By Jeremy Rodriguez, JD
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One of the many issues facing self-employed individuals is how to save for retirement. Of course, one option is to open a traditional or Roth IRA. However, the annual maximum contribution is low in terms of retirement planning. In 2018, it $5,500 if you are under age 50 or $6,500 if you are age 50 and over. Therefore, the self-employed often look to adopt employer-sponsored retirement plans. While there are a number of options, the Solo 401(k) is one of the most popular arrangements. Not only does the Solo 401(k) produce higher contribution levels than other arrangements, but employer contributions are tax deductible! Of course, like anything else, there are pros and cons.
The Basics: Plan Contributions
Outside of a defined benefit plan, the Solo 401(k) produces the highest possible annual contribution for a self-employed individual. You can make pre-tax deferrals into a Solo 401(k). For 2018, the limit on pre-tax deferrals is $18,500 (plus up to $6,000 in catch-up contributions if you are age 50 or over). Additionally, you can even add a Roth feature to the plan, allowing you to contribute after-tax dollars (more on that later).
You can also make an employer contribution for yourself. The contribution can be flexible and vary from year-to-year. For single member LLCs and sole proprietorships, employer contributions are limited to 20% of net earnings. On the other hand, for a corporation, the maximum employer contribution is capped at 25% of compensation. The maximum amount of compensation you can consider for these purposes is limited and indexed each year. For 2018, the maximum is $275,000.
Finally, the plan is subject to an overall limit, called the “415 Limit,” that looks at all contributions to the plan -- both employer and employee. For 2018, total annual contributions to a single participant cannot exceed $55,000. Thus, when you make contributions to a Solo 401(k), you want to keep three limits in mind:
- Salary deferral limit
- Employer contribution limit
- Overall 415 Limit
Deducting the Contribution
While the employer contribution is deductible for any business, there are different rules for corporations and other unincorporated businesses. For corporate entities, the rules are straightforward: the deduction is limited to 25% of the total compensation paid to employees in the plan. For unincorporated businesses (i.e., single member LLCs and sole proprietorships), the rules are a little more complex. Here, the maximum deduction is calculated by factoring in the self-employment tax deduction and the deduction for the contribution itself. IRS Publication 560 has a worksheet and rate table that a self-employed person must use. In some circumstances, employer contributions above the deduction limit can be carried over to the following year. However, a 10% excess contribution tax may also apply.
Unlike traditional 401(k) plans, there is no need for annual non-discrimination testing in a Solo 401(k). That’s because there’s only one participant! However, when compared to SEP and SIMPLE IRAs, Solo 401(k)s do require additional work. First, a plan document must be adopted and maintained. That means frequent updates (though the recordkeeper may provide standard amendments) and specific amendments to modify plan provisions in the future. Second, once assets reach $250,000, the plan must file a simplified version of Form 5500 each year. Clearly, both steps add additional costs.
The Solo 401(k) is great tool to use for retirement savings, but it isn’t for everyone. You cannot adopt one if you have any employees other than your spouse. There’s also the additional fees and expenses that were previously mentioned. They do, however, open an interesting strategy if your self-employment income isn’t very high. As previously stated, you can add a Roth feature to the Solo 401(k). By doing so, you can use the current low tax rates to your advantage by contributing after-tax dollars to the plan. Assuming your tax bracket will be higher in the future, this strategy will save you money. Even better, with proper planning withdrawals from the account can be tax-free!
In the end, it’s easy for the self-employed person to become shortsighted -- focusing on sales, inventory, and networking. But saving for retirement with an employer plan can reduce your taxable income now and even bring you to a lower tax bracket. Not only will this save you money in the short term, but it will give you financial stability in the future.