From the moment we begin working, the importance of saving for our retirement is drilled into our heads. The benefit of doing so can’t be overstated and, perhaps, takes on even greater significance when we go into business for ourselves. In fact, when one is in business for themselves, finding ways to maximize the amount of retirement savings often becomes one of the primary goals of that business owner.
So, how can a self-employed individual achieve that goal?
By going Solo; opening a Solo 401(k), that is.
What is a Solo 401(k)?
A Solo or individual 401(k) plan is nothing more, really, than a combined profit-sharing plan and 401(k) plan implemented by a self-employed individual or small business owner with no full-time employees. Note that there is an exception where the full-time employee is the owner's spouse.
While the legislation permitting Solo 401(k) plans has been place for fifteen years, having been enacted in 2001, many small business owners are unaware of the benefits of such a plan. Prior to 2001 (and, to a large extent, continuing even today), self-employed individuals and small businesses adopting employer-sponsored retirement plans largely implemented either simplified employee pensions (SEPs) or savings incentive match plans for employees (SIMPLE) IRA plans. These plans generally offered benefits that were somewhat comparable to those offered by profit-sharing plans and 401(k) plans at the time, but without the associated administrative costs.
Since the 2001 legislative changes, though, 401(k) plans have become much more appealing to self-employed individuals and small business owners. In fact, when combined with a profit-sharing plan, 401(k) plans can allow for significant tax-deferred contributions.
Additional reading: The Potential Pitfalls of a Self-directed IRA
When can it be used?
Any private business is allowed to establish a 401(k) plan. However, only self-employed individuals or businesses (including partnerships) with no full time employees can adopt a Solo 401(k) plan as described here. As mentioned earlier, employing your spouse does not prevent you from adopting a Solo 401(k) plan. In addition, if you have only part-time employees who work fewer than 1,000 hours per year, you may also be able to open a Solo 401(k) plan since part-time employees can generally be excluded from participation in the plan.
However, if you have any (nonspouse) full-time employees age 21 or older or part-timers working more than 1,000 hours a year, you will generally be required to allow them to participate in your plan. In this case, you can still adopt a 401(k) plan, but it will not be a Solo 401(k) plan as discussed here.
Why can you adopt a Solo 401(k) plan even though you employ your spouse? The reason has to do with nondiscrimination testing. You, as the business owner, are considered a highly compensated participant. Because of special attribution rules, your spouse is also considered a highly compensated participant. Therefore, a plan that covers only you and your spouse includes only highly compensated participants and is, therefore, not subject to nondiscrimination testing. This significantly simplifies administration of the plan. If the plan were to include any non-highly-compensated employees, nondiscrimination rules would apply, thus eliminating the simplicity of the plan.
One more benefit? An employed spouse may be entitled to a fairly significant annual Solo 401(k) contribution as well.
FREE E-book: Year End Tax Planning Guide
How does it work?
As with any 401(k) plan, you, as an owner-employee, may defer up to $18,000 in compensation in 2016 (unchanged from 2015). If you are age 50 or older, you may also make an additional "catch-up" contribution of up to $6,000 in 2016 (also unchanged from 2015). These limits are adjusted for inflation each year.
You may also designate all or part of your elective deferrals as Roth 401(k) contributions. If you opt to do this, your contribution would grow tax-free, at the expense of no longer being currently tax deductible. Consult with your tax advisor as to the advisability of a Roth 401(k).
In addition to the deferral aspect of the plan, there is the profit-sharing piece. Under current law, the maximum deductible amount an employer may contribute to a profit-sharing plan is 25 percent of total eligible compensation under the plan. Significantly, compensation deferred as part of a 401(k) plan does not count toward the 25 percent limit. Therefore you, as an owner-employee, can defer the maximum permitted amount of compensation under the 401(k) plan and still contribute up to 25 percent of total compensation to the profit-sharing plan on your own behalf.
In calculating total eligible compensation under the plan, the maximum compensation that can be considered for any single individual is $265,000 in 2016 (unchanged from 2015).
If the business is unincorporated, Solo 401(k) plan compensation is based upon net earned income. To calculate this, self-employed individuals must deduct one-half of their self-employment tax as well as any plan contributions to determine their compensation base. Effectively, this means that an unincorporated business with one owner-employee can deduct contributions of up to 20 percent of the owner-employee's earnings after the deduction for one-half of the self-employment tax.
