A Great Way For Small Business Owners To Save Money On Taxes
Andy Smith is a Certified Financial Planner , licensed realtor and educator with over 35 years of diverse financial management experience. He is an expert on personal finance, corporate finance and real estate and has assisted thousands of clients in meeting their financial goals over his career.
The Economic Growth and Tax Relief Reconciliation Act of 2001 authorized the creation of a new type of 401 plan called the Roth 401. As you may have guessed, this was designed to create a 401 equivalent of the Roth IRA, to which the investor contributes after-tax funds , but in exchange they will never have to pay taxes again on any of the capital gains, dividends, or interest.
This distinction means that the Roth 401 is, for all intents and purposes, one of the single best tax shelters ever devised in the history of the United States. Nothing comes close to allowing you to put away so much money, compound it for decades, and then live off the passive income without ever sending anything to the federal or state governments again.
For self-employed individuals and their spouses who operate without any employees, setting up a so-called âone-participant Roth 401 Plan,â more commonly known as an âindividual Roth 401,â can be one of the most extraordinary wealth-building tools in the arsenal.
Contribution Limits If You Participate In Another 401 Plan
If you have a solo 401 and you also work for another company and participate in its 401 plan, the limits on employee contributions are cumulative across all accounts. The employer contribution limits are based on plans, meaning two unrelated employers can contribute up to the employer maximum annually.
Note that anyone who is considering a solo 401 to save earnings from a side job for retirement should check first with a tax professional, who can help confirm your eligibility for the account, including your self-employment status.
How To Set Up A Solo 401k Plan In 2020
The Solo 401 retirement plan, also called the self-employed 401 or individual 401, is similar to a traditional 401, except that it was designed to benefit business owners with no full-time employees .
The Solo 401k plan isnt a new type of plan, and not all plans are the same. In this article, well explain how to easily set up a Solo 401k plan to make traditional, as well as non-traditional investments.
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You Can Rollover Previous 401s
Lastly, you can rollover your old 401s-even from previous employer-sponsored plans-into your Solo 401.
When managing your retirement savings, consolidating your accounts makes it easy to monitor how well your investments are performing.
Beagle does the hard work for you to find your old 401s, identify any hidden fees you might be paying, and gives you advice on how best to consolidate them. for free to get started organizing your retirement accounts.
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Next Steps To Consider
Keep in mind that investing involves risk. The value of your investment will fluctuate over time, and you may gain or lose money.
The change in the RMD age requirement from 70½ to 72 only applies to individuals who turn 70½ on or after January 1, 2020. Please speak with your tax advisor regarding the impact of this change on future RMDs.
Fidelity does not provide legal or tax advice. The information herein is general and educational in nature and should not be considered legal or tax advice. Tax laws and regulations are complex and subject to change, which can materially impact investment results. Fidelity cannot guarantee that the information herein is accurate, complete, or timely. Fidelity makes no warranties with regard to such information or results obtained by its use, and disclaims any liability arising out of your use of, or any tax position taken in reliance on, such information. Consult an attorney or tax professional regarding your specific situation.
This information is intended to be educational and is not tailored to the investment needs of any specific investor.
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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.
How To Set Up A 401 Plan
Now that you know the landscape, youre ready to set up a plan as an employer or self-employed individual. Whether youre establishing a plan for a large enterprise or or on your own the next steps are:
- If youre self employed, decide if you want a SoloK, SEP, or SIMPLE.
- Decide which plan provisions you want , Safe Harbor, matching, vesting schedules?).
- Choose a vendor .
- Complete the adoption agreement along with other agreements and submit to your vendor.
- Communicate and educate: Inform employees of the plans existence and features.
- Set up individual participant accounts.
- Fund the plan through payroll or any employer contributions.
- Review the plan regularly to ensure its meeting the needs of plan participants.
- Monitor and adjust the plan as regulations change and your needs evolve.
- Provide required information to participants on an ongoing basis.
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Solo 401 Withdrawals And Details
As with all qualified retirement plans, there are rules to when you can and must start taking withdrawals from your Solo 401 plan. You must begin taking the minimum required distribution no later than age 72 . There is a 10% early withdrawal penalty for distributions take before age 59 1/2, but exceptions may apply.
Please refer to the IRS page on individual 401s and review our Solo 401 Guide for additional details.
