Imagine that you are a sole proprietor with a high income, and you’re looking for a way to maximize your retirement savings while reducing your taxable income. You’ve heard about SIMPLE IRAs and SEP IRAs, and you used to contribute to a 401(k) when you had a corporate job. Did you know that it is simple to set up your own 401(k) and you can contribute up to $61,000 a year to it ($67,500 if over age 50)? Introducing the Individual 401(k)!
Individual 401(k)s are also known as Solo 401(k)s, Solo-ks, Single-ks, Self-Employed 401(k)s, Uni-ks and One-participant ks. This type of plan is like a traditional 401(k) covering business owners with no other employees. The plan can also cover the business owner’s spouse. It is also possible for the business to have employees, but they cannot be full time, as defined by the plan document.
Individual 401(k)s, as compared to traditional 401(k)s, are easier to set up and administer, allow for the maximum amount of retirement plan contributions in a defined contribution plan, can allow for loans of up to 50% of the plan value up to a $50,000 maximum, and can accept rollovers from other retirement plans like IRAs, traditional 401(k)s and 403(b)s. Another remarkable benefit is that the Individual 401(k) can accept both Roth (after-tax) and traditional (pre-tax) employee contributions, which allow for greater flexibility of contribution type depending on the business owner’s tax situation.
You need to take a few steps to start maximizing the benefits of an Individual 401(k):
- Set up the Individual 401(k) plan.
- Appoint a plan administrator.
- Find a financial institution to hold the plan’s investments.
- Calculate allowable contribution amounts.
- Make contributions to the plan.
- Invest the plan contributions.
Setting up the Individual 401(k)
The first step toward making contributions to an Individual 401(k) is creating the actual plan. This requires the business owner or plan administrator to complete a basic plan document, adoption agreement, account applications and other paperwork. This process has been simplified for Individual 401(k)s and is handled in tandem with the plan administrator or financial institution that will hold the plan’s assets.
Appoint a Plan Administrator
Plan administrators have the fiduciary duty of taking care of the administrative responsibilities and ensuring the plan is operating according to the plan document. This could include completing and maintaining the plan’s adoption agreement, establishing accounts for the business owner, filing annual informational returns with the IRS, and calculating contribution amounts. The business owner can choose to fill this role or outsource it to a firm that specializes in retirement plan administration, like Compass Retirement Group in New Hampshire.
Find a Financial Institution
Once you have the plan established, you will need to find a financial institution that allows you to set up Individual 401(k) accounts that you can make contributions to. Key considerations that you’ll want to look at when opening the accounts are the fees, account minimums, investment options, trading costs and plan features. Fidelity offers a simplified process for setting up Individual 401(k) plan documents and accounts with no account fees and no minimums. Schwab, Vanguard, TD Ameritrade, and E-Trade also have Individual 401(k) account options.
A business owner may make contributions to an Individual 401(k) as both an employee and the employer. The process for determining the maximum contributions for each is dependent on the type of business structure. The chart below shows the maximum contribution amounts for each contribution type.
Determining “Earned Income”
The first step is to determine the amount of compensation or earned income that the calculation is based on to ensure that you make the appropriate contribution amounts for both the employer and employee contribution. As mentioned above, this depends on the type of business and entity.
- Sole Proprietors: Net profit on Schedule C of the IRS Form 1040. On the 2021 Schedule C, this can be found on line 31.
- Partnerships and LLCs Taxed as Sole Proprietors: Ordinary business income, which is box 1 on Schedule K-1.
- S Corporation, C Corporation, or LLCs Taxed as a Corporation: Wages paid to the business owner that would be represented on Form W-2.
Employee contribution calculations are handled differently depending on the business type described below:
- Sole Proprietors, Partnerships, and LLCs Taxed as Sole Proprietors: An adjustment for 1/2 of the self-employment tax must be made to calculate the maximum allowable employee contribution. This number is calculated by multiplying the net profit or ordinary business income by 7.65% (1/2 of 15.3%). This 1/2 of self-employment tax figure is also represented as an adjustment to income on line 15 of Schedule 1 of the IRS Form 1040.
