How a Solo 401(k) Can Increase Retirement Savings

If you’re self-employed, you could be facing deadlines for important decisions about establishing a retirement account before year-end. One of the most valuable self-employed savings vehicles, whether you’re a sole proprietor or more formally established, is a solo 401(k), also known as an individual 401(k). This powerful retirement savings account allows flexibility and a significant tax-deferral opportunity, far greater than traditional 401(k) accounts. If this account is right for you, you can defer contributions until your tax filing, but the deadline to establish an account for the current tax year is December 31.

Why Is a Solo 401(k) So Powerful?

A solo 401(k) is more powerful than traditional employer 401(k) plans as it allows you to complete salary deferrals up to the same limits of traditional plans, plus you have the potential to make a significant profit-sharing contribution over and above those traditional contribution limits. Depending upon your income, a solo 401(k) plan could allow you to contribute up to $53,000 in 2016 (or up to $59,000, if you’re age 50 or older). That’s significantly higher than the traditional limits of $18,000 or $24,000 if you’re age 50 or older for traditional employer-sponsored 401(k) plans (For more, see: Taxable Pay Strategies for Business Owners.)

The explanation of how this is possible is that you effectively get to wear two hats when you’re self-employed and running your own business: both an employee hat and an employer hat. From the standpoint of being an employee, you can make the same traditional salary deferral contributions of up to $18,000 (or $24,000 if you’re age 50 or older) as any other employee of an employer-sponsored 401(k) plan.

However, you also get to wear an employer hat, allowing you to reward yourself for your hard work by making a profit-sharing plan contribution. This contribution may be up to 20% of your annual net income, adjusted for self-employment taxes. This feature allows you to save in excess of the traditional employer 401(k) limits, helping to defer more taxable income and boost your retirement nest egg.

Contribution Flexibility

Just like a traditional 401(k) plan, all contributions to a solo 401(k) are elective, meaning there are no requirements to contribute each year. This gives you broad flexibility on the timing and amount of your contributions. Furthermore, your profit-sharing plan contribution can be made anytime before you file your tax return. This allows you more time to save, if needed, in order to gain the maximum tax deferral benefit.

Can I Contribute If I Have a Business on the Side?

Even if you’re employed elsewhere and have a business on the side, a solo 401(k) plan could represent a significant financial opportunity for you. If you’re covered by a 401(k), 403(b), thrift savings plan, or other qualified retirement accounts, you can maximize your salary deferral (or employee) contribution through either your employer plan, your own solo 401(k) or a combination thereof. However, you can’t exceed the maximum employee salary deferral limit in aggregate. (For related reading, see: A Defined Benefit Plan for Small Business Owners.)

Example: If you’re age 52 and you already contribute $24,000 to your employer plan, you can only make a profit-sharing contribution to your solo 401(k). Conversely, if you only contributed $20,000 to your employer plan, you can contribute an additional $4,000 in salary deferral contribution to your solo 401(k) plan, plus a profit sharing plan contribution.

What Precautions Do I Need to Know?

Solo 401(k)s offer you greater contribution potential by allowing you to make profit-sharing contributions on top of traditional 401(k) contribution thresholds. However, there are three key elements that you need to consider:

  1. The investment selections available to you within a solo 401(k) plan are often far greater than those offered under traditional employer 401(k) plans. This means that you have a lot more investment due diligence to perform, more extensive decisions to make with broader potential impacts on your long-term wealth objectives. We recommend that you work with a Registered Investment Advisor who can evaluate your options and guide your decision making.
  2. When your individual 401(k) balance exceeds $250,000, you must file a Form 5500 with the IRS.
  3. Maximum profit-sharing contribution calculations are generous, but the calculation can be complex due to adjustments for self-employed taxes. It’s best to work with a professional tax preparer to calculate your maximum contribution and to ensure that it’s properly reported for tax deduction purposes.  

If you’re self-employed or a small business owner, a solo 401(k) is one of a range of options available to help maximize your tax planning opportunities and minimize your taxes. As the end of the year approaches, it’s important to ensure that you’re benefiting fully and that the financial decisions you make support both your personal and business financial objectives. (For more, see: 4 Mistakes to Avoid with Your Retirement Plan.)


The information contained herein is obtained from sources believed to be reliable, but its accuracy or completeness is not guaranteed. This article is for informational purposes only. The views expressed are those of SageVest Wealth Management and should not be construed as investment advice. All expressions of opinions are subject to change and past performance is no guarantee of future results. SageVest Wealth Management does not render legal, tax, or accounting services. Accordingly, you, your attorneys and your accountants are ultimately responsible for determining the legal, tax and accounting consequences of any suggestions offered herein.

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