Solo 401k Contribution Limits
Many people choose a solo 401k because it potentially has the highest contribution limit of any self-employed retirement plan. The contribution limit is up to $57,000 in 2020, and you can contribute up to $58,000 in 2021. Theres an additional catch-up contribution of $6,500 for those 50 or older.
You can make contributions to your solo 401k as both the employee and employer. You play both roles because youre self-employed. Heres how it works:
- Employer: You can make profit-sharing contributions of up to 25% of your self-employment income. This amount is your business net profit minus half of your self-employment tax and the employer plan contributions you make for yourself . The limit on compensation for 202 is $285,000 and its $290,000 for 2021.
- Employee: You can contribute up to $19,500 in 2020 and 2021, or 100% of your compensation for the year, whichever is less. The catch-up contribution for those 50 and older applies here. So as the employee, you have the potential to contribute $26,000 to your solo 401k.
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How A Solo 401 Works
A solo 401 is like a regular 401 plan except it is for cases where you are the only employee of your business. If your spouse works in the business, he or she can also be included in the plan too. If you already have employees, you cant use a solo 401. If you eventually hire any employees, the solo 401 simply converts to a regular, employer 401 plan.
There are three primary factors that differentiate the solo 401 from an employer 401:
- As the business owner, you are both the employer and employee on the plan
- The contributions that you make to a solo 401 are generally more generous than they will be for an employee participant in typical large company 401 plans
- A solo 401 can be set up for any type of self-employment, including if you are an independent contractor or a freelancer
A solo 401 plan can also be a self-directed plan since you can choose to invest the money with any investment broker trustee that you choose. You can even set up a solo Roth 401 within the plan, and contribute up to $5,500 toward that portion of the plan each . However, any employer matching contributions on the solo Roth 401 portion of the plan will need to be contributed to the regular solo 401 part of the plan.
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.
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Make Contributions To Your Solo 401
Once the account is opened, it can be funded. Most providers accept checks, wire transfers, or automated clearing house payments to fund the solo 401. You can fund the account monthly or in a lump-sum payment.
The IRS allows you to contribute up to $20,500 from your salary if youre younger than 50 years old. If youre 50 or older, you can contribute up to $27,000). The second part comes from employer profit-sharing contributions of up to 25% of your net self-employment income.
The IRS limit on compensation used to determine your contribution is $305,000 in 2022. Consult your tax advisor to develop an optimal strategy thats IRS-compliant. Penalties for excessive contributions are applied in the year the contribution is made and when the money is distributed, so its essential to get your contribution correct.
Once your account reaches $250,000 in assets, youll have new requirements, including filing IRS Form 5500. If you ever hire employees who become eligible for your plan, youll need to make adjustments to accommodate these new participants.
Complete Plan Documents & Disclosures
After selecting a provider, youll receive a collection of documents called an employer kit or employer application. These documents will help you set up your plan.
Documents that need to be completed for your provider include:
- Client agreement
- QRP basic plan document
- Adoption agreement
This is the stage in the process when youll make initial investment choices. Those initial choices can be changed at any point in the future. Youll receive disclosures and instructions on how to remain compliant. These disclosures will include information on the plan and the benefits of tax-free savings.
In addition, youll receive information regarding items that would go on IRS Form 5500 if you have over $250,000 in your account or have additional plan participants. If you eventually convert your solo 401 to a traditional 401 with more participants, those participants will also receive the same disclosures from the plan administrator.
The primary disclosures for a solo 401 plan include:
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How To Contribute To The Solo 401k
The real difference between a Solo 401 and a traditional 401 is that you can make two types of contributions: employer contribution and employee contribution. This gives you the ability to increase your retirement savings faster.
If you are under the age of 50, you can make a maximum employee contribution in the amount of $19,000. The business can make a 25% profit sharing contribution up to a combined maximum of $56,000. This includes the employee contribution. For a sole proprietorship or single member LLC, the contribution is 20%.
For individuals 50 and over, you can make a maximum employee contribution in the amount of $25,000. Again, the business can make a 25% contribution 20% in the case of a sole proprietorship or single member LLC. The combined maximum contribution is $62,000.
Administering A Solo 401 Plan
Once your Solo 401 plan exceeds $250,000 in assets at the end of the year, the IRS requires you file an annual Form 5500 EZ. Or if you ever terminate the plan, you must also file a Form 5500 EZ.
