A solo 401k is a retirement plan for self-employed individuals and their spouses. This type of 401k plan is sometimes called an individual 401k or a self-employed 401k.
E-Commerce businesses are usually excellent candidates for these plans, as many don’t employ full-time workers. Physicians can be great candidates as well, as some have side jobs as consultants.
How does a solo 401k work?
Contributions to a solo 401k can be made in three ways: employee deferrals, pre-tax employer contributions, and after-tax contributions. The funds in the solo 401k grow tax-deferred and, depending on the contribution type, are distributed taxable or tax-free when you retire.
All limits mentioned are for 2023, and all assume the participant is under age 50 unless noted otherwise.
As an employee of your business, you can contribute up to $22,500. This can be a pre-tax deferral or a Roth contribution. You can’t contribute more than you earn in your business. If you have another W-2 job outside your business, you can’t count that income to determine your deferral.
This limit applies across all plans if you have a 401k at that job. You don’t get to contribute $22,500 to each plan. However, you can split contributions up to that limit across those plans. This can make sense if you have a 401k match at your other job but prefer the investment options in your solo plan. For example, if you earn $100,000 at your day job, and that plan offers a 3% match, you’d contribute $3,000 to the day job plan and put $19,500 into your solo 401k.
These are also known as profit-sharing contributions. Sole Proprietors and single-member LLCs can contribute 20% of profit, while corporations can contribute up to 25% of W-2 earnings. If you have enough income, you can contribute an additional $43,500 over your employee deferral for a total of $66,000 overall. Employer contributions are always pre-tax.
Unlike employee deferrals, employer contributions are not limited by other 401k plans, so there’s no need to worry about contributions from other employers unless those contributions are made to a 403b plan. This would affect many physicians at hospitals, so they need to be aware of it.
Voluntary After-Tax Contributions
These come into play if you want to put more into the plan than your employer contributions will allow. The limits for after-tax contributions are the lesser of $66,000 or your income minus employee deferrals minus employer contributions.
For example, an S-Corp owner with a W-2 income of $70,000 could make the following contributions, assuming he isn’t contributing to another 401k:
$22,500 as pre-tax employee deferral
$17,500 as a pre-tax employer contribution
$26,000 as an after-tax contribution
Another reason to consider after-tax contributions is the option to convert these contributions to Roth immediately. The $26,000 above could be converted with no adverse tax consequences in what is commonly called a Mega Backdoor Roth conversion.
The business owner above would be taking all the deductions he could through the deferral and employer contribution and sheltering the after-tax contribution from future taxes!
Flexibility of Contributions
Let’s take that same business owner but assume he has the goal of maximizing Roth contributions instead. It would look like this:
$22,500 as a Roth employee deferral
$0 as a pre-tax employer contribution
$43,500 as an after-tax contribution
The after-tax would then be converted to Roth.
Let’s change it up one more time. Let’s say the same business owner had a day job and already contributed the max to the 401k there. He could contribute:
$0 as an employee deferral
$17,500 as a pre-tax employer contribution
$48,500 as an after-tax contribution
Again, the after-tax would be converted to Roth.
The contribution strategy could be changed year to year to give you control for proactive retirement and tax planning.
The same strategies can be utilized for single-member LLCs or sole proprietors, but the calculations to arrive at the compensation number would be slightly different to account for one-half of self-employment tax.
How is a solo 401k different than an IRA?
Let’s look at similarities first. You have options for Roth contributions or pre-tax with either, and both are meant to help fund retirement while providing tax advantages during your working years.
Higher Funding Limits for Solo 401k
The funding limit for IRAs is $6,500. People fifty or over can contribute an additional $1,000.
As we’ve discussed, contribution limits for solo 401k are much higher for high earners, up to $66,000.
Easier and Larger Roth Conversions
High earners cannot contribute directly to a Roth IRA, while Roth solo 401k has no income limitations. Yes, a backdoor Roth IRA contribution is possible, but you might run into the pro-rata rule with an IRA.
We won’t get into it in detail here, but the pro-rata rule can prevent you from making tax-free Roth conversions. A standard solution for this would be to roll over your IRAs into a…you guessed it…solo 401k!
Since 401k dollars aren’t subject to the pro-rata rule, a solo 401k provides a solution and potentially provides a significant advantage with Mega Backdoor conversions, as we discussed above.
Access to Loans Can Encourage Contributions
IRAs do not allow for loans, while a solo 401k can be set up to enable them. This has become more important recently, as the Great Resignation has led more people away from working for companies. Many are starting businesses independently, and not all business owners have confidence in their cash flow from year to year.
Nobody wants to need a loan from their retirement plan. However, the option to access up to $50,000 or 50% of the account value (whichever is less) through a loan can provide enough peace of mind to begin making contributions instead of delaying retirement contributions.
Required Minimum Distributions
Roth IRAs aren’t subject to RMDs, while 401ks are.
Restrictions on Withdrawals
Contributions to Roth IRAs can be distributed at any time without penalty.
Roth 401k can only be distributed if you reach age 59 ½, terminate employment, or suffer a disability or death.
What are the advantages compared to a SEP?
A SEP is a type of IRA, so most of the same limitations (no loans, pro-rata rule) apply. An exception is that SEP IRAs and solo 401s share the same overall contribution limit of $66,000.
One issue with a SEP is that you’ll be limited on what you can contribute unless your income is high. For example, our $70,000 example from earlier would only be able to contribute $17,500 or 25% of W-2 income. We’ve already seen a 401k would allow for a $66,000 contribution.
Is a solo 401k harder to administer?
Only a little. You’ll need to establish the plan by December 31 of the tax year you want to make your first contributions, so advance planning is required. You can pay an administrator to set up the plan and handle filings for you. Your contributions can wait until the following year. If your business is a corporation, you’ll need to include the employee deferral amount on the W-2.
Is a solo 401k right for you? Please contact us with your questions.