July 19, 2020
Many self-employed business owners lament the fact that they do not have a corporate company 401(k) plan. They must not be aware that they can set up their own 401(k) plan that has even more flexibility than a corporate one. And those who do know this usually investigate the plan only for the tax advantages, but they should also be thinking of the retirement benefits.
Recently, I was talking to a doctor who is planning to go into business for himself. He elected to incorporate as an S Corp. He had accounts from prior employers and was wondering what to do with them. In his business, he will not have any employees. I suggested he investigate a Roth Solo 401(k), which really should be called a Solo Roth 401(k), profit-sharing plan.
Qualifying for a Solo Roth 401(k)
One-participant 401(k), Solo 401(k), and Solo Roth 401(k) plans are tax-advantaged retirement accounts for the self-employed or for business owners with no full-time employees. These plans may also be called Self-Directed 401(k), Individual 401(k), Individual Roth 401(k), Self-Employed 401(k), Personal 401(k) or One-Participant 401(k), Solo 401(k), Solo-k, Uni-k, or One-Participant k depending on the vendor offering the plan. Qualifying for a Solo 401(k) requires earned income, which is also true for a 401(k), SEP plan, IRA, etc. As with the traditional IRA and Roth IRA, the difference between a Solo 401(k) and Solo Roth 401(k) is that the Solo 401(k) involves tax-deductible savings and taxable withdrawals. The Solo Roth 401(k) involves already-taxed savings and tax-free withdrawals. Most other features of these two Solo plans are the same, including tax-free growth. I will use the terms interchangeably except when discussing their tax implications.
Many people refer to their employer-sponsored retirement plan as a 401(k). Technically, though, that refers only to the portion of an employer-sponsored plan that allows for employee savings, and there are limits to the annual amount of employee savings. When referring to a Solo 401(k), there are savings limits to both the employee and employer amounts. Some people are unaware that there are income limits associated with traditional IRA and Roth IRA accounts. The Solo 401(k) has no income limits for the employee contribution. That allows high-income earners to qualify for much larger savings amounts in a 401(k) profit-sharing plan.
Recall that the Solo 401(k) plan is for businesses with no full-time employees. There is one exception—a spouse who earns income from the business. Your spouse, as a full-time employee, can make the same employee contribution you can make as the business owner up to the legal limits, including catch-up provisions if he or she has qualifying income. In addition, you as the owner can provide the same percentage of employer contribution to your spouse that you give yourself, up to 25% of compensation.
What are the contribution levels and limits of a Solo Roth 401(k)?
The savings inside of a Solo Roth 401(k) are made up of both employee and employer contributions. In this case, the employer is the employee. That is the definition of self-employed. When contributing to a Solo 401(k) as the employee, you are allowed up to $19,500 or 100% of compensation (whichever is less) for the tax year 2020 (and an additional $6,500 if you are over age 50). 1
Employers with Solo 401(k) plans or Solo Roth 401(k) plans can make a profit-sharing contribution of up to 25% of eligible compensation, capped at a total of $57,000 for both employer and employee contributions in 2020. Over age 50 catch-up contributions are in excess of the $19,500 and $57,000 caps.
Here’s one place where the tax distinction between the Solo 401(k) and Solo Roth 401(k) comes into play. In a Solo 401(k), the only option is tax-deductible, or pre-tax, savings. By contrast, the Solo Roth 401(k) offers two options. The doctor mentioned above could opt for traditional, tax-deductible savings or exercise the Roth feature—pay taxes today and not be concerned with paying taxes in the future, possibly at a higher rate. Roth savings are often referred to as post-tax savings with tax-free growth and tax-free withdrawals. While it’s nice to have both options, he would probably be wise to take the Roth route due to the restrictions on the employer contribution described below. This would also allow him to diversify his retirement savings from a tax perspective.
As an employee, the doctor will be able to save $19,500. (He is not yet 50.) This is a big advantage since, because of his $285,000 income, he would be unable to fund a regular Roth IRA because of the income phase-out in 2020 of $139,000 for Roth contributors who are single tax filers. (In 2020, for those who are married filing jointly, it is $206,000.) The traditional IRA income phaseout for singles is even lower at $75,000.
As an employer, the doctor can save an additional $37,500 for the tax year 2020 because employers with Solo 401(k) plans can make a profit-sharing contribution of up to 25% of compensation from the business. The $37,500 employer profit-sharing contribution is counted as traditional savings, which are tax-deductible for the doctor as the employer. The total contribution now totals $57,000 in tax-advantaged retirement savings, consisting of $19,500 in employee contributions and $37,500 in employer contributions. Even if the doctor, as an employee, had not made an employee contribution for the calendar year, he could make one as the employer for a total of $57,000. However, by doing it this way, he would not be able to save the money as a Roth contribution.
Mix-and-match contribution types
In our example, the doctor took advantage of both 2020 tax-deductible contributions as the employer and the Roth’s post-tax savings with tax-free withdrawals as the employee. In a Solo Roth 401(k) plan (not in a Solo 401(k) plan), the employee contributions could have been split in any combination between traditional and Roth. Typically, your employee contributions reduce your personal taxable income for the year and can grow tax-deferred, with distributions in retirement taxed as ordinary income. Roth contributions do not reduce your current taxable income, but your distributions in retirement are usually tax-free. However, with the employer contribution being made by himself, he is already getting a tax deduction for the contribution he made as an employer (the $37,500 tax-deductible contribution). You should see your tax advisor for guidance in this area.
Complement with outside employer plans
The Solo 401(k) and Solo Roth 401(k) can also complement other retirement plans in which one is an active participant. For example, say our doctor works for himself and for a hospital or clinic where he participates in a 401(k) plan that matches up to 3% of income. The doctor can leverage the Solo Roth 401(k) plan to add on top of those savings up to the statutory limits. Recall that the 2020 limit on the employee contribution is $19,500 and on the employer $57,000. On a $200,000 income at the clinic, the doctor saves up to the 3% limit to get the clinic’s match. So, the doctor receives $6,000 in a traditional, tax-deductible contribution to match the doctor’s own $6,000. Assuming the doctor has not made any other contributions to his Solo Roth 401(k), he could save $13,500 as an employee in Roth or traditional contributions. As an employer, he could make a $31,500 employer contribution.
Choose vendor based on investment strategist
When you sponsor your own Roth 401(k), you are also able to evaluate investment strategies from various investment strategists and decide which suits you best. You can then choose the recordkeepers, administrators, and custodians based on who works with the investment strategist of your choice. When working for someone else, you have to select from the investment choices made available through your plan. If you want to choose a brokerage, this typically comes with a fee on top of what your investment strategist or investment advisor charges. That sector fee could easily defeat the purpose of selecting the investment strategist with the plans that best suit you.
Business owners may find themselves strapped for cash. Unlike its cousin the SEP IRA plan, the Solo 401(k) allows the business owner the ability to take out a plan loan. Of course, there is a downside in that you must pay the loan back. And monies that aren’t invested can’t grow. As a result, this should be a last resort, but it’s a resort, nonetheless. The maximum loan you can take from your Solo 401(k) account is $50,000 or one-half of your account balance, whichever is less. (The Cares Act increased these limits for those affected by Covid.)
With its high savings of $57,000 in 2020 and its ability to provide both Roth and traditional savings, the Solo Roth 401(k) is packed with benefits. While the savings limits are the same as the SEP plan, the Solo Roth 401(k) allows for Roth savings contributions as well as the ability to take out plan loans. With all these features, it’s poised to boost the tax and savings opportunities for the self-employed business owner.