If you’re self-employed or a small business owner with no employees other than a spouse, a Solo 401k can help you save considerably more for retirement than you could with just an IRA or even through another employer’s retirement account (day job). You can have your cake and eat it too! You can have a corporate 401k at your day job and a Solo 401k for your small business. You can increase your retirement savings while at the same time reducing your tax bill for the year.
If you are only familiar with a corporate 401k through your employer, you probably have no idea that the allowable tax-deferred contribution limit is much higher than what they offer through their limited plan. You can max out your day job 401k to make sure you take all the matching contributions that your employer offers and still make another matching contribution to your Solo 401k by being your own boss. It pays to be your own boss!
A Solo 401k Has the Highest Allowable Contribution Limits
The dollars are huge when you take full advantage of contributions to a Solo 401k plan. In 2022, employees of a business with a Solo 401k can contribute up to $20,500 per year. This is a $1,000 increase over 2021. But that is only part of the contribution story. There is also the catch-up contribution of $6,500. This is for people that are at least 50 years old. And… when you include the employer (profit sharing) portion, the total contribution limit rises to $61,000 or $67,500 if age 50 or over in 2022. Now… double that for a spouse for a whopping $122,000 or $135,000 if both are at least 50 years old.
Solo 401k contributions are a powerhouse in your retirement plan for several reasons:
- Contributions can be tax deductible. This can result in paying fewer taxes on the money you’ve earned.
- Contributions can be Roth, allowing your investments to grow tax-free.
- High contribution limits for a Solo 401k plan can help you supercharge aggressive wealth growth.
Here we summarize the Solo 401k contribution basics and the multiple options available for you to customize your account in ways that maximize your retirement savings while reducing your taxable income at the same time.
Solo 401k Employee Contributions
When you are a business owner, you are both the owner (employer) and an employee of your business. That gives you incredible flexibility about how much you can contribute to your Solo 401k in both roles. It is the combination of the employee and employer contributions that make up the total $61,000 or $67,500 if age 50 or over in 2022.
The contribution that you make as an employee is known as an “Elective Deferral.” As an employee, you can contribute 100% of your compensation up to $20,500 for 2022 ($27,000 for employees age 50 or older). Keep in mind, as your own boss, you get to decide how much compensation you earn each year.
Only the employee portion of the contribution can be made to after-tax Roth accounts (more on Roth accounts below). As an employee, you also have the flexibility to make traditional tax-deferred or Roth after-tax contributions. Rollovers of assets are also permitted.
You need to know that the total of $20,500 in elective deferrals is capped across all plans. Therefore, if you make employee contributions to your “day job,” you have to subtract that amount from your remaining Solo 401k employee contributions. However, a similar cap does NOT apply to the business contribution. You can receive the full contributions of both your day job matching funds and your own business contributions.
Solo 401k Business Contributions
The business contributions are also known as “employer profit-sharing” contributions or “matching” contributions in a Solo 401k. You can contribute 25% of the net profits your business makes. Employer contributions are pre-tax only.
Your business can contribute up to 25% of compensation not to exceed $61,000 for the 2022 tax year. This is a huge advantage because your day job 401k is not going to share this amount of their business profits. Additionally, this contribution lowers your business tax because contributions are deductible as a business expense. Keep in mind, as the owner, you can vary the amount contributed each year, and contributions aren’t required every year.
Business profit-sharing contributions are based on your net profits minus half of your self-employment tax and the plan contributions you made for yourself (and any participating spouses). The limit on compensation used to factor in your annual contribution is $305,000 for 2022.
Total contributions. As a business owner, you can contribute both as an employer and employee. The combined amount of employer plus employee contributions can’t exceed $61,000 for the 2022 tax year ($67,500 if age 50 or older).
The Solo 401k plan by Nabers Group is the most flexible and compliant plan available. That’s because we designed a plan we would want to use ourselves as fellow business owners. Therefore, we made the total allowable contributions in our documents as flexible as possible. Plus, you can contribute on your own schedule, and there are no minimum contributions. Use the Solo 401k Contribution Comparison Calculator to estimate the potential contribution that can be made to a Solo 401k plan compared to a Profit Sharing, SIMPLE, or SEP plan.
