Solo 401(k) Retirement Plans Offer Flexibility and Higher Contribution Limits for the Self-Employed
If your self-employed clients are like the ones I know, saving for retirement might be way down at the bottom of their priorities. In the early years, the cash coming in gets divvied up between growing their business, paying themselves and making quarterly tax payments. There might not be much left for long-term savings. A traditional or Roth IRA can be a good start, but as a small business grows, those options don’t allow for much in the way of tax savings or deferral.
A solo 401(k) plan can be a terrific and flexible option. These are just like any other 401(k) plan, but are limited to just the business owner and perhaps a spouse. Let’s take a look at how these work.
Two layers of contributions accelerate retirement saving. Like an employer-sponsored 401(k) plan, contributions come from two sources: deferrals from the employee and contributions from the employer. These dual sources mirror the two hats that solo entrepreneurs wear as employees and business owners. For sole proprietors, the base for calculating contribution limits is net income. The base for corporations is the W-2 wages paid to the owner.
Employee portion. As an employee, for 2018, a solo professional can defer up to 100 percent of their contribution base, to a maximum of $18,500. Those over age 50 can make an extra $6,000 on catch-up contribution. These contributions must be made by year-end. The employee portion can also be designated as a Roth 401(k) contribution, which means it won’t be deductible now, but like a normal Roth IRA, distributions can be tax-free.
Employer portion. Putting on their employer hat, your solo professional clients can also make profit sharing contributions of up to 25 percent of the contribution base. For sole proprietors, the calculation is more complex: the maximum contribution is 25 percent of net self-employment income, less one-half of self-employment tax and the contribution itself. The math works out to 20 percent of net self-employment earnings.
No Roth option is available for the employer portion, but it is tax deductible. Total employer and employee contributions are limited to $55,000 for 2018, plus $6,000 of catch-up contributions for those over 50.
While the plan itself must be set up by year-end, the employer piece can be made up to the date that the tax return is filed, including extensions.
Administration is pretty simple. Until the plan has over $250,000 in assets, no annual filing is required. Above that threshold, a Form 5500-sf is needed, but many plan providers help out with that.
Advantages over a SEP plan. As I wrote about here, SEP plans are great for small businesses and solo professionals. However, a solo 401(k) offers several advantages over a SEP plan:
- Borrowing.Up to $50,000 or half of plan assets – whichever is smaller – can be borrowed from a solo 401(k) without penalties or interest. SEP plans don’t allow this.
- Roth option.The employee portion can be set up as a Roth account, which isn’t currently allowed with a SEP plan.
- Catch-up contributions.Solo 401(k) plans allow an extra $6,000 employee deferral for those over 50, so the total contribution is $61,000 versus $55,000 for a SEP plan.
Contributions can be higher for a solo 401(k). If net self-employment income is under $275,000, allowable contributions to a solo 401(k) plan are higher than for a SEP plan. Let’s take a look at how this works.
Jasmine has self-employment income of $100,000. She can make an employee contribution of up to $18,500. Her business can then make a profit by sharing contribution of 20 percent of her net income, or $20,000, for a total of $38,500. If she’s over 50, she gets an extra employee contribution of $6,000, which boosts her allowable contribution to $44,500.
In contrast, if Jasmine sets up a SEP plan for her business, her contribution will be limited to 20 percent of her self-employment income, or $20,000.
If your clients have other jobs that also have 401(k) plans, they need to be aware that the $18,500 limit for employee deferrals is by person, not by job. This means total deferrals from all jobs can’t exceed $18,500.
The flexibility and higher contribution limits make solo 401(k) plans another great retirement option for solo professionals. But, the real secret is to encourage your clients to start saving for retirement now!