Here’s How To Plow Some Of Your Profits Into Retirement Savings
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Just because you are a one-person outfit, a freelancer, or an independent contractor doesn’t mean you have to do without a retirement savings plan or the tax benefits that accompany them.
One option If you are self-employed is the solo 401, also known as an independent 401 plan. In fact, the Solo 401 has some benefits over other types of retirement accounts available to the self-employed.
The Modern Small Business Owner Is Lean And Efficient
While employment offered stability for factory workers and factory owners in the Industrial Era, employment has many disadvantages in the modern Information Era.
Disadvantages of employment to the worker now include:
- Employment is becoming harder and harder to find
- Over 70% of college graduates today will not work in their field of study
- Employees get less tax deductions
- Employees usually have their retirement money locked up in the stock market, leaving their financial future at high risk
- Employees in the Information Era are less likely to have career stability because their employers are less lean and efficient than modern small businesses
Disadvantages of employment to the business owner now include:
- Its harder to attract great staff because with employment more money goes to taxes and less goes to the staffs take-home paycheck
- Its nearly impossible to provide powerful retirement and investment tools to employees
- Its more difficult to compete with lean and efficient companies and respond to changes in the marketplace with employees
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Bankrate follows a strict editorial policy, so you can trust that were putting your interests first. All of our content is authored by highly qualified professionals and edited by subject matter experts, who ensure everything we publish is objective, accurate and trustworthy.
Our reporters and editors focus on the points consumers care about most how to save for retirement, understanding the types of accounts, how to choose investments and more so you can feel confident when planning for your future.
Who Can Open A Solo 401
As mentioned, Solo 401s provide self-employed individuals a place to save for their retirement. The term individual is vital because Solo 401s are limited to small business owners with zero employees.
Freelancers and the self-employed tend not to have any employees however, small businesses with even one other employee on the books are not eligible.
There is one caveat to this rule. If your spouse is the only other person employed by your small business, both of you can contribute and receive matching contributions from the business-but more on that in a bit.
Solo 401k Rules & Contribution Limits
Contribution Limits for the Solo 401k are very high! So you definitely want to follow the rules to get the most out of your contributions. For 2021 the max contribution is $58,000 and $64,500 if you are 50 years old or older. For Solo 401k, the contributions have to come from your sponsoring business. They cant come from your W2 job, pensions, rental income, or other sources not considered to be self employment income
Whats great is that you can contribute pre-tax/traditional and lower your taxable income. Or you can contribute after-tax to Roth, so your distributions later in retirement are tax-free. You can also do a combination of both traditional and Roth
There are many ways to contribute to a Solo 401k because you play multiple roles in the plan. You are the employee. So you can do employee salary deferrals up to $19,500 and $26,000 if you are 50 years old or older. This can be up to 100% of your net compensation or W2 depending on your business structure. This employee salary deferral can be pre-tax or Roth or a combination of both. You are also the employer. So you can do 20-25% as a employer profit sharing contribution depending on your business structure. 20% is for sole proprietors and single member LLCs. 25% is for S Corp, C Corp and partnerships. These contributions are always tax deductible.
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Benefits To Your Business
Your employer contributions are a deductible business expense, which reduces your business taxes.
Your business can get tax credits and other incentives for starting a plan. The tax credit is for employers with 100 or fewer employees, and is applied to 50% of your eligible startup costs for a 401, up to a maximum of $500 a year. The credit is given for setting up and administering the plan and educating your employees about it.
Beyond that, offering a retirement plan is attractive to current and potential employees, giving you a competitive advantage when hiring and retaining talent.
Contribute To An Ira And Solo 401k Plan
QUESTION 1: Can I make both solo 401k and Traditional IRA contributions for the same year?
ANSWER: Yes you can contribute to both your solo 401k plan and your IRA in the same year. However, the IRA contributions may not be fully tax deductible since you are also contributing to a solo 401k plan. It comes down to your modified AGI which means you may be able to deduct some of your IRA contribution. for the AGI chart.
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What Is A Solo 401
A Solo 401 is a retirement account designed for small business owners, entrepreneurs, and self-employed individuals. Solo 401s generally operate in the same way as traditional employer-sponsored 401 plans and carry the same rules set by the IRS.
You can elect to contribute pre-tax income into a Solo 401, or you can contribute after-tax earnings into a Roth 401.
Like traditional 401s, Solo 401s also allow matching contributions by your âemployer.â
Solo 401s are the same as any other 401 however, there are some limitations on who can participate in them.