Traditional Solo 401k Contributions
You have a choice about which type of Solo 401k tax advantage will work best for you. You can pick the traditional Solo 401k under which your employee contributions reduce your income in the year they are made (tax-deferred). In this case, the distributions that come later will be taxed as ordinary income – possibly when you are in a lower tax bracket. The alternative is the Roth Solo 401k, which does not have a tax advantage in the contribution year but does provide tax-free distribution of all the earnings. You should also know that you can make a combination of traditional and Roth contributions in any given year — the maximum flexibility possible.
The big desirability of a traditional Solo 401k is the high contribution limit mentioned above. Additionally, Solo 401k contributions can make you eligible for added tax breaks. If your business is not incorporated, you can generally deduct contributions for yourself from your personal income. If your business is incorporated, you can count the contributions as a business expense. Contributions to a traditional Solo 401k let you reduce your taxable income, helping to reduce your tax bill.
After taking the tax-deferred income deduction, any money you invest will continue growing and compounding tax-deferred until retirement. Besides the tax treatment, a major difference between traditional and Roth contributions comes at the time of withdrawal (distribution).
With traditional Solo 401k plans:
- Withdrawals before age 59½ may be subject to a 10% early withdrawal penalty, along with any applicable income taxes. But you can retire at age 59½ without paying penalties.
- You must take the required minimum distributions from Solo 401ks beginning at age 72.
- Plans can be structured to allow for loans or hardship distributions.
Because of its high contribution levels, flexible investment options, and relatively easy administration, the Solo 401k is an attractive option for small-business owners or sole proprietors who want to be able to save aggressively for the future.
Roth Solo 401k Contributions
Truth be told, not paying those taxes today could turn out to be a disadvantage of the Traditional Solo 401k. Choosing between a Traditional and Roth 401k mostly involves what income tax bracket you are in today and what income bracket you expect to be in when you retire. When your Solo 401k account accumulates substantial wealth, you may end up in a higher tax bracket during your retirement years than during your working years. This could mean paying taxes today will be less than taxes after retirement.
In general, a Roth Solo 401k can be a better option if you expect your income to be higher in retirement. All of the earnings are tax-free at distribution. And since you’ve already paid taxes on contributions in the year earned it means you pay NO TAXES at distribution.
However, a Roth Solo 401 is not just about your tax bracket in retirement. It could be about your tax bracket today. If this is a time in your life when your income is low (usually at a young age), it can make good financial sense to pay the taxes on that income while in a lower tax bracket and allow your Solo 401k to grow tax-free for many years and remain tax-free at retirement. Remember, you are not locked into a traditional or a Roth account. When your income goes up in a few years and the deferred tax makes more sense, you can switch to a traditional Solo 401k or even make contributions to both in the same tax year.
Another exceptionally good time to choose this investment vehicle is when you expect an extraordinarily high rate of return on an investment because the earnings are tax-free at retirement. For instance, Nabers Group began investing in Bitcoin using a Roth Solo 401k in early 2013 because we expected the payoff to be extraordinary and gains will be tax-free whenever we’re ready to cash out and take our distribution at retirement age.
Solo 401k Contributions for Sole Proprietors
A sole proprietorship is the most common business structure. That’s probably because it’s the easiest structure to use! A sole proprietorship means a “single owner.” As a sole proprietor, you might do business under your own name, or you could have a DBA (doing business as) fictitious business name. You might have an employer identification number (EIN) for your business, or you might use your social security number.
As a sole proprietor, you can make the same level of contributions as you could if you incorporated, had a partnership, or operated as an LLC. First, determine or estimate your net profits for the business. This will generally be reflected on Schedule C of your tax return.
Then, determine your employee (elective deferral) and employer (profit sharing) contribution amounts. Use our contribution calculator to determine your Solo 401k contribution for your sole proprietorship. Your maximum profit-sharing contribution may be up to 20% of your net compensation (as shown on Schedule C). The total contribution to your Solo 401k plan will be the aggregate of your salary deferral and profit-sharing contribution.
Solo 401k Contributions for Partnerships and LLCs
A Limited Liability Company (LLC) is a very popular business structure. It’s easy to set up and simple to maintain. The owner of the LLC is known as the member. An LLC can be a single-member or multi-member company. Further, the LLC may be taxed as a partnership or taxed as a corporation. LLCs are formed at the state level with the secretary of state.
The LLC contribution limits may change according to a couple of factors:
- Is the LLC single or multi-member?
