This article is part of a series on self-employed retirement plans, and was written by Robert D. Flach. Robert has been preparing business and individual tax returns for people in all walks of life since 1972. He writes the tax blogs THE WANDERING TAX PRO.
Article assumptions: Self-employed individuals have many types of retirement plans from which to choose. While these plans are available regardless of the type of business “entity” chosen, I will be discussing them from the point of view of the Schedule C filer. In such a situation the determination of the amount of the allowable contribution begins with the “net profit” reported on Line 31 of Schedule C or Line 3 of Schedule C-EZ.
All of the retirement plans that I will discuss are available to the one-man business with no employees, and I will limit my discussion to the contributions of the business owner. However these plans will require coverage of any qualifying W-2 employees of the business, and special rules will apply to contributions for employees.
Solo 401(k) Plan – Eligibility & Rules
A recently added self-employed retirement plan option is the Single-Participant 401(k) Plan, also called a Solo 401(k). The Solo 401(k) was created by the Economic Growth and Tax Reconciliation Act of 2001, and is similar to a traditional 401(k) plan that would be offered by a corporation or other large business. However, the Solo 401(k) plan is designed for a self-employed individual and requires less administrative upkeep compared to the corporate version of the 401(k).
Where can you open a Solo 401k? Small business retirement plans are found with many major brokerage houses, including Vanguard, Fidelity, Merrill Edge, TD Ameritrade, Charles Schwab Investments and more.
Solo 401(k) plan eligibility. The Solo 401(k) plan is only available to an individual business owner and his/her spouse. Part time workers that work less than 1,000 hours per year are excluded. If you have full-time employees, you will need to select another self-employed retirement plan.
Plan establishment and contribution deadlines. Like the Keogh Plan, a Single-Participant 401(k) must be established by December 31st. And, also like a Keogh Plan, an annual Form 5500 is required when your plan reaches $250,000 in assets. You have until the tax filing deadline (plus extensions) to make contributions.
Contribution limits. The Single-Participant 401(k) allows for a combination of “employee” deferral of up to the regular 401(k) maximums, $18,000 with a $5,000 catch-up for 2017 , and a discretionary employer match of up to 25% of compensation (20% of net earnings as with the SEP IRA and other plans). The combined maximum cannot exceed $54,000 for 2017, plus the appropriate “catch-up” additions if applicable.
Example Solo 401(k) contribution:
Let us say that for 2017 John Q Proprietor, a 53 year-old Schedule C filer, had $60,000 in net earnings from self-employment after the ½ of SE tax deduction. With a SEP IRA John can contribute $12,000 ($60,000 x 20%). However, with a single-participant 401(k) plan John can make a $23,000 ($18,000 + $5,000 catch up) “elective deferral contribution” as an “employee” and a $12,000 “employer” contribution, for a total of $32,500.
IRS Publication 560 (Retirement Plans for Small Business) has a worksheet to determine the deductible amount of contributions to a single-participant 401(k).
Benefits of Solo 401(k) plans
Maximize retirement contributions. Depending on your income, the solo 401(k) gives you the potential to put away more of your income than the SEP IRA, which has the same maximum contribution limit ($54,000 in 2017). Like the SEP IRA, Solo 401(k) plan owners can contribute 25% of their compensation as profit sharing, but Solo 401(k) plan owners can also contribute up to the first $18,000 as tax deferred contributions. So unless you can max out the entire $54,000 with a SEP IRA, the Solo 401(k) will allow you to contribute more money toward retirement. These are additional benefits of the individual 401(k) plan.
- Minimal administrative work. The associate paperwork is easy to file and maintain.
- Discretionary contributions; immediate vesting. Members are not required to contribute to their Solo 401(k) account. Your contributions are 100% vested immediately.
- Traditional and Roth options. The Solo 401(k) plan comes in two flavors – traditional and Roth. Like Traditional and Roth IRAs, the different versions of the Solo 401(k) give you different options for managing your taxes both now and in the future.
Here is more information about different self-employed retirement plans.