What are the potential tax benefits of a Solo 401(k)?
One of the potential benefits of a Solo 401(k) is the flexibility to choose when you want to deal with your tax obligation. In a Solo 401(k) plan all contributions you make as the "employer" will be tax-deductible (subject to IRS maximums) to your business with any earnings growing tax-deferred until withdrawn. But for contributions you make as an "employee" you have more flexibility. Typically, your employee "deferral" contributions reduce your personal taxable income for the year and can grow tax-deferred, with distributions in retirement taxed as ordinary income. Or you can make some or all of your employee deferral contributions as a Roth Solo 401(k) plan contribution. These Roth Solo 401(k) employee contributions do not reduce your current taxable income, but your distributions in retirement are usually tax-free. Generally speaking, there are tax penalties for withdrawals from a Solo 401(k) before 59 1/2 so be sure to know the specifics of your plan.
What are the contribution levels and limits of a Solo 401(k)?
To take full advantage of contributions to a Solo 401(k) plan you must understand your limits as an employee and employer, as well as contributions allowed on behalf of a spouse if applicable.
When contributing as the employee, you are allowed up to $19,500 or 100% of compensation (whichever is less) in salary deferrals for tax years 2020 and 2021. If you are over 50, an additional $6,500 catch-up contribution (total contribution of $26,000) is allowed for tax years 2020 and 2021. This is the type of contribution that can be made as pre-tax/tax-deferred or Roth deferral or a combination of both. Additionally, as the employer, you can make a profit-sharing contribution up to 25% of your compensation from the business up to $57,000 for tax year 2020 and $58,000 for tax year 2021. When adding the employee and employer contributions together for the year the maximum 2020 Solo 401(k) contribution limit is $57,000 and the maximum 2021 solo 401(k) contribution is $58,000. If you are age 50 and older and make catch-up contributions, the limit is increased by these catch-ups to be $63,500 for 2020 and $64,500 for 2021.
Compensation from your business can be a bit tricky. This is calculated as your business net profit minus half of your self-employment tax and the employer plan contributions you made for yourself (and other business owners and any participating spouses who are also in your Solo 401(k) plan). The limit on compensation that can be factored into your tax year contribution is $285,000 for 2020 and $290,000 for 2021.
A Solo 401(k) can only be used by business owners who have no employees eligible to participate in the plan. You will set up your plan eligibility requirements in the Solo 401(k) plan documents used to establish your plan legally. The IRS has set limits on when employees must be included in your plan, so be sure to follow the rules. If an employee meets your plan eligibility, then you must include them and begin following certain testing and discrimination rules, which may require you to hire a benefits consulting or administration firm to help you. The one exception to the no-employee rule for a Solo 401(k) is for a spouse who earns income from your business. In 2020 and 2021, your spouse can contribute up to $19,500 as an employee (plus the catch-up provision if 50 or older), and you can make the same percentage of employer contribution that you made for yourself (up to 25% of compensation). This exception effectively allows you to double the amount you can contribute as a family.
How do I open a Solo 401(k)?Give us a call at 800-472-0586 to order a complete Individual 401(k) kit. We'll provide you with an adoption agreement, and a basic plan document to meet your legal plan requirement. It is best if you obtain an Employer Identification Number for your business as well. We also provide you with a Participant Application to open your investment accounts. Once you have gone through these steps you will be able to set up your contributions. Check out our Solo 401(k) Guide for more in-depth details.
Solo 401(k) important dates and deadlinesIn order to make a contribution for this year, you must establish your Solo 401(k) plan by December 31, 2020 and make your employee contribution election by the end of the calendar year. Keep that election in your 2020 tax files. Unless your business is incorporated, you can make the contribution once you have calculated your net business income for the year, but no later than your tax filing deadline including extensions. Employer profit-sharing contributions can also be funded up until your tax return due date, plus extensions.
Solo 401(k) withdrawals and details
As with all qualified retirement plans, there are rules to when you can and must start taking withdrawals from your Solo 401(k) plan. You must begin taking the minimum required distribution no later than age 72 (unless you turned 70 1/2 prior to January 1, 2020. Then you must start taking your RMD at age 70 1/2). There is a 10% early withdrawal penalty for distributions take before age 59 1/2, but exceptions may apply.
One of the advantages of Solo 401(k) is you can choose to allow a plan loan. With a plan loan your investments are liquidated to send you a loan check, so this may limit your ability to meet your retirement goals. You also must pay our loan back regularly - at least quarterly. You must assess interest on your plan loan and pay that back into your account with each loan repayment too. If you do not follow the plan loan rules your loan will be taxable to you and a 10% penalty will apply if you are under age 59 1/2. The maximum loan you can take from your Solo 401(k) account is $50,000 or one-half of your account balance, whichever is less.
Administering a Solo 401(k) plan
Once your Solo 401(k) plan exceeds $250,000 in assets at the end of the year, the IRS requires you file an annual Form 5500 EZ. Or if you ever terminate the plan, you must also file a Form 5500 EZ.
Unlike Traditional 401(k) plans, there are no compliance testing requirements to ensure Solo 401(k) plans do not favor highly compensated employees and are non-discriminatory, as long as you have no employees participating in the plan.
These plans can be called Self-Directed 401(k), Individual 401(k), Individual Roth 401(k), Self-Employed 401(k), Personal 401(k) or One-Participant 401(k) depending upon the vendor offering the plan services.
Find a small business retirement plan that fits you
- A Simplified Employee Pension (SEP) IRA is a plan funded by the business. It allows for tax-deductible contributions that are flexible and grow tax-deferred, making it a consideration for businesses with varying profits.
- A Savings Incentive Match Plan for Employees (SIMPLE) allows both employer and employee to contribute to employee retirement accounts with tax-deductible employer contributions. It enables employees to make pre-tax salary contributions and may be a consideration for businesses with steady profits.
- Profit-Sharing plans reward employees with a percentage of company profits, but do not have to be profit based. Employer contributions are discretionary and tax-deductible to the business.