Last Updated: 11/29/18
The Solo 401(k), also known as the Individual 401(k), is a powerful retirement and tax planning tool for the self-employed. Although this vehicle was primarily intended for retirement, if managed properly, it can have great usefulness at any time. We will discuss more about those benefits in a later article.
Here’s the thing about a Solo 401(k), there’s actually not much in the title. A Solo 401(k) is simply a normal 401(k), just like what you may have (or once had) while working for a larger company. The only key difference between the two involves an IRS provision that states a “One-Participant 401(k) Plan” does not need to perform nondiscrimination testing. It also avoids a few other guidelines and requirements. That makes setting up a Solo 401(k) much simpler, which results in very low fees to maintain.
Make no mistake, as with a normal 401(k) plan, not all Solo 401(k) plans are created equal. There are many important considerations to how the plan is designed in order to maximize the benefit for you.
Who can participate in a Solo 401(k)?
Anyone that owns a business with no additional employees (other than a spouse) can operate a Solo 401(k). The business can be a Sole-Proprietorship, Partnership, LLC, S-Corp, or C-Corp. There are no age or income restrictions.
In the case of a partnership, all partners (and their spouses) are eligible to participate in the plan.
Spouses are eligible to participate in the Solo 401(k). In order for spouses to participate, they must receive earned income from the business. In many cases, to maximize this benefit, there needs to be some strategic planning to ensure that this is properly done.
What are the benefits?
Tax savings is the number one benefit to a Solo 401(k) plan. Since a participant and their spouse can potentially contribute up to $55,000 each, there is a lot of potential tax savings. $110,000 in contributions for the owner and spouse might equal $31,900 in tax savings (assuming 24% federal tax rate and 5% state).
Since nondiscrimination testing is not required on a Solo 401(k), the fees to maintain a Solo 401(k) are very low.
The plan is also relatively simple to set up and maintain. Once the plan has over $250,000 in assets there is an annual filing of Form 5500.
Access to the Money
One of the most underrated benefits to the Solo 401(k) is the ability to access a portion of the money via loans. When combined with proper tax planning, the Solo 401(k) can be a powerful tool to accomplish non-retirement goals as well. See below for more detail.
Can I have a 401(k) and a Solo 401(k)?
Yes, if you (or your spouse), have a normal W-2 paying job in addition to your business income, you can maintain both. Keep in mind that all of your 401(k) plans are combined when it comes to your maximum contributions.
How much can I contribute?
There are two types of contributions to a Solo 401(k). For 2018, the combined amount cannot exceed $55,000. For 2019, the limit is $56,000.
Elective Deferrals – Employee Contributions
The maximum employee contribution is $18,500 for 2018 ($19,000 for 2019). If the earned income is lower than the maximum amount, the maximum amount is 100% of the earned income from the business.
Profit Sharing – Employer Contributions
The employer contribution calculation can be a little more complicated as it generally requires some calculations based on your business entity (Sole-Prop, Partnership, LLC, S-Corp, & C-Corp) and your eligible income. With that being said, here are some simple guidelines.
If the business is a Sole Proprietor/Partnership, the maximum profit sharing contribution is 20% of the net income, subject to the maximum total contribution.
If the business is a Corporation, the maximum profit sharing contribution is 25% of the gross income, subject to the maximum total contribution.
If you are age 50 or older, you are eligible for a catch-up contribution on your Elective Deferrals. That brings the max employee contribution to $24,500 for 2018 ($25,000 for 2019). It also raises the maximum total contribution to $61,000.
You may rollover eligible amounts that you may have in another 401(k), 457(b), 403(b), or Traditional IRA into your Solo 401(k). There is no limit on rollovers.
Can I access the money inside the Solo 401(k)?
Withdrawals are subject to the same guidelines as a normal 401(k). If funds are withdrawn without a qualifying exception before you are 59 ½, you will be subject to a 10% early withdrawal penalty. However, you may borrow from the account via loans.
Solo 401(k) Loans
You are eligible to borrow 50% of the account balance up to a maximum of $50,000 from your Solo 401(k) account. You need to make regular monthly or quarterly payments back to the account and you must pay yourself a reasonable interest rate. Keep in mind that the interest you pay is to yourself and not to the investment company.
The loan provision is the number one reason why many of our clients hire their spouses as employees. The couple then can potentially have $100,000 that is rapidly accessible via a loan to assist in any of their goals. It is very important that a strategy such as this is done with care and in conjunction with a proper plan. The funds need to be properly managed so that the account is still able to achieve its long-term expected return.
Can I have a Roth Solo 401(k)
Yes, you can make Roth contributions to your Solo 401(k). Keep in mind that employer contributions cannot go into your Roth account. You can also make after-tax contributions to a solo 401(k), which allows for the Mega Back-Door Roth Strategy.
It is important to note that we generally don’t use Roth accounts with Solo 401(k)s. That is because of how we normally use a Solo 401(k) as a tax planning vehicle instead of just a retirement vehicle. With that being said, there are many exceptions to this.
What are the Deadlines?
A solo 401(k) plan must be established by December 31st of the current tax year. The deadline for employee contributions and employer contributions is the tax deadline. If you are a corporation, the employer contributions must be made by the business tax deadline (generally March 15th).
Important Planning Considerations
Although the Solo 401(k) is relatively straightforward, they should not be implemented without proper planning. There are still very important IRS guidelines that are not so obvious that need to be taken into account. It is crucial that one considers all business that they own as well as what their future plans are with this business or any others. A qualified professional, such as Vitality Capital Management, can assist with this.
All businesses that are owned must be taken into account for Controlled Group Testing prior to opening up a Solo 401(k). Businesses that are owned by a spouse, parent, or child, may need to be involved in the testing as well.
Future Business Plans
Proper tax planning involves considering your goals individually, and as a business. Each situation is unique here, but it important that the net results of a Solo 401(k) enhances your goals and does not interfere from them. Otherwise, other strategies may be more optimal.
The general rule is that if the business hires employees (other than the spouse), the Solo 401(k) must be converted to a normal 401(k) or terminated and rolled over into an IRA.
The solo 401(k) can be maintained as long as all employees (other than the spouse), work less than 1,000 hours per year (which is roughly 20 hours per week).
Independent Contractors or “1099 Workers” do not qualify as employees; however, the IRS has guidelines on this and those should be considered if the business employs 1099 workers.
The Solo 401(k) is one of our favorite tax planning vehicles. While it is not appropriate for everyone, we believe that each business owner that has no employees should at least consider the option and how it can work for them.
As discussed in more detail in another article, the Solo 401(k) can provide enormous benefits now, and not just for retirement. It can be a great tool that saves in taxes, allows us to have greater control over our taxes year in and year out, while still maintain a reasonable amount of liquidity that can be used in the near future.
While the Solo 401(k) comes with a lot of benefits, careful planning must be done to ensure that the net result enhances your goals and does not interfere with them. Remember, as a business owner, your best investment is, and always will be, you and your business. Everything we do financially must be centered on that.