- Example: Steve, age 40, is a self-employed business owner who reports his business earnings on a Schedule C of the IRS Form 1040. In 2022, his net profit was $15,000. Although the IRS allowed contribution is a $20,500 employee contribution to his Individual 401(k), he does not have the income to support it. The maximum contribution he can make is $15,000 minus $1,147.50 (1/2 of the self-employment tax) for a total limit of $13,852.50.
- S Corporation, C Corporation or LLCs Taxed as a Corporation: Wages paid to the business owner that would be represented on Form W-2 are all countable toward elective deferrals that the employee can make toward the maximum contribution amount, and no adjustments need to be made.
Employer contribution calculations are also handled differently depending on the business type described below:
- Sole Proprietors, Partnerships and LLCs Taxed as Sole Proprietors: Up to 25% of earned income (defined above) can be contributed as employer contributions but with two adjustments. The 1/2 of self-employment tax must first be subtracted from earned income before the calculation is made. Further, the 25% figure is reduced to a maximum of 20% because for each $1.00 that is being contributed as an employer contribution, the earned income is being reduced by another $1.00. Because this is a circular calculation, the effective maximum contribution amount is 20% of earned income after 1/2 of the self-employment tax adjustment.
- Example: Bob, age 55, is a sole proprietor with $100,000 of net profit reported on his Schedule C. He has an Individual 401(k) and wants to maximize his contributions to the plan for 2022. He first maximizes his employee elective deferrals that he makes to the plan of $20,500 and $6,500 for a total of $27,000. To calculate his employer contribution, he subtracts $7,065 (the deduction for 1/2 of self-employment tax) from $100,000 for a starting point of $92,935. He then multiplies $92,935 by 20% for a maximum employer contribution of $18,587. His total employer and employee contribution is $45,587 ($27,000 + $18,587).
- S Corporation, C Corporation or LLCs Taxed as a Corporation: Up to 25% of compensation as defined by the plan. This is a straightforward calculation because no adjustments need to be made.
For all business types, the total contribution amounts are limited to $61,000 (2022), or $67,500 if the business owner is 50 or older. Since the employee contribution is limited to 100% of earned income vs 25% for employer contributions, it makes sense to start by contributing the maximum employee contribution first and then making employer contributions if there is sufficient earned income to support it.
Once you calculate how much you can contribute to the Individual 401(k), you can start making contributions immediately. Both employee and employer contributions can be made throughout the year, as long as there is sufficient income to support the contributions. Sole proprietors, partnerships and LLCs taxed as sole proprietors can make both employee and employer contributions up to the tax filing deadline (April 15 or September 15 with an extension). For S corporations, C corporations or LLCs taxed as corporations, the employee deferrals must be elected by the end of the tax year (December 31) and made by January 15 of the following year at the latest. Employer contributions can be made up to the tax filing deadline (April 15 or September 15 with an extension).
Roth (After-Tax) vs. Traditional (Pre-Tax) Contributions
Employee contributions can be made to either a Roth (after-tax) or traditional (pre-tax) account. Employer contributions must be made to a traditional (pre-tax) account. Deciding which tax type of account to contribute to largely depends on your individual tax situation, and it is best to consult with your tax advisor for this decision.
The basic difference between a Roth 401(k) and a traditional 401(k) is that the Roth 401(k) is funded with after-tax contributions, while the traditional 401(k) is funded with pre-tax contributions. With a Roth 401(k), you pay taxes today on your earned income in return for tax-free withdrawals in retirement. Traditional 401(k) contributions are tax deductible today, but withdrawals are taxed in retirement.
As mentioned before, one of the great benefits of the Individual 401(k) is that you have the flexibility to contribute to both types of accounts, which isn’t the case in SEP IRAs and SIMPLE IRAs.