most it’s way higher). Further, no catch-up contribution is allowed for those age 50 and older and worst of all, no Roth option is available either.
Keogh Plans: Open to sole proprietors, partnerships, and limited liability companies and is often used as a profit-sharing vehicle for professional practices such as doctors' and lawyers' groups. It has the same “all in” contribution limits as the SEP IRA and the Solo 401(k) but poses a greater administrative burden. There is no Roth option.
Simple IRA: Designed for businesses with 100 or fewer employees. It is open to sole proprietors but has a lower contribution limit than the Solo 401(k) or the SEP IRA. The max employee contribution is $14,000 in 2022 plus 3% of salary as an employer contribution. There is no Roth option.
IRA’s (Roth IRA and/or Traditional IRA): Contributions to these are limited to $6,000/year, $7,000 if age 50 or older (way lower than the others). Contributions to a Roth IRA get phased out for incomes above $144,000 (single) or $214,000 (married filing jointly).
Lack the time, desire, or knowledge to do this on your own? Help is available.
If making financial decisions leaves you feeling confused, stressed, or wanting to avoid them entirely, consider working with a CFP® professional. Time is money. What is the cost of inaction as it relates to getting your finances in order? A good financial planner helps you take action now (not “later”), by simplifying this burdensome process, and helping you avoid costly mistakes along the way. A good CFP® will:
Explain financial concepts in simple English (nobody wants to hear a bunch of financial jargon).
Educate and empower you every step of the way so you don’t feel lost.
Help you gain mental clarity around where you’re at financially and where you want to go.
Create a financial roadmap of prudent ways to get you there with clear prioritized action steps you can start acting on right away.
Understand the tradeoffs of different decisions (buy that home, take this job, plan around kids, travel more, etc).
Feel a sigh of relief knowing a professional is looking over your finances… you don’t have to be in this alone.
San Diego Financial Advisor | Fee-only Fiduciary
Disclosure:
None of the information provided is intended as investment, tax, accounting or legal advice, as an offer or solicitation of an offer to buy or sell, or as an endorsement, of any company, security, fund, or other securities or non-securities offering. The information should not be relied upon for purposes of transacting securities or other investments. Your use of the information is at your sole risk. The content is provided ‘as is’ and without warranties, either expressed or implied. Wonder Wealth, LLC does not promise or guarantee any income or particular result from your use of the information contained herein.