When you think of a 401k plan, you likely think of a retirement plan offered by large corporations. But did you know as a self-employed person, you can have your own 401k plan? That’s right! A Solo 401k, also referred to as a Uni k, Solo k, one participant 401k, and an individual 401k can be a valuable wealth-building tool for the self-employed.
Self Employment is a rewarding endeavor. Nevertheless, managing finances and choosing a retirement plan can bring challenges. This blog post will break down the benefits and what you need to know about the Solo 401k to help you determine if it’s right for your business.
A Solo 401k is built for small business owners, entrepreneurs, side hustlers, freelancers, 1099 independent contractors, and those with self-employed earned income. The kicker is, you must have no full-time W2 employees excluding yourself, a spouse involved with the business, or business partners.
The high contributions limits are an advantage of the Solo 401k. For 2023, the total limit is $66,000. For those age 50 or older, an additional $7,500 is allowed for a total limit of $73,500.
This total limit is the combination of employee (you) and employer contributions (also you). You’re self-employed, and that means you’re the employee and employer! As the employee, you can make elective deferral contributions up to the lesser of 100% of compensation or $22,500 (+$7,500 if you are over age 50). Elective deferral means the amount you contribute as an employee.
As the employer, you can make profit share contributions up to $38,500. Profit share is a term for the company portion of the contribution.
To determine the total contribution limit, you’ll need to calculate the employee and employer contributions. Keep in mind; you don’t have to make both employee and employer contributions.
First, as the employee, the maximum contribution is 100% of compensation or net business profit up to $22,500 ($30,000 age 50+).
Next, the employer profit-sharing contribution will depend on your business setup.
For sole proprietors, partnerships, and single-member LLCs, profit share contributions are up to 20% of net business profit. To calculate net profit, take gross self-employment income, subtract business expenses, and subtract 1/2 of the self-employment tax.
For LLCs taxed as an S Corp, profit share contributions are up to 25% of W2 earnings. As an S Corp, you pay yourself a reasonable W2 wage which will be the factor in determining the company contribution.
Under previous law, Solo 401k’s needed to be established by Dec 31. Thanks to the SECURE Act, you can adopt a Solo 401k up the business tax return deadline, including extensions. Keep in mind the business tax deadline will depend on your business structure.
This new deadline is a big benefit for self-employed businesses. It allows for more time to determine if a solo 401k is worth establishing based on earnings and projected growth.
Depending on your business structure, the deadline to make solo 401k contributions (employee+employer) is the business tax deadline or personal tax return deadline, including extensions.
For sole proprietorships and LLCs taxed as a sole proprietorship, the deadline to make contributions is April 15 of the following year (or tax day for that year). This is the same deadline as personal tax returns and includes extensions.
For partnerships, LLCs taxed as partnerships, and S Corps, the deadline to make contributions is March 15 of the following year (or observed tax deadline), or extension.
For an LLC that elects S Corp taxation, you’ll want to elect or let your payroll company know to report contributions before Dec 31. This will ensure accuracy for tax reporting.
Here are some of the biggest benefits a Solo 401k has to offer.
Ability to invest more. As discussed, the contribution limits are much higher than other retirement plans such as traditional IRAs or even SEP IRAs. A SEP IRA is another popular choice for self-employed individuals but does not allow for employee contritions. Depending on income, this can limit the maximum SEP contribution allowed.
Hire your spouse for double the contributions! If your spouse earns compensation from your business, this can double the total contribution limit! Your spouse can make employee contributions, and the business can make profit-sharing contributions.
Pay less money to Uncle Sam. Pre-tax contributions reduce taxable income. In addition, the ability to make large contributions can reduce taxes in the current year.
Make Roth contributions. When setting up a Solo 401k, you can elect to allow for Roth contributions. The Roth option is a great way to diversify pre-tax investments and navigate tax brackets. Furthermore, it’s an alternative if you’re over the income phaseouts to make direct Roth IRA contributions.
Supercharged Roth. By setting up your Solo 401k to allow after-tax contributions, you can take advantage of the mega backdoor Roth strategy.
Diversify total investments. Your business is likely your largest investment. If you’re like most business owners, you reinvest a lot into your business. A Solo 401k can provide diversification from your business by selecting other types of investments.
Take loans from the plan. You can set up a Solo 401k to allow for loans. While loans are generally not recommended, they offer flexibility for a self-employed person. In addition, the sense of security that you access a loan in a pinch may keep you afloat during stressful times.
For high-performing self-employed businesses or side hustles, a solo 401k is a tool to help you reach financial freedom and get more out of your business.
It should be noted that if you aren’t ready to save more than the IRA limit of $6,500 (2023), you should start there. As always, it’s important to work with your tax and financial professional to help determine what type of retirement account is right for your business.
Maybe retirement isn’t on your radar, but contributions to a Solo 401k can provide optionality in the future. If you want to learn more about the Solo 401k and how we can help optimize your self-employed business, let chat!
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