You don’t need to be a big company to have a 401(k).  In fact, you don’t even need any employees, aside from yourself…

If you’re in business for yourself, you’ve probably heard of a SEP IRA. You might even have one. It’s a pretty good deal in a lot of situations. The account is quick and easy to set up and you can fund it with “pre-tax dollars” up to about 25% (which, in reality, is closer to 20% for the self-employed) of net earnings, up to a limit of $58,000 (for 2021; $57,000 for 2020).1 A higher SEP contribution generally means lower taxable income and, in theory, a lower tax bill in the year the contribution is made, compared to if there were no contribution.
But what if you’re looking to contribute more than the approximate 20% of net income the SEP allows for?
That’s where the Solo 401(k) comes in. With the Solo 401(k), you get to contribute as both an employee and an employer (after all you are employing yourself, right?).
Here’s how the Solo 401(k) contributions break down:

  • Elective deferrals up to 100% of compensation (“earned income” in the case of a self-employed individual) up to the annual contribution limit:
    • $19,500 in 2020 and 2021, or $26,000 if age 50 or over; plus
  • Employer nonelective contributions up to:
    • 25% of compensation as defined by the plan, or
    • for self-employed individuals, see discussion below2

Based on these contribution guidelines, the Solo 401(k) may provide for the same percent contribution that the SEP IRA does on the employer side, BUT with the Solo 401(k) you also get the additional elective deferral on the employee side ($19,500 in 2020 and 2021, or $26,000 if age 50 or over) on top of that.
But wait, there’s more…
Add in the capability of Roth 401(k) contributions and loan provisions, and you now have a retirement plan for your one-person business that’s close to what you would see at a large company with many participants.
See below for key facts to know about the Solo 401(k)

Who is eligible?
Self-employed individuals and owner-only businesses. The owner’s spouse may participate in the plan.

Tax Benefits
Tax-deferred growth, tax-deductible contributions, and pre-tax deferral contributions.

Who contributes?
Funded by compensation deferrals and employer contributions.

Contribution Amounts
Individuals may contribute up to $19,500 for 2020 and for 2021. Employers may contribute up to 25% of compensation, up to a maximum of $57,000 in 2020 and $58,000 for 2021. Profit sharing contributions allowed up to 25% of compensation, up to the annual maximum of $57,000 for 2020 and $58,000 for 2021. Total contributions cannot exceed $57,000 in 2020 and $58,000 for 2021. Additional salary catch up of $6,500 for 2020 (if age 50 or older) and $6,500 for 2021.

Withdrawals
Cannot take withdrawals from the plan until a “trigger” event occurs, such as turning age 59½, disability or death. 10% early withdrawal penalty applies if you are under age 59½ and taking a distribution. Required minimum distributions start at age 72.

Investment Options
A wide range of mutual funds, stocks, bonds, ETFs.

Fees
There may be costs associated with setting up and maintaining the plan. Similar to other investment accounts there are fees associated with managing the investments.

Administrative Responsibilities
Annual IRS Form 5500 filing after plan assets exceed $250,000.

Deadlines
The deadline to open a new plan is generally December 31 (or fiscal year end) if compensation deferrals are intended.3

If you or someone you know may benefit from a Solo 401(k), please reach out and schedule a time to speak with us to go over the details. As always, it is important to consider how retirement plan contributions and strategy fit into your financial plan. While there are costs associated with setting up a Solo 401(k) due to the number of moving parts and administrative requirements, in a lot of cases it is worth the time and money to jump through the hoops required. Coordination between you, your tax advisor and a financial advisor is key.

 


Joe Daly
Wealth Advisor

 

 

Sources: 1 irs.gov; 2 https://www.irs.gov/retirement-plans/one-participant-401k-plans; 3 https://www.fidelity.com/retirement-ira/small-business/self-employed-401k/overview