Updated for 2020. The Individual (or Solo) 401(k) plan is very similar to a Traditional 401(k) plan, only designed for business owners with no employees. Compared to the other types of retirement plans typically used by small business owners, the Solo 401(k) offers a higher contribution limit, tax-deferred growth, a wide array of investment options, and loan provisions. There is a lot to juggle as a business owner, but don't overlook the importance of having a solid investment management strategy and retirement plan.
The Individual or Solo 401(k) is only suitable for self-employed individuals or the owners of a small business (sole proprietors, partnerships, C and S corporations) with no other employees, unless that employee is a spouse. If you have other employees or expect to hire in the future, this likely is not the best option for you.
Solo 401(k) Contribution Limits
Contributions for an Individual 401(k) are comprised of two parts: the elective contribution (at the individual level) and a profit sharing contribution (at the business level):
- The maximum elective deferral in 2019 is the lesser of $19,000 ($25,000 if over age 50 due to the $6,000 catch up contribution) or 100% of W-2 compensation or net self-employment income. In 2020, the deferral limits increase to $19,500 and $6,500, respectively.
- A profit sharing contribution can also be made of up to 25% of W-2 wages or 20% of net self-employment income for a partnership, sole proprietorship, or single-member LLC that has not elected to be taxed as a C-corporation or S-corporation.
In 2019, the combined total annual contribution cannot exceed $56,000 in 2019 ($62,000 if over age 50). In 2020, the combined total increases to $57,000, and $63,500 if 50+.
Solo 401(k) Tax Benefits
The Individual 401(k) offers tax benefits like other qualified retirement plans. For sole proprietors, the employee and employer contribution will be combined as an above-the-line deduction on your tax return.
If your business is taxed as a C-corporation, S-corporation, multi-member LLC or partnership, the tax benefits will be split in two parts:
- Your employee contribution will reduce your W-2 taxable income as an above-the-line deduction.
- The profit sharing contribution from the business will be deducted as an expense by the business, reducing the company’s net taxable income, which then reduces the taxable income that will be passed through to an owner on their K-1.
Other Solo 401(k) Pros:
- Loan provisions – potentially penalty-free loans may be taken, subject to certain limits
- Flexibility – the Solo 401(k) allows discretionary contributions to be made by both the individual and the business.
- Catch-up contributions – the availability of the catch-up contribution after age 50 may allow business owners to save more compared to other types of qualified retirement plans
- After-tax Roth component – similar to other 401(k) plans that have a Roth component, an Individual 401(k) can be designed as either a Traditional Individual 401(k) or a Roth Solo 401(k) plan. There are no income limitations for contributions to a Roth Solo 401(k) although annual additions are still aggregated by the individual and cannot exceed the overall limitations.(Note: only individual deferrals may be allocated to Roth plans)
Other Solo 401(k) Cons:
- Administration and reporting – unlike the SEP IRA which is not subject to annual IRS filings, annual reporting is required for Individual 401(k) plans through Form 5500 once the accumulated funds reach $250,000
- Inability to have employees – except for a spouse, Solo 401(k) plans do not allow any other employees of the business
- More restrictive timelines to establish and fund – compared to the SEP IRA, the Solo 401(k) offers less flexibility for business owners to set up and fund. Plans must be set up by December 31st or the last day which the plan year is effective, if different. Unincorporated businesses (sole proprietorship, LLCs) must fund their plan by the corporate tax return deadline, including extensions. Individual elective deferrals must be declared by December 31st even though funding can be postponed. Incorporated businesses (C or S corporations) may also wait until the tax filing deadline, including extensions, for the employer contribution. However, employee deferrals must be made within 7 days of electing the contribution. To avoid issues, annual employee contributions should be completed in advance of the December 31st
Business owners need to plan for the future
As a business owner, you are always juggling multiple priorities and likely focused on short-term hurdles. It may be difficult to even think about having the cash flow to save for retirement, especially early on. One of the advantages of being an entrepreneur is the flexibility to do things independently and on your terms. Of course, with that comes the responsibility to do everything independently, including setting up and funding your inevitable retirement.
At Darrow, we strongly encourage business owners and entrepreneurs to start saving for their retirement today, no matter how far off it may seem. By taking advantage of one of the tax-advantaged plans available, you have the ability to reduce your taxable income today while investing for the future and potentially leaving a legacy for your family. Betting the farm on a liquidity event down the road is a dangerous proposition. The only real sure thing is that one day you will want to, or need to, retire.