Having joined the ranks of the self-employed by co-founding my own firm in 2007, I no longer had the option to contributing to my previous employers 401k plan.
I has officially started my own small business and was now open to a slew of retirement plan choices.
I had done my fair share of advising clients on the investments inside these plans, but it's whole new ballgame when you are on the other side deciding what plan is best for you.
I initially choose the SEP IRA for the first several years of running my own business, but then switched to the Solo 401k 2 years ago. Now that I have more than one employee, I'll be setting up a traditional 401k this year.
Although the plan is designed for the individual business owner (or self employed), it is technically available to the spouse of the owner and any shareholder or partner in the business, as well.
1. A Solo 401(k) is Simple
Setting up a Solo 401k makes a lot of sense for sole proprietors, owners of an S Corporation, C Corporation or partnership. Initially my business was structured as a sole proprietor so setting up a Solo 401k seemed like it made a lot of sense. Unlike traditional 401ks, there are no complicated discrimination tests or Form 5500 filing.
Not sure what a 5500 is? It's a form that larger 401k plans have to file with IRS to be compliant. A Solo 401k doesn't have to worry until the plan reaches in excess of $250,000 to have to file a Form 5500. If and when I have to file a form 5500, I won't complain that much. 😉
2. Who is a Solo 401k Plan For?
Although it is called a “Solo” 401k, you can actually set up for you and your spouse. If you have a bona fide partnership, it would work for them as well. You are able to exclude any part time employee who works fewer than 1,000 hours per year.
If you have any employee that works these hours, the Solo 401k is not an option for you. Also, if you plan on hiring employees in the near future, you may want to consider a different plan.
3. Solo 401k Maximum Contribution Limits For 2015
There are two types of Solo 401k contributions: elective (meaning you don't have to contribute; you decide to contribute) contributions of your earned income as the “employee” of the business and nonelective (meaning they have to contribute according to the plan) by the business to your account.
Unlike traditional 401k plans, there is no vesting schedule for Solo 401k. That means when you (or your business) contribute to your account you are 100% vested immediately. Like the regular 401k contribution limits for 2015, you can elect to defer up to $18,000 of your pre-tax income in elective contributions.
If you are over the age of 50, you can do the catch up contribution of $6,000, for a total of $24,000.
On top of the $18,000, as the employer you can also make a nonelective profit sharing contribution up to 25% of your pay (which would be based on your W-2).
Total contributions (not including any catch up contributions for being 50 or older) cannot exceed $53,000 for 2015. (I have an example below). This means that if you max out your elective deductions at $18,000 then the business can contribute a maximum of $35,000 to your account.
4. When Does a Solo 401k Plan Have To Be Established?
The plan has to be established by the end of the business tax year in order to make a contribution for that year (unlike the SEP IRA which can be setup until your tax filing). This is in part why I passed on the Solo 401k for 2009.
Since 2008 was my first full year in business, I had opted to file an extension to allow some time for me to completely figure out my tax situation. Since I had missed the year end deadline, the SEP IRA made the most sense.
Since the Solo 401k plan is for you ONLY, your administrative requirements are minimal. That is one of the major benefits of the plan.
If you maintain a Solo 401k, in addition to a traditional 401k through another employer (yes I've seen this done before but rare), the total salary deferral you can make, between all your 401ks combined is $18,000 for 2015.
For example, in addition to your self employment income, you work another job and contributed $10,000 to that 401k for 2014. When it comes to your self employed salary deferral, you can only add an additional $8,000 for 2015.
5. How Do You Contribute to the Plan?
When it comes to making the profit sharing contributions, each owner and spouse must receive the same percentage of pay contribution; there is no flexibility here, as there is with the salary deferral portion of the Solo 401k.
You can wait till year end to make the contribution, just remember that the plan has to be set up before December 31st.
6. Choosing Between Solo 401k Plan vs. SEP IRA
For somebody like a business owner who has a significant net income and wants to sock away a good chunk of money pretax, the Solo 401k deserves a long hard look. One big reason is that 100% of your pay can be set aside (unlike a SEP IRA), which allows you to potentially contribute a lot more to a Solo 401(k). Let's look at a quick example for a self-employed 50 year old business owner who has $100,000 in compensation:
For both the SEP IRA and Solo 401k you would be able to make a $21,175 employer contribution (25% X $84,700, which is Net Earnings after self-employment tax is deducted).
But here is where the Solo 401k kicks into hyper drive.
On the top of the $21,175, the business owner can also make a $18,000 employee contribution and an additional $6,000 catch up contribution. With the SEP IRA, this is not an option. In 2015 the SEP IRA contribution limit is 25% of compensation, so for our 50 year old business owner that is $25,000. In total, the business owner can contribute $45,175 to a Solo 401k which is $20,175 more than its SEP IRA counterpart. That is a significant difference and tax savings!
7. Can Your Borrow From a Solo 401k?
Just like a regular 401k, a Solo 401k does have borrowing provisions. A Solo 401k participant can borrow up to either $50,000 or 50% of their account value (whichever is less) with the following terms:
- To be repaid over an amortization schedule of 5 years or less
- Regular payments no less frequently than quarterly
- At a reasonable rate of interest… generally interpreted as prime rate + 1%
Be sure to check your custodian to make sure that borrowing is allowed. Some low fee custodians prevent borrowing based on the low administrative fee that they charge. Read the fine print!
A Solo 401k example
Just so I haven't left you too confused, I thought I would close with another Solo 401k example to bring it all home:
A business owner, 48 year old Tony Stark, founder of Stark Industries, has net earnings $150,000, has no employees, and decides that the Solo 401k is the best plan for him.
Tony decides he will defer the maximum for 2015 $18,000. In addition, the business is typically permitted to deduct contributions up to 25% of Tony's total compensation. In this case, 25% would be $37,500.
But the business can't contribute that much to his account this year. Why?
Remember, the maximum you can contribute in total from both the employee and employer perspective is $53,000. If Tony maxes out his personal contribution at $18,000 and the business contributed $37,500, he would be contributing $55,500 total. Instead the business will only be able to contribute $35,000 this year to bring his total contribution back down to the total limit of $53,000.
Remember the $18,000 salary deferral does not reduce the amount of the business deductible contributions.
If Tony were over the age of 50, he would have been allowed a catch up contribution to be able to max out the full benefit. He would have been allowed to contribute up to $59,000 in that case.
My Plans for a Solo 401k
Initially, the SEP IRA made the most sense if what I was trying to accomplish. I ended up switching to the Solo 401k so that I could invest into some non-traditional investments which currently includes Peer to Peer Lending with Prosper and Lending Club.
Before deciding if a Solo 401k is right for you, be sure to consult a tax advisor first.