Roth 401k And Voluntary After
- Voluntary after-tax solo 401k contributions fall under the employee contribution umbrella.
- This type of contribution is not considered employer contributions, so the contribution is not tax deductible because it is considered made with post-tax dollars.
- When voluntary after-tax solo 401k contributions are converted to a Roth IRA or the Roth Solo 401k, the conversion has to be documented in writing by completing a conversion Form , and a Form 1099-R has to be issued to report the conversion whether taxable or not. This reporting is covered by our annual service and fee.
- Voluntary after-tax solo 401k contributions can be distributed and thus converted at any time. This is why the conversion of voluntary after-tax solo 401k contributions has been dubbed the mega-backdoor Roth solo 401k.
- There is a lesser known rule called the overall 415 limits. The overall 415 limit for 401 plans including solo 401k plans. For 2020, the overall limit is $57,000. The overall limit increased to $58,000 for 2021. The overall limit looks at the total annual additions to all of a participants accounts in plans maintained by one employer and includes not just their salary deferrals, but also matching contributions, allocations of forfeitures and other amounts. Voluntary after-tax solo 401k contributions are subject to the overall annual limit $57,000 for 2020, and $58,000 for 2021.
I have provided the following links for more information and examples: https: 401k-contributions/
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Who Is Eligible For A Solo 401k
The Solo 401k is open to anyone who can say yes to these 2 key requirements:
As long as you meet these 2 criteria, your small business qualifies to have a Solo 401k. Many times, people who have a full-time W2 job, dont think about their side hustle or side gig as a business. Whats interesting is that according to the IRS, it is a small business.
Taking the definitions a little further, how much self employment income is enough to qualify? This is a grey area. The IRS does not say exactly how much income is needed to qualify to have the Solo 401k. Probably a few thousand dollars per year will be sufficient.
Where is the line between a full-time W2 employee and a part-time W2 employee? The IRS says that anyone working more than 1,000 hours per year is considered to be full time. If you have any employees that pass the 1,000 hour threshold, you would no longer qualify for the Solo 401k.
How A Simple Ira Works
The SIMPLE IRA follows the same investment, rollover, and distribution rules as a traditional or SEP IRA, except for its lower contribution thresholds. You can put all your net earnings from self-employment in the plan, up to a maximum of $13,500 in 2021 , plus an additional $3,000 if you are 50 or older.
Employees can contribute along with employers in the same annual amounts. As the employer, however, you are required to contribute dollar for dollar up to 3% of each participating employee’s income to the plan each year or a fixed 2% contribution to every eligible employee’s income whether they contribute or not.
Like a 401 plan, the SIMPLE IRA is funded by taxdeductible employer contributions and pretax employee contributions. In a way, the employer’s obligation is less. That’s because employees make contributions even though there is that mandated matching. And the amount you can contribute for yourself is subject to the same contribution limit as the employees.
Early withdrawal penalties are hefty at 25% within the first two years of the plan.
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Why Do I Need A Plan Restatement
Every six years, the IRS requires all qualified retirement plans to update their plan documents to reflect recent legislative and regulatory changes. Some updates are made during the normal course of business through plan amendments, but others require more substantial rewriting of plan documents through a formal process known as a plan restatement.
Who Qualifies For A Solo 401k Plan
There are two main eligibility requirements: one is that you must be self-employed, and the second is that you must earn self-employment income.
You can typically fit the first requirement if youre a freelancer, sole-proprietor, business owner without any employees , or independent contractor. The second requirement, self-employment income, can be verified through tax records.
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Contribution Limits For Self
You must make a special computation to figure the maximum amount of elective deferrals and nonelective contributions you can make for yourself. When figuring the contribution, compensation is your earned income, which is defined as net earnings from self-employment after deducting both:
- one-half of your self-employment tax, and
- contributions for yourself.
Use the rate table or worksheets in Chapter 5 of IRS Publication 560, Retirement Plans for Small Business, for figuring your allowable contribution rate and tax deduction for your 401 plan contributions. See also Calculating Your Own Retirement Plan Contribution.
Getting Your Solo 401 Started
Once you have established the type of plan you want, you will need to create a trust that will hold the funds until you need them or you reach retirement age. You can select an investment firm, online brokerage, or insurance company to administer the plan for you.
You also need to establish a record-keeping system, so that your investments are accounted for properly.
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Solo 401k Plan For A Sole Proprietor
QUESTION 2: Can a sole proprietor open a solo 401k plan?
ANSWER: Yes a sole proprietorship can also sponsor a solo 401k plan. A sole proprietor files a Schedule C to report the self-employment activity. We would list your name as the self-employed business on the solo 401k plan documents, and your contributions to the solo 401k plan would be based on line 31 of the Schedule C.
