Many freelance business owners regret the fact that they do not have a corporate business 401 (k) plan. They should not be aware that they can establish their own 401 (k) plan that has even more flexibility than a corporate one. And those who do know this generally research the plan only for tax advantages, but should also think about retirement benefits.
Recently, he was talking to a doctor who plans to go into business for himself. He decided to join as S Corp. He had accounts from previous employers and was wondering what to do with them. You will have no employees in your business. I suggested that he research a Roth Solo 401 (k), which should really be called Solo Roth 401 (k), profit-sharing plan.
Qualification for a Solo Roth 401 (k)
A Participant’s 401 (k), Solo 401 (k), and Solo Roth 401 (k) plans are tax-advantaged retirement accounts for self-employed or business owners without full-time employees. These plans can also be called Self-Directed 401 (k), Individual 401 (k), Individual Roth 401 (k), Self-Employed 401 (k), Staff 401 (k), or One Participant 401 (k), Solo 401 (k), Solo-k, Uni-k, or One Participant k, depending on the provider offering the plan. Qualification for a Solo 401 (k) requires earned income, which is also true for a 401 (k) plan, SEP, 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 The Solo Roth 401 (k) involves savings already withdrawn tax free. Most of the 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 401 (k). However, technically, that refers only to the part 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 for employee and employer amounts. Some people are unaware that there are income limits associated with traditional and Roth IRA accounts. The 401 (k) Solo has no income limits on the employee’s contribution. That allows high-income people to qualify for much greater savings on a 401 (k) profit-sharing plan.
Remember that the Solo 401 (k) plan is for companies 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 that you can make as a business owner up to the legal limits, including recovery provisions, if you have qualified income. Additionally, you, as the owner, can provide the same employer contribution percentage to your spouse as yourself, up to 25% of compensation.
What are the levels and contribution limits of a Solo Roth 401 (k)?
Savings within a Solo Roth 401 (k) are made up of contributions from employees and employers. In this case, the employer is the employee. That is the definition of autonomous. By contributing to a Solo 401 (k) as an employee, you are allowed up to $ 19,500 or 100% of compensation (whichever is less) for fiscal year 2020 (and an additional $ 6,500 if you are age 50 or older).one
Employers with Solo 401 (k) plans or Solo Roth 401 (k) plans may make a profit-sharing contribution of up to 25% of eligible compensation, with a total limit of $ 57,000 for contributions from both the employer as well as employees in 2020. Over 50s recovery contributions exceed limits of $ 19,500 and $ 57,000.
Here’s a place where the tax distinction between Solo 401 (k) and Solo Roth 401 (k) comes into play. In a 401 (k) Solo, the only option is tax deductible or pre-tax savings. In contrast, the Solo Roth 401 (k) offers two options. The doctor mentioned above could go for traditional tax-deductible savings or exercise the Roth function: pay taxes today and not worry about paying taxes in the future, possibly at a higher rate. Roth savings are often called after-tax savings with tax-free growth and tax-free withdrawals. While it is good to have both options, it would probably be wise to take the Roth route due to the restrictions on employer contribution described below. This would also allow you to diversify your retirement savings from a tax perspective. (You may want to read my previous articles on traditional savings versus Roth savings and their possible impact on retirement.)
As an employee, the doctor will be able to save $ 19,500. (He is not 50 years old yet.) This is a huge plus since, due to his $ 285,000 income, he would not be able to fund a regular Roth IRA account due to the 2020 elimination of income of $ 139,000 for Roth taxpayers who are single taxpayers . (In 2020, for those who are married filing a joint return, it is $ 206,000.) The gradual elimination of income from the traditional IRA for singles is even less at $ 75,000.
As an employer, the doctor can save an additional $ 37,500 for fiscal year 2020 because employers with Solo 401 (k) plans can make a profit-sharing contribution of up to 25% of company compensation. The $ 37,500 contribution to the employer’s share of earnings is counted as traditional savings, which are tax deductible to the physician as an 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 during the calendar year, she could still make one as an employer totaling $ 57,000. However, by doing it this way, you could not save money as a Roth contribution.
Match and combine contribution types
In our example, the doctor took advantage of 2020 tax deductible contributions as an employer and Roth’s after-tax savings with tax-free withdrawals as an employee. In a Solo Roth 401 (k) plan (not a Solo 401 (k) plan), employee contributions could have been split in any combination between traditional and Roth. Generally, your employees’ contributions reduce your personal taxable income for the year and can grow with tax deferrals, with retirement distributions taxed as ordinary income. Roth contributions do not reduce your current taxable income, but your retirement distributions are generally tax-free. However, with the employer contribution made by yourself, you are already receiving a tax deduction for the contribution you made as an employer (the $ 37,500 tax deductible contribution). You should consult your tax advisor for guidance in this area.
Supplement with external employer plans
Solo 401 (k) and Solo Roth 401 (k) can also complement other retirement plans in which one is an active participant. For example, suppose our doctor works for him and for a hospital or clinic where he participates in a 401 (k) plan that equals up to 3% of income. The doctor can take advantage of the Solo Roth 401 (k) plan to add in addition to those savings up to the legal limits. Remember that the 2020 limit for employee contribution is $ 19,500 and for the employer $ 57,000. With a $ 200,000 income in the clinic, the doctor saves up to the 3% limit to get the clinic match. The doctor then 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 your Roth Solo 401 (k), you could save $ 13,500 as a Roth employee or traditional contributions. As an employer, you could make an employer contribution of $ 31,500.
Choose a provider based on investment strategist
When you sponsor your own Roth 401 (k), you can also evaluate the investment strategies of various investment strategists and decide which one is best for you. You can then choose the registrars, managers, and custodians based on who works with the investment strategist of your choice. When working for someone else, you must select from the investment options available through your plan. If you want to choose a broker, this usually comes with a fee in addition to what your investment strategist or investment advisor charges. That industry fee could easily defeat the purpose of selecting the investment strategist with the plans that suit him best.
Business owners may find themselves strapped for cash. Unlike its cousin the SEP IRA plan, the Solo 401 (k) allows the business owner the possibility of obtaining a loan from the plan. Of course, there is a downside to having to pay back the loan. And the money that is not invested cannot grow. As a result, this should be a last resort, but it is a resource nonetheless. The maximum loan you can get from your Solo 401 (k) account is $ 50,000 or half your account balance, whichever is less. (The Care 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, Roth Solo 401 (k) allows Roth savings contributions as well as the ability to borrow from the plan. With all of these features, you’re ready to increase tax and savings opportunities for a self-employed business owner.