If you are a solo business owner or part of an owner-only partnership and have excess income that you would like to put toward retirement, a solo 401(k) could be a great option for you. Its biggest benefit over other defined contribution retirement plans is the contribution limit. This type of plan allows you to make contributions as both an employee and an employer:
Employee Contributions
For 2019, you can put up to $19,000 as an ‘employee’ (plus an extra $6,000 “catch up contribution” if you are 50 or older for a total of $25,000). These contributions can be either pre-tax contributions or Roth.
Employer Contributions
As an employer, you can contribute up to 25% of net earnings from self employment (minus your employee contributions and 1/2 of your self employment tax).
Annual Maximum Contributions
The maximum amount of combined employer and employee contributions for 2019 is $56,000 (or $62,000 if you are 50 or older because of the catch up contributions.).
If you hit the $19,000 employee contribution limit, have fully funded the employer contributions up to that maximum, and still haven’t hit the $56,000 annual limit, you can make elective after-tax contributions as an employee into the plan until you hit the total annual max. These after-tax contributions can be rolled into a Roth IRA each year to grow potentially tax free. This technique has cleverly been coined as the “mega backdoor Roth”.
Compared to a SEP IRA:
SEP IRA’s work much the same way as the solo 401(k) except it only allows employer contributions as described above, not employee contributions. Also, it doesn’t allow any Roth contributions (all employer contributions must be made on a pre-tax basis). SEP IRA’s have the same annual contribution limit of $56,000 but you have to make at least $280,000 in net self employment income in order to fully fund this type of account.
When to go with a SEP and when to go with a Solo 401(k):
If your income is high enough to fully fund a SEP IRA to the maximum limit (if your net self employment income is $280,000 or higher), you may be better off with a SEP IRA. Since you would be in a relatively high income tax bracket, deferring taxes today may not be a bad idea if you believe you could be in a lower tax bracket in retirement. Also, employer contributions are not subject to FICA taxes so you may be able to save money that way as well.
On the other hand, if your income is below that $280,000 level and you have extra income that you would like to put toward retirement or if you have a pile of money somewhere that you have already paid taxes on and would like to put toward retirement, the solo 401(k) may be for you.
You should always speak with a tax advisor and financial advisor before making any decisions regarding your retirement plan or savings strategy. I invite you to give me a call with any questions or to see which type of retirement plan may be a good fit for you.