- Is the LLC taxed as a partnership or a corporation?
A single-member LLC is a disregarded entity. Generally, a single-member LLC doesn’t have its own tax return. Instead, the revenue flows onto Schedule C of the member’s tax return.
A multi-member LLC taxed as a partnership files tax form 1065 and issues a K-1 to each member. The member then files his Schedule K1 with his annual tax return. If the LLC is taxed as a corporation, the entity files tax form 1120S and pays its members via W2.
All are relatively simple to accomplish. First, determine or estimate your net profits for the business. These will either be reflected on Schedule C or Schedule K1 of your tax return, depending if your LLC is single or multi-member. Then, determine your employee (elective deferral) and employer (profit sharing) contribution amounts. Use our helpful contribution calculator to determine your Solo 401k contribution for your partnership or LLC.
If your LLC is a single-member entity, your maximum profit-sharing contribution may be up to 20% of your net compensation (as shown on line 14 of Schedule K-1). If your LLC is a multi-member entity, your maximum profit-sharing contribution may be up to 25% of your net compensation (as shown on line 14 of Schedule K-1). The total contribution to your Solo 401k plan is the aggregate of your salary deferral and profit-sharing contribution.
Solo 401k Contributions for Corporations
Owners of corporations are called shareholders. Corporations are formed at the state level with the secretary of state. All business is done under the Corporation name, using the designated corporation tax ID number. This can give limited liability protection to the shareholder. In the case of a lawsuit, the shareholder’s assets are generally protected. Only the corporation assets are involved in the suit.
There are generally two types of corporations:
- Subchapter S Corporation: also known as an S-corp. The S-corp is a type of pass-through entity for taxation. The S-corp does not pay corporate taxes. Instead, earnings are passed through to the shareholders, who then pay taxes on the earnings on their personal tax returns.
- C-Corporation: must pay corporate income taxes. Owners/shareholders pay taxes on their profits/dividends and earnings. Both the owner (personal) and corporation (business) pay taxes on the earnings. This creates double taxation.
Determining corporate Solo 401k contributions is much the same as with the other business structures. First, determine or estimate your net earnings. Keep in mind earnings are different than dividends. Contributions are based on earnings, not dividends. Similarly, S-corp shareholders must calculate contributions based on earnings, not pass-through profits. You will generally show your earnings in Box 1 of the IRS W2 form.
Next, determine your employee (elective deferral) and employer (profit sharing) contribution amounts. Use our helpful contribution calculator to determine your Solo 401k contribution for your corporation. The total contribution to your Solo 401k plan will be the aggregate of your salary deferral and profit-sharing contribution.
Solo 401k voluntary after-tax contributions are a special way to get some extra cash into your self-directed retirement plan. But beware, as not all Solo 401k providers offer voluntary after-tax contributions in the plan.
The Solo 401k voluntary after-tax contribution is a type of employee salary deferral contribution. However, unlike the pre-tax or Roth employee contribution, the amount you can contribute can be much higher. While all Roth contributions are after-tax, not all after-tax contributions are Roth.
Solo 401k voluntary after-tax contributions do not start out as Roth funds. However, if you designate your plan to allow it, you can convert the voluntary after-tax contributions to Roth funds with an in-plan Roth conversion. The Solo 401k by Nabers Group allows for both voluntary after-tax contributions and in-plan Roth conversions.
These pieces are necessary to implement a strategy called the Mega Backdoor Roth Solo 401k. The mega backdoor Roth strategy allows you to compliantly get far more than the typically allowed limit of Roth funds into the plan via contributions.
When Does a Solo 401k Have to Be Established?
To make a contribution to a Solo 401k for 2022, you are required to establish your account before the end of the year — by December 31, 2022. It’s possible to make contributions to a Solo 401k after the new year (and before your tax filing deadline, which is normally April 15) provided your business isn’t incorporated.
Others imitate, but as the #1 Solo 401k provider, we innovate. You can be a freelancer, independent contractor, or small business owner. Your business can be structured as a sole proprietorship or a formally structured LLC, C Corp, or S Corp. All of these meet the IRS qualifications for a Solo 401k as long as there are no outside full-time employees in any business owned by you and/or your spouse.
The Solo 401k from Nabers Group provides more investment options, the highest contribution limits, and the lowest fees of any fully self-directed retirement plan.