Most Americans in the workforce save for retirement by contributing to their employer-sponsored plans. But how do self-employed individuals save for retirement?
Today, we are going to talk about Solo 401(k)’s. To understand how a Solo 401(k) works, let’s recap the basics of a traditional, employer-sponsored 401(k) plan. A 401(k) allows an employee and their employer to save for the employee’s retirement in a tax-efficient way. From the employee perspective, individuals can defer taxes while they are working, allow the money to grow. Taxes will be paid when they need to fund their retirement. In 2021, the IRS allows employees to contribute up to $19,500 annually in salary deferral. Anyone over the age of 50 can contribute an additional $6,500 due to the “catch-up” provision, increasing their salary deferral to $26,000 per year.
Arguably the best component of a 401(k) is the company match that employees can benefit from. A company will usually match based on a percentage of the employee’s salary. For example, a company may match every dollar up to 6% of your salary that you contribute into your 401(k). An employee earning $100,000 a year who contributes at least $6,000 to their 401(k) account annually will also receive $6,000 from their company in the form of a match. The benefit for the employer is that their match is tax-deductible come tax time.
If you are self-employed, you serve as both the employee and the employer for your business. So, when contributing to a Solo 401(k), you wear two hats in the eyes of the IRS. You are able to contribute to the account as both employee and employer, but there are important limitations to understand.
As an employee, you can defer up to 100% of your compensation up to the IRS limit of $19,500 ($26,000 for those 50 and over). As an employer, you can make a profit-sharing contribution up to 25% of net adjusted self-employed income, or 20% for a sole proprietorship or single member LLC. In 2021, the combined total contribution between the employee and employer cannot exceed $58,000 ($63,500 for individuals 50 and over).
Like many 401(k) plans, you can fund a Solo 401(k) with pre-tax dollars or after-tax dollars (Roth). Pre-tax contributions reduce your taxable income for that tax year and later distributions are taxed as income. With after-tax or “Roth” contributions, your contributions have already been taxed. When Roth distributions take place, distributions are tax-free.
Solo 401(k)’s have straight-forward tax reporting requirements. If the total value in your Solo 401(k) is less than $250,000 at the end of the year, there are no annual tax filings to report to the IRS. If the value is over $250,000 by calendar year end, you will need to file a Form 5500 with the IRS before July 31st following the tax year of your contribution.
Let’s assume that Ben is 51 years old and earned $30,000 in salary compensation from his consulting business (LLC) in 2020. The net adjusted self-employment of the business was $50,000. Ben elected to contribute $19,500 to his Solo 401(k) in salary deferrals plus $6,500 in catch-up contributions to the plan $26,000 total via employee contributions). As an employer, his business was able to contribute 20% of the net income ($10,000). In this instance, Ben’s contributions to his Solo 401(k) for the year total $39,500.
Typically, 401(k) plans only give you the option to choose from a handful of mutual funds to invest in. Solo 401(k)s allow for more flexibility regarding investment options. In a Solo 401(k), you can purchase individual stocks, bonds, mutual funds, and FDIC-insured CDs. You can even purchase real estate held by a Solo 401(k) plan if you choose the self-directed option.
When you are ready to begin receiving distributions from your Solo 401(k), there are few things to note. In order for a distribution to be considered “qualified” and to avoid a 10% penalty upon withdrawal, typically you must wait until you turn 59 ½ (or older). If the distribution is qualified, you will then pay income taxes on the distribution (if you funded your account with pre-tax dollars). Roth distributions will be tax-free. If you have a mix of pre-tax and after-tax dollars inside your Solo 401(k), tax treatment upon withdrawal will be prorated between the two different buckets.
How do I set-up a Solo 401(k)?
Setting-up a Solo 401(k) plan is fairly simple. One of the easiest ways is to partner with a financial institution. They can walk you through necessary plan documents and discuss the various options you can choose inside the plan. This service is typically free.
Business owners often overlook ways to save for retirement in a tax efficient way. A Solo 401k is an easy way to get the ball rolling to set yourself up for success in retirement. If you have any questions about setting up a Solo 401(k) or are a business owner that would like to set one up today, please reach out to our team here at Taylor Hoffman!
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