Transfer Retirement Funds To Solo 401
When you choose your solo 401 provider and you set up your IRS compliant Solo 401k plan, transfer your retirement funds from your current custodian to a financial institution or credit union that can serve as your custodian. There is no fee, and the transfer is also tax-free.
Make a tax-free direct rollover to your new Solo 401k plan bank account. You can contact the specialists at IRA Financial Group can assist you in completing this step in setting up your Solo 401. We will expedite the process in a tax-free manner.
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Solo 401 Contribution Limits
The total solo 401 contribution limit is up to $58,000 in 2021 and $61,000 in 2022. There is a catch-up contribution of an extra $6,500 for those 50 or older.
To understand solo 401 contribution rules, you want to think of yourself as two people: an employer and an employee . Within that overall $58,000 contribution limit in 2021 and $61,000 in 2022, your contributions are subject to additional limits in each role:
As the employee, you can contribute up to $19,500 in 2021 and $20,500 in 2022, or 100% of compensation, whichever is less. Those 50 or older get to contribute an additional $6,500 here.
As the employer, you can make an additional profit-sharing contribution of up to 25% of your compensation or net self-employment income, which is your net profit less half your self-employment tax and the plan contributions you made for yourself. The limit on compensation that can be used to factor your contribution is $290,000 in 2021 and $305,000 in 2022.
Keep in mind that if youre side-gigging, employee 401 limits apply by person, rather than by plan. That means if youre also participating in a 401 at your day job, the limit applies to contributions across all plans, not each individual plan.
How Does A Solo 401 Work
As a reminder, a Solo 401 plan is nothing more than an individual retirement plan for self-employed people or small businesses without any employees. Also, remember that a Solo 401 is nothing more than a vessel youll use to save for retirement. You still have to choose the investments youll use within your account to build wealth.
The biggest benefit of this account is the fact that individuals who use it can contribute considerably more than they can with a traditional 401 plan, which in turn helps these individuals save more for retirement and reduce their taxable income.
As an employer, one of the main features of a Solo 401 is that youll need to determine what your actual income is to determine your maximum employer contribution, which can be up to 25% of your compensation. According to the IRS, your compensation is earned income, defined as net earnings from self-employment after deducting one-half of your self-employment tax and contributions for yourself. But once again, this depends on the business structure for your company.
Solo 401 participants can open their account with any brokerage firm they want, although online providers have become extremely popular due to the fact you can get started at home and on your own time, and often with access to an array of helpful investing tools and resources. Online brokerage firms also tend to come with low costs overall, which is another reason investors seek them out.
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How A Solo 401 Works
The one-participant plan closely mirrors the 401s offered by many larger companies, down to the amounts you can contribute each year. The big difference is that you get to contribute as the employee and the employer, giving you a higher limit than many other tax-advantaged plans.
So if you participate in a standard corporate 401, you would make investments as a pretax payroll deduction from your paycheck, and your employer has the option of matching those contributions up to certain amounts. You get a tax break for your contribution, and the employer gets a tax break for its match. With a one-participant 401 plan, you can contribute in each capacity, as an employee and as a business owner .
Elective deferrals for 2021 can be up to $19,500, or $26,000 if age 50 or older . Total contributions to the plan cannot exceed $58,000, or $64,500 for people age 50 or older as of 2021 . If your spouse works for you, they can also make contributions up to the same amount, and then you can match those. So you see why the solo 401 offers the most generous contribution limits of the plans.
Prototype Plan Vs Custom Plan
Once you understand what options you want for your solo 401k plan, it’s time to discuss plan documents.
See, your solo 401k really has two parts:
When it comes to the solo 401k plan documents, you can either use a prototype plan, or create your own custom plan.
A prototype plan is typically offered by the brokerage firms that offer free solo 401k plans. They are called prototype plans because they are very generic plans that were created by a lawyer, and anyone can use them. However, because these are generic plans, they might not offer all of the options you’re looking for in a solo 401k.
For example, Fidelity’s solo 401k plan doesn’t offer a Roth solo 401k option. Vanguard’s solo 401k plan doesn’t offer loans from your 401k. As such, you need to carefully consider the options available in a prototype solo 401k. E*Trade offers the most robust prototype solo 401k plan.
On the other hand, you can create a custom solo 401k plan. This is where you pay a company to draft you plan documents that are custom to your needs. The reason you create this is because you want to invest in alternative assets like real estate.
Other options include:
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