“The individual 401(k) plan provides an interesting and viable alternative for those self-employed individuals seeking to create their own nest egg without stringent contribution rules.” – Bloomberg Wealth Manager
Creating and executing a long term financial plan involves making numerous assumptions about the future. There are many unknowns, including investment returns, future tax rates, earnings, medical expenses, etc. Simply put, most key components of a financial plan can be reasonably forecasted but are ultimately outside of our control. One variable that we can exercise some control over, however, is how much we save into tax-deferred accounts along the way.
Along these lines there are a variety of different account and retirement plan options available to us as we try to put money away for retirement. For business owners in particular it can be a struggle determining which of the many potential options are the right fit. Historically many self-employed individuals have defaulted to the SEP IRA which allows for annual contributions of up to 25% of income, subject to an annual cap. But another option that we are huge fans of is the Solo 401k (aka “Individual 401k” or “Solo(k)”). Under the right circumstances a Solo 401k plan can offer a self-employed individual or couple a significant amount of tax-deferred savings capacity in a simple and flexible structure.
Who is eligible?
Solo 401k are referred to as “owner only” plans, and as such have strict eligibility requirements that must be met before contributions can be made. First of all, there must be some amount of self-employment income generated, meaning the plan is only available to you if you own a business or operate as an independent contractor. That said, it’s important to note that this requirement can be met even if you also have a “day job” and participate in a 401k plan at work. Secondly, while the plan is available to you and all your partners in the business, the business cannot have any full time employees (>1,000 hrs per year) other than owner spouses. While there is a bit more nuance than what I’m presenting here, in a basic sense as long as you meet these two requirements you should be eligible for a Solo 401k.
Is it hard to set up and maintain?
No! The paperwork requirement for setting up a Solo 401k is very simple, and once open the account functions just like a normal brokerage account. Depending on the custodian, there shouldn’t be any additional fees or expenses associated with it, either. Finally, a Solo 401k is not subject to all of the complex ERISA regulations that traditional 401ks fall under, although once the plan has over $250,000 in assets the owners must file a Form 5500-SF on an annual basis.
How much can I contribute?
This is where the Solo 401k really begins to shine vs a SEP IRA. Just like with a normal 401k, contributions come from two different sources. The first is called “salary deferral” and can be as much as 100% of your income up to a cap of $18,000 a year (or $24,000 if you’re over 50 years old). On top of the salary deferral the business can then make a “profit sharing” contribution of up to 25% of your wages (or 20% of your self-employment income if you don’t pay yourself W2 wages). The combined salary deferral and profit sharing contributions cannot exceed $54,000 a year, or $60,000 a year if you’re over 50 years old.
Depending on income levels, and assuming the business is producing enough in free cash flow to fund the contributions, the Solo 401k may provide significantly more savings capacity than a SEP IRA plan which is limited to just 25% of wages and doesn’t allow for catch up contributions. Let’s look at an example.
Example: HouleHouse, Inc.
Let’s assume that David (age 49) and Mandy Houle (age 50) own a small family business together called HouleHouse, Inc. As President and CEO, Mandy works an average of 50-60 hours a week and draws a salary of $144,000. David, who has a separate day job, also works for HouleHouse on nights and weekends and draws a salary of $30,000. They also have one employee, but since she only works 5-10 hours a week she doesn’t disqualify David and Mandy from a Solo 401k plan. Finally, let’s assume the business drops a healthy amount of profit to the bottom line.
Under a SEP IRA plan both David and Mandy would be able to contribute no more than 25% of their salaries, or $36,000 for Mandy and $7,500 for David, thus reducing their taxable income in the current year by $43,500. Assuming a marginal joint income tax bracket of 30%, maxing out SEP IRAs would knock $13,500 off their tax bill in the current year and put $43,500 into an investment account that would grow on a tax-deferred basis until retirement. Not bad.
However, with a Solo 401k plan David and Mandy could contribute far more. Mandy, for instance, would be able to contribute the annual max of $60,000 for someone 50+ years old. Her salary deferral and catch up contribution would take care of the first $24,000, and her profit sharing contribution (25% of wages, or $36,000) would then be exactly enough to reach the annual max of $60,000. David, who has not yet turned 50, could simultaneously make his maximum $18,000 salary deferral and then still receive the $7,500 profit sharing contribution on top, for a total of $25,500. In this scenario, David and Mandy have contributed $60,000 + $25,500 = $85,500 into their tax sheltered retirement accounts, worth $25,650 in tax savings in the current year.
If the circumstances are right, the Solo 401k can be a powerful retirement savings tool for our small business owner clients. Compared to the commonly used SEP IRA it offers far more savings capacity without any additional expense or complexity. Maximizing the amount of money deferred into retirement accounts reduces tax drag, allows for more tax-deferred growth and is one of the few components of a long term financial plan that we know we can control.
Author David Houle, CFA is a founding member of Season Investments. He serves as the firm's Chief Compliance Officer as well as sitting on the investment committee overseeing the management of client assets. David spent nearly ten years in various roles primarily managing individual client assets prior to co-founding Season Investments. David graduated with a degree in Finance from Colorado University in Colorado Springs in 2003 and earned the Chartered Financial Analyst (CFA) designation in 2006. David and his wife Mandy have three children and spend most of their free time with friends and family.
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