For example, Sally is a 40-year old sole owner of a small corporation, and she had annual pretax wages of $50,000 in 2016. Since she has no employees, she is the only participant in her business's 401(k) plan. Under current tax law, Sally's plan account can receive a tax-deductible business contribution of $12,500 (25 percent of $50,000), plus a 401(k) employee elective deferral contribution of $18,000 in 2016. This combination results in a total contribution of $30,500, well within Sally's 2016 annual additions limitation of $50,000 (the lesser of $53,000 or 100 percent of her pretax wages).
Let's assume the same facts as above, except that Sally is a sole proprietor instead of the sole owner of a corporation. In this case, her plan account can receive a total contribution of up to $27,293 for 2016--a $9,293 tax-deductible profit sharing contribution (20 percent of Sally's net earnings after the deduction for one-half of self-employment tax), plus a 401(k) elective deferral contribution of $18,000.
As mentioned above, the maximum amount that a participant can receive in the form of combined employee deferrals and employer contributions is limited to the lesser of one’s compensation and $53,000 (for 2016). This means that the total of one’s 401(k) deferral and profit-sharing contribution cannot exceed the lesser of $53,000 and one’s compensation for 2016.
In addition to the $53,000 contribution limit referenced above, individuals age 50 or older may also make "catch-up" 401(k) contributions of $6,000 in 2016. Therefore, the maximum allowable contribution for individuals 50 or older is $59,000 this year. Individuals eligible for catch-up contributions are still limited to the 100 percent of compensation limit for their total contributions.
As you can see, a qualifying self-employed individual or small business owner seeking to put aside the maximum amount of funds for retirement on a tax-deferred basis, really can't do much better than a Solo 401(k). In addition, because the business owner has the flexibility to determine how much to contribute each year (or whether to contribute at all), a Solo 401(k) becomes a very powerful retirement savings vehicle. A Solo 401(k) may also be particularly appealing to individuals who have full-time careers, but also have their own business "on the side". These individuals could potentially contribute a large portion, if not all, of the side business earnings into a Solo 401(k).
A word of caution; an individual who participates in an employer-sponsored retirement plan must be careful. Compensation deferrals and total amounts received under multiple plans must be coordinated. The deferral limit applies to all 401(k), 403(b) and Simple IRA plans in which an individual participates.
Additionally, like all 401(k) plans, Solo 401(k) plans may allow loans and may allow hardship withdrawals. Note that withdrawals made prior to age 59½ may be subject to a 10 percent federal penalty tax. You can also roll over funds to your individual 401(k) plan from a former employer's 401(k) plan as well as from other types of retirement arrangements, such as IRAs, SEP and Keogh plans, and governmental Section 457(b) plans.
Like a regular 401(k) plan, a Solo 401(k) plan must follow certain requirements under the Internal Revenue Code.
- Since you are generally the only participant in a Solo 401(k) plan, meeting these requirements isn't nearly as difficult as with plans that have multiple participants.
- Solo 401(k) providers will typically bundle the product with administrative support. However, there is still a cost associated with establishing a Solo 401(k), as well as a cost relating to the plan's ongoing administration, in particular, when it becomes necessary to file a Form 5500 on an annual basis.
- If contributions to a Solo 401(k) plan are desired for a particular tax year, the plan must be set up by the end of the year. For example, you would have to set up the plan by December 31, 2016 if you want to make deductible contributions for 2016. The deferral amount is withheld from the owner's salary, and must be deposited into the plan as soon as it's reasonably possible to do so, but no later than 15 days after the deferral amount is withheld from the paycheck. Practically speaking, a sole proprietor typically doesn't know the final deferral amount until their Form 1040 is completed.
- For this reason, many CPAs contend that the due date of the deferral is the extended due date of the taxpayer's Form 1040. The profit sharing amount is also due by the extended due date of the business or individual income tax return.
- Another issue to consider is whether a Solo 401(k) will meet your future needs. If your business grows and you hire a full-time employee who is not your spouse, that employee will generally need to be covered by your retirement plan. If that happens, you're no longer dealing with a Solo 401(k), but a full-blown qualified plan subject to all coverage and discrimination rules. At that point, it would be essential to meet with your advisors to determine if a new retirement plan would better suit your needs.
As you can see, there are many opportunities for self-employed individuals to boost their retirement savings and reduce their tax liability. To explore your options, contact me at [email protected] or 216-831-0733 for a no obligation consultation. Myself, along with our team of professionals, are ready to help.