Self-employed individuals have multiple options to save for retirement and invest in a tax-efficient manner. One of those options, the Solo 401(k), can be particularly attractive to entrepreneurs running their own business, including those with both a 9-to-5 corporate employer and a “side-hustle” that earns them additional income.
Q2 2021 hedge fund letters, conferences and more
What Is A Solo 401(k)?
A Solo 401(k) plan, also commonly referred to as a solo-k or uni-k, is just like any other 401(k) plan, but is designed to cover a self-employed person with no employees other than his or her spouse. Because it covers only one employee, there is no burdensome nondiscrimination testing every year, which larger employer retirement plans must undergo. A Solo 401(k) also allows for contributions that are flexible in timing and amount, and the ability to make a larger total contribution with the same amount of self-employment income, compared to other options. This is because the plan participant can “wear two hats” and contribute as both the employee and employer. This makes for a powerful savings combination.
Who Does A Solo 401(k) Make Sense For?
A Solo 401(k) is well suited for those with self-employment income, stable cash flow, no employees (other than a spouse), and no plans to hire any in the foreseeable future. While having self-employment income and no employees are requirements, ensuring that there is sufficient cash flow to make contributions is also important.
The plan can also be a fit for those who are self-employed, but only on a part-time basis, and still earn W-2 income from a corporate employer. As a result, contributions can be made to both a Solo 401(k) and company 401(k) plan – as long as each employer is substantially unrelated. There are also contribution limits that apply.
How Much Can I Contribute To A Solo 401(k)?
There are two types of contributions that can be made:
- Employee salary deferrals of up to $19,500 in 2020 and 2021, as well as catch-up contributions of $6,500 for 2020 and 2021 if over age 50. Salary deferrals can be made on either a pre-tax or Roth basis, depending on the plan custodian.
- The salary deferral limit is per person and combined across all 401(k) plans an individual participates in.
- Employer “profit-sharing” contributions of 25% of self-employed earnings, or 20% of net adjusted self-employed earnings depending on entity type. Profit-sharing contributions are always made on a pre-tax basis. The total contribution limit (combination of salary deferrals and employer contributions) is of $57,000/$58,000 for 2020 and 2021, respectively, or $63,500/$64,500 if over age 50.
- The profit-sharing limit is determined on a per plan basis and is not combined between 401(k) plans.
It is important to consult your accountant to calculate the profit-sharing contribution if you plan to open and contribute to a Solo 401(k).
What Are The Deadlines For Opening And Making Contributions To A Solo 401(k)?
The deadline to both open and contribute to a Solo 401(k) is now the applicable tax-filing deadline of the taxpayer, including extensions, thanks to the SECURE Act passed in late 2019. This means that, depending on the business entity, a Solo 401(k) could be opened as late as September or October of the following year for prior year contributions, as is the case for SEP IRAs.
Importantly, if you open a Solo 401(k) in the following calendar year, but still plan to make prior year contributions, please consult your accountant. The SECURE Act extended the establishment deadline to open a Solo 401(k), but the IRS has not changed its guidance that the plan participant must make his/her salary deferral election by the last day of the calendar year. In other words, to make salary deferrals that first year, the plan needs to be in existence by December 31st! The good news is that the same rule does not apply to profit-sharing contributions, which can still be made the following calendar year.
Solo 401(k) vs. SEP IRA Contribution Example
Consider John Smith who, in addition to his regular corporate salary, earns $150,000 of consulting income. The consulting income is earned and paid to his business, John Smith LLC, which files as a sole proprietorship. John wants to save more dollars from this consulting income in a tax-advantaged way. The below compares the total contribution(s) possible with an SEP IRA vs. a Solo 401(k) plan:
| SEP IRA | |
| Compensation | $150,000 |
| Allowable % of Compensation | 20% |
| Maximum Profit-Sharing Contribution | $30,000 |
| Solo 401(k) | |
| Compensation | $150,000 |
| Allowable % of Compensation | 20% |
| Maximum Profit-Sharing Contribution | $30,000 |
| 2020 Salary Deferral Limit | $19,500 |
| Total Contribution | $49,500 |
What If I Hire Employees In The Future?
While a Solo 401(k) is best suited for employers who do not plan to hire employees, circumstances can change. Needing to hire employees, after all, is likely a good sign for a business! Several options exist, depending on the circumstances and needs of the business owner:
- The Solo 401(k) could be dissolved and “rolled over” into a Traditional or Roth IRA maintained by the business owner.
- It could be maintained and turned into a safe harbor 401(k) plan, which does require a minimum contribution amount to all employees but, in return, is exempt from annual nondiscrimination testing.
- If there is a significant age gap between the owner and employee(s) or if the owner wishes to set aside significantly more dollars for his/her retirement, options like “New Comparability” Profit-Sharing plans and/or “Defined Benefit” Pension plans exist also.
Can I Still Make 'Backdoor Roth IRA' Contributions?
Yes, a Solo 401(k) does not affect the ability to make backdoor Roth contributions. Employer sponsored retirement accounts, including a Solo 401(k), are not subject to aggregations in the eyes of the IRS for the purposes of the pro-rata rule. This is another advantage the plan has over an SEP IRA, which would be aggregated with other IRA accounts.
Are there any other considerations or administration requirements?
Yes, once the Solo 401(k) balance exceeds $250,000 at the end of the year, the IRS does require a Form 5500-EZ to be filed, similar to other 401(k) plans. Plans with balances below this amount are exempt.
About the Author
Kevin Brady, CFP, is a wealth advisor for Wealthspire Advisors in New York. Kevin is responsible for investment and financial planning analysis on behalf of clients and works to implement the resulting solutions. He also volunteers regularly with the IRS Volunteer Income Tax Assistance Program (VITA).
Wealthspire Advisors LLC is a registered investment adviser and subsidiary company of NFP Corp.
Certified Financial Planner Board of Standards, Inc. (CFP Board) owns the certification marks CFP®, Certified Financial Planner™, and CFP® (with plaque design) in the United States, which it authorizes use of by individuals who successfully complete CFP Board’s initial and ongoing certification requirements.
This information should not be construed as a recommendation, offer to sell, or solicitation of an offer to buy a particular security or investment strategy. The commentary provided is for informational purposes only and should not be relied upon for accounting, legal, or tax advice. While the information is deemed reliable, Wealthspire Advisors cannot guarantee its accuracy, completeness, or suitability for any purpose, and makes no warranties with regard to the results to be obtained from its use. © 2021 Wealthspire Advisors