Unlike Traditional 401 plans, there are no compliance testing requirements to ensure Solo 401 plans do not favor highly compensated employees and are non-discriminatory, as long as you have no employees participating in the plan.
These plans can be called Self-Directed 401, Individual 401, Individual Roth 401, Self-Employed 401, Personal 401 or One-Participant 401 depending upon the vendor offering the plan services.
Important Plan Provision Changes: New plan loan provisions are no longer offered in the TD Ameritrade Individual 401 plan. All outstanding plan loans must be paid off by May 31, 2022 to continue to use the TD Ameritrade plan document. Roth 401 deferral contributions in the Individual 401 plan will no longer be accepted as of December 1, 2022.
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Who Should Get A Solo 401
Solo 401 plans are best for business owners who want the most flexibility in how they save for retirement. Before signing up for a Solo 401, you may also want to consider a SEP IRA or SIMPLE IRA as well.
Solo 401 plans take more paperwork to get started but offer more flexibility in what you are able to contribute. For example, SEP plans only accept employer contributions, while a solo 401 takes contributions from either the employee or employer. SIMPLE IRAs are available to businesses with up to 100 employees. SEP IRAs dont have that limit.
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How Do You Start One Of These 401 Plans
Bergman says you first need to select a provider. One of the most common ways to establish one of these plans is to go through a bank. You usually arent charged a fee for these, but your investment options are limited to the financial products the bank or financial institution sells. You can also go through a brokerage. In addition, there are self-directed solo 401 plan document providers, which do not sell investments and will allow you to establish a self-directed solo 401 plan to make alternative asset investments, such as real estate, as well as gain access to all other available plan options, such as Roth contributions and a $50,000 loan option.
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Choose The Right Provider
With your provider, its important to ask questions. Two common questions people ask are how to make contributions with the Solo 401, and how to use the Solo 401 loan.
However, tailor your questions to your specific needs. At IRA Financial Group, you can call at 401 specialist for a free consultation. With the 401 specialist, you can answer any questions you may have regarding the Solo 401 retirement plan.
IRA Financials Solo 401 plan allows you invest in alternative and traditional assets. While some Solo 401 providers only allow you to make traditional investments like stocks and bonds, IRA Financial allows you to invest in what you know. For example, individuals can invest in real estate, cryptocurrencies, hard-money loans, private companies, and more!
How Does A Self
The solo 401 is like the classic 401. You contribute into the account from your pre-tax income, and you can invest the savings without paying taxes. However, you will pay taxes on withdrawals when you retire. A self-employed 401 allows your spouse to contribute in the same plan.
A major difference between an individual 401, a standard 401, and other personal 401 options is that you can make more contributions. If you qualify for a self-employed 401, the higher contribution restrictions, and easy administration of the account, makes it an ideal choice for retirement savings.
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Find A Solo 401 Provider
The most critical step in the setup process is finding the right solo 401 provider. The best solo 401 providers should provide a simple, straightforward, affordable plan. You should choose a provider that can also support your business as it grows and its needs change.
When choosing a solo 401 provider, you should consider these three factors:
- Costs: Choose a provider with manageable and competitive fees. Be sure to compare the fees of multiple providers to find the most affordable plan that matches your business needs.
- Level of management: Some providers will offer hands-on management for a monthly or annual fee, assisting you with regulatory and compliance filings. However, not all providers actively administer solo 401 plans. Consider the level of management needed from your provider before choosing.
- Investment flexibility: Choose a provider that gives you access to the investment options you want in alignment with your financial needs.
If you already have an investment account or IRA plan, ask your current provider if they offer solo 401 plans. Otherwise, choose a provider that offers factors that align with your personal needs.
You Can Take A Loan From Your Solo 401
Most solo 401 providers let account owners take out 401 loans from their accounts. With a Solo 401, you can borrow up to the lesser of 50% of the plan value or $50,000. You must pay back the loan in five years or lessunless its used to buy a primary residence, in which case you have up to 30 years.
Just because youre borrowing from yourself doesnt mean it wont cost you. Youre required to pay your account interest comparable to what youd pay for a similar non-401 loan. Youll also miss out on potential returns that money would have earned if it had stayed invested. While you will eventually earn what you borrow back, plus interest, that interest rate may be less than the returns the money would have earned if you had left it untouched and invested in the stock market.
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