If you run your own business or are self-employed, you might be looking for ways to cut your tax burden.
One way to do that is contributing to pre-tax retirement plans.
You have quite a few options when it comes to retirement savings vehicles.
One type of retirement account that you should strongly consider is a solo 401(k).
This particular plan allows flexibility and gives you different ways to fund the account.
Learn how solo 401(k)s work and compare them to other retirement accounts that are most suitable for the self-employed and small business owners.
What Is a Solo 401(k)
A solo 401(k) is a type of retirement plan designed for business owners with no employees. It goes by many names, including solo-k, individual 401(k), uni-k and one-participant k.
What may surprise you:
A solo 401(k) isn’t a special type of retirement plan.
Instead, it’s simply a regular 401(k) plan. However, what makes it a solo 401(k) plan is it is only for business owners with no employees.
The only exception:
It can also be used for a business owner and their spouse.
These solo 401(k) plans have the same requirements as a regular 401(k) plan. Thankfully, they’re not too hard to manage since you have no employees to complicate the plan.
How Does a Solo 401(k) Work?
As a small business owner running a solo 401(k), you perform the role of both the employee and the employer.
Like 401(k)s at corporations, both the employee and the employer can make contributions to your solo 401(k).
Depending on your solo 401(k) provider, you may be able to decide whether your employee contributions are made pre-tax in a traditional 401(k) or after-tax in a Roth 401(k).
This gives you options depending on your income tax situation in the current year. It also opens up more possibilities for you when you withdraw the money in retirement.
Some providers only allow pre-tax 401(k) contributions.
If the Roth option is important to you, investigate this before opening a solo 401(k).
For the employer contributions, you (as an employer) must make traditional pre-tax 401(k) contributions.
Since a solo 401(k) is a regular 401(k) plan, they have the same rules.
First, your overall contributions are limited.
In total, contributions cannot exceed $56,000 in a year (2019).
For those that are age 50 or older the limit is $62,000.
As the employee
As an employee, you can contribute up to 100% of your compensation (or earned income for a self-employed individual) up to $19,000 each year.
If you’re age 50 or over, this limit increases to $25,000.
These contributions are called elective deferrals. Since they come out of your salary as an employee, you might call them salary deferrals, too.
If you have the ability to contribute to multiple 401(k) plans, you need to be careful with your contribution totals. This may happen if you run a side business outside of a traditional 9-5 job.
Your elective contributions cannot exceed the $19,000 limit across all plans.
Similarly, the total of employee and employer contributions across all plans cannot exceed $56,000. These limits are higher if you qualify for catch up contributions.
As the employer
As an employer, you can contribute up to 25% of compensation.
If you’re self-employed, things get more complex for this portion. Self-employed people should use the rate table or worksheets listed in Chapter 5 of IRS Publication 560 to calculate their contribution limits.
401(k) plans with multiple employee participants typically have to perform non-discrimination testing.
As a solo 401(k) with just yourself and your spouse, you don’t have to do this. This changes if your company decides to hire employees in the future.
If your solo 401(k) has more than $250,000 in assets, you normally have to file an annual report using Form 5500-SF. Solo 401(k) plans with less than $250,000 in assets may not have to file this annual report.
Withdrawals in retirement work like regular 401(k)s.
Traditional contributions withdrawn after 59 and ½ are penalty-free, but you’ll have to pay income tax on them.
Qualifying Roth contributions withdrawn after 59 and ½ are both tax and penalty-free.
Cost and Fees
The cost of a solo 401(k) plan will vary by provider.
Some providers, such as Vanguard, charge an annual fee each year based on the number of mutual funds you hold. That said, Vanguard will waive this fee if you hold over $50,000 in assets at Vanguard.
Other providers will charge you a set fee per trade you make within your solo 401(k). Depending on the investments you pick, you may have to pay investment management costs, as well.
Once your plan exceeds $250,000 in assets, you may want to have someone prepare your Form 5500-SF annual report.
That said, you could do it yourself if you read the instructions carefully and have the necessary information.
Where You Can Open a Solo 401(k)
Many brokerage firms allow you to open a solo 401(k) plan.
You can check with the broker that holds your current brokerage account or ask around to find one that best meets your needs.
When looking for a place to open your solo 401(k), pay special attention to what investment options you’ll have.
Additionally, carefully consider the fees that you’ll be charged to have an account and the fees you’ll pay on your investments or to make trades. Fees can easily eat up a large portion of your investment returns over decades.
Whatever you decide, opening a retirement account sooner rather than later can help you put more money away for retirement. The earlier you start investing, the more opportunity your money has to grow.
Compared to SEP IRA
SEP IRAs and solo 401(k)s are both retirement plans for small business owners or self-employed individuals, but they have a few key differences that you need to consider.
- SEP IRAs only allow company contributions. An employee cannot make contributions at all.
- Contributions are limited to a percentage of your compensation. Depending on your business structure, this may be 25% or 20%.
These first two facts combined can severely limit the amount you can contribute unless you’re a highly compensated individual.
Additionally, SEP IRAs cannot offer a Roth option. This means you can only contribute pre-tax to these accounts. Unfortunately, it also limits your tax planning options.
These aren’t the only differences. If you think a SEP IRA is a good idea for you, investigate them further.
Compared to a Traditional IRA
A regular IRA, either in the traditional IRA or Roth IRA form, is much easier to set up and maintain than a solo 401(k).
The worst part:
For the self-employed, a regular IRA has a much lower contribution limit.
You can currently only contribute up to $6,000 per tax year if you’re under age 50. Those age 50 or over can add a catch-up contribution of $1,000 for $7,000 in total contributions.
This is a huge difference when compared to the $56,000 limit for a solo 401(k).
If you don’t plan to invest enough to exceed the regular IRA limits, they’re a great choice.
However, if you want to shelter even more income from taxes either now or in the future, a solo 401(k) may provide that option.
Compared to SIMPLE IRA
If you run a small business with a handful of employees, a solo 401(k) won’t work.
Instead, you’d have a regular 401(k) with all of the reporting and testing requirements which could be a major headache.
Rather than opt for a regular 401(k), a SIMPLE IRA may be a solution.
SIMPLE IRAs allow employees to contribute up to $13,000 each year. This increases to $16,000 for those age 50 or older.
Employer contributions must be made in one of two ways.
The first is a 2% nonelective contribution that is made to each eligible employee’s account whether they contributed on their own or not.
The second is an employer match of the first 3% an employee elects to contribute on a dollar-for-dollar basis.
Unfortunately, any time you have a plan with multiple employees, it requires more work.
Before you open a SIMPLE IRA, make sure you understand all of the requirements. The above are just some of the highlights of a SIMPLE IRA.
Does It Make Sense to Use a Solo 401(k)?
Only youcan decide if it makes sense to use a solo 401(k) in your situation.
Solo 401(k)s give those with lower compensation the ability to make employee contributions of up to 100% of their compensation.
This advantage could help these people lower their taxable income either now or in the future.
A solo 401(k) may not be a good idea if you aren’t saving enough to exceed a traditional IRA or Roth IRA.
This type of retirement account takes more effort and headache to set up and maintain than the very common and easy to use regular IRAs.