Going solo with your 401k
Q: A couple of years ago, I decided to start my own consulting business. It has been doing pretty well and someone recently suggested I set up a solo 401k plan to reduce my taxes and boost my retirement savings. It is an S corporation. Would a solo 401k plan make sense?
A: As long as you and your spouse are the only full-time employees in the business, a solo 401k sounds like a good idea. In most situations, solo 401k plans are easy and straight-forward. However, like all retirement plans, there are some rules you need to follow. If you break the rules, you can cause your plan to be disqualified—a situation that could lead to unpleasant tax headaches. You probably want to work with an advisor to make sure you get it set up correctly.
The term “solo 401k” is another name for what the IRS refers to as “one-participant 401(k) plans.” These plans were created to help owners of small businesses save for retirement without the cost and administrative burden usually associated with retirement plans. Eligible business types including sole proprietorships, S Corporations, C Corporations, Partnerships and LLCs. To qualify for a solo 401k plan, a business can have no full-time employees except the owner and the owner’s spouse or partner if the business is a partnership.
Solo 401k plans are a streamlined version of the retirement plans offered at larger companies. Since there are no employees beyond the owner, solo 401k plans do not need to do the nondiscrimination tests that larger plans require. However, like their larger cousins, solo 401k plans are organized under ERISA and enjoy all the legal protections ERISA affords. Contribution limits and catch-up provisions for participants are the same as in larger plans and company contribution limits are the same. Participants can even borrow money tax-free on the same terms and conditions as the larger plans.
As the owner of your small business, you are both employer and employee when it comes to the plan. If your company pays you a W-2 wage, the limits on your solo 401k plan contributions are easy to calculate. You, as employee, can defer up to 100 percent of your compensation or $19,500, whichever is less, plus a catch-up provision of $6,500 if you are age 50 or older.
As employer, you can also make nonelective contributions up to 25 percent of your compensation. Total contributions to your account in 2020 cannot exceed $57,000 or $63,500 if you are eligible for the catch-up provision.
If you are self-employed (meaning you are supported by the business, but are not paid W-2 earnings), things get a bit trickier. In that case, your contribution limits are based on your net earnings from self-employment after deducting one-half of your self-employment tax and the amount of contributions you have made to the plan on your behalf. (I know it’s confusing. If your head is starting to spin, you aren’t alone. Even the IRS admits the reasoning is circular.) Let’s just say you would do well to get an advisor to help you with the calculations.
Solo 401k plans can accept Roth contributions as long as they come as elective deferrals from you as employee. Employer nonelective contributions can only be made on a traditional (pre-tax) basis. Remember that you will not get a current-year tax deduction for your Roth deferrals and that tax-free withdrawals from the Roth are available only after the Roth 401k account has been established for five years. The five-year clock starts running at the time the first deposit is made into the Roth 401k account.
Steven C. Merrell MBA, CFP®, AIF® is a Partner at Monterey Private Wealth, Inc., an independent wealth management firm in Monterey. He welcomes questions you may have concerning investments, taxes, retirement, or estate planning. Send your questions to: Steve Merrell, 2340 Garden Road Suite 202, Monterey, CA 93940 or email them to firstname.lastname@example.org.