A Solo 401(k) is a fantastic tool for growing wealth with tax-sheltered retirement savings.
When most people think about a self-directed IRA or 401(k) plan, they concentrate on the investment flexibility. Being able to invest in real estate, private placements, digital currencies and more is certainly appealing and can give you much more control over investment outcomes.
Making regular contributions to your plan is one of the best – and often overlooked – ways to take full advantage of plan benefits.
The generous contribution features of a Solo 401(k) are what really allow this plan to stand out. As a self-employed businessperson, you can pay yourself first by setting aside income into your plan and take generous tax deductions when doing so. The more you have available to invest, the more you will benefit from the compounded tax-sheltering benefits over time that a Solo 401(k) provides.
Here are a few tips about making Solo 401(k) contributions.
All contribution limits below apply to the 2020 tax year. We maintain a Solo 401(k) Contribution page with detailed information on current contribution amounts.
1 – Generous Contribution Limits
A Solo 401(k) allows for contributions of up to $57,000 for 2020. In 2021, this number will bump up to $58,000.
For plan participants age 50 and older, it is possible to add $6,500 as a “catch up”, bringing the overall maximum up to $63,500.
There are two avenues you can use to allocate income from your business into your plan – employee contributions and employer contributions.
2 – Employee Contributions
As an employee of your business, you can choose to make an employee deferral into your plan.
With this type of contribution, you claim the income amount as compensation from your business, but then set it aside into your retirement plan rather than take it personally.
You can choose to make your deposit to the plan on a tax-deferred or Roth basis.
The employee contribution is capped at $19,500, with a $6,500 catch up provision for savers age 50 and older.
Employee contributions may be made with up to 100% of eligible compensation, which is your W-2 wage if you are taxed as a corporation or the net business income after self-employment taxes in a pass-through environment.
Because the employee deferral can tap into all available income, this is the preferred choice of sourcing plan contributions in a low-income business.
3 – Employer Contributions
Your business can also contribute to your plan on a profit-sharing basis.
This profit-sharing contribution can be up to the plan maximum of $58,000 and is based on a percentage of income.
In a pass-through environment, contributions can be made from net business income, which is your gross income, less operating expenses, less half of self-employment taxes.
The business then makes the contribution to the plan ahead of being deemed compensation to you, which eliminates the employee half of self-employment taxes. Because of this potential savings on self-employment taxes, high earners will typically favor using profit sharing as the primary means to contribute.
It would take net business income of $285,000 in a pass through to max out the plan with profit-sharing contributions only.
In a corporate environment where you pay yourself W-2 wages, the maximum profit-sharing amount is 25% of your W-2 compensation. You cannot utilize shareholder distribution income for purposes of plan contributions.
4 – Combining Contributions
You can combine employee and employer contributions to reach your savings goal.
If you are age 50 or older and want to take advantage of the additional $6,500 catch up amount, you will need to first max out your normal employee contribution of $19,500.
Savers looking to pursue a Roth contribution strategy will also likely make employee contributions the primary method of plan funding.
Most other investors will want to use profit sharing to the maximum amount allowable and then use employee deferrals to meet the balance of their savings goal.
5 – Roth Contributions
With employee deferral contributions, you can choose to set money aside on a tax-deferred (Traditional) basis or on a tax-free Roth basis.
Unlike IRA based plans, there are no income limits on your ability to make Roth contributions. This means you can put $19,500 into your Roth 401(k) plan or $26,000 if you are age 50 or older.
6 – If You Participate in More than One 401(k)
If you have a Solo 401(k) associated with your own self-employment activity and also have another job with an employer that offers a Solo 401(k), you will need to think carefully about employee deferral contributions.
You have only one individual cap of $19,500 (or $26,000 if 50 or older) that you can make, and this is spread across all plans you participate in. You can make a full contribution in one plan, or split your contribution across multiple plans. Of course, you can only use income from a specific employer to contribute to that employer’s plan.
If your other employer makes matching contributions, that is essentially free money and something you should take advantage of. Some employers may offer a match, but only up to a certain threshold that may be less than the full employee limit.
If matching is limited, you may want to contribute above that amount to your own plan. If there is no matching, then simply choose which plan you would rather have the money available to invest in.
Employer matches and profit-sharing contributions are not linked across plans. Even if your employer offers a match or profit-sharing formula, you can max out profit sharing based on your eligible income in your own Solo 401(k).
7 – Making Solo 401(k) and IRA Contributions
Your Solo 401(k) is not impacted by participation you may have in an individual Traditional or Roth IRA.
The reverse is not true, however. If you have access to an employer sponsored retirement plan, which would include your business’ Solo 401(k), your ability to benefit from a separate IRA may be limited.
You can always contribute to a tax-deferred (Traditional) IRA. Based on your overall income and tax-filing status, however, you may not be able to take a deduction for such contributions. While the contributed amount is still taxable in the year of contribution, earnings on non-deductible IRA contributions are tax-deferred.
Self-employed persons with moderate income who may not be able to reach their full savings goal with the Solo 401(k) may choose to make a contribution to a separate IRA and then roll that over to the Solo 401(k).
With a Roth IRA, participation in your own Solo 401(k) does not prohibit you from making contributions. The potential issue here is that you cannot make separate Roth IRA contributions if you are over a specified income amount based on your tax filing status. Since the Solo 401(k) has generous Roth contribution features, it is rare that someone would have enough income to max out the 401(k) Roth and still be below the limit where they could separately contribute to a Roth IRA.
Because Roth IRA contributions cannot be rolled over to a Solo 401(k), there is not often much benefit to a parallel Roth IRA strategy if you have access to a Solo 401(k).
8 – When to Make Contributions
You can make contributions throughout the tax year and between the end of the year and your tax filing date including extensions. There are some timing considerations to keep in mind, however.
You cannot make contributions with income you have not yet earned. Even if you know you will make a good amount of money, you cannot simply dump $58,000 into your plan in January before any earnings have been recorded.
If you operate as a corporation and pay yourself a wage, employee contributions must be made as a payroll event, generally within 7 days of payroll issuance. This means your last opportunity to make employee contributions is in early January when you process your year-end payroll.
You can contribute regularly throughout the year, on a quarterly basis, or at the end of the year, but there must be a linkage between the payroll received and the amount contributed to the plan. If you want to wait to the end of the year and make a bigger contribution on a one-time basis, plan to pay yourself a bonus that will cover the contribution amount.
In a pass-through tax environment, you really do not “pay yourself” until you file your taxes. While you may take draws throughout the year, there is no payroll event to which employee contributions are linked. That means you have until your tax filing date including extensions to make employee contributions.
The deadline to make employer profit-sharing contributions is the tax filing due date for the business return, including extensions. This is true in both pass-through and corporate environments.
9 – How to Make Contributions
We get a lot of questions on this one…
To make a plan contribution, put the money in your plan bank account.
It really is that simple (almost).
There is no special process for making contributions to the plan. Since you are the plan administrator and trustee, you just need to make deposit(s) by the appropriate deadline.
You should make the deposit from your business bank account for proper bookkeeping.
There is no plan level reporting required for the contribution event. You will want to have a record of your contributions to use when you file your tax returns.
If your total plan value exceeds $250,000 and your plan is therefore required to file IRS form 5500-EZ, then you will need to know the total amount of both employee and employer contributions made during the year, so keep a record to make your filing process easy.
The primary reporting for contributions will be on your business and personal tax returns.
10 – Special Considerations for new Plans
Prior to passage of the SECURE Act in December of 2019, you had to open your Solo 401(k) plan by December 31st of the tax year in order to contribute for that year.
Starting in 2020, that changed. You can now open your Solo 401(k) up until the tax filing deadline of your business, including extensions.
There is one catch, however. You can only fund such a new plan created after year-end with employer profit-sharing. The plan cannot accept employee contributions for the prior tax year.
Consult with your Tax Professional
When it comes to plan contributions, your self-directed Solo 401(k) is no different from a conventional Solo 401(k) limited to investing in stocks and funds. Most any qualified CPA who deals with small businesses will be familiar with contribution rules and calculations.
If you have questions about designing the best contribution strategy, determining the maximum amount you can contribute, or reporting, please work with your licensed CPA or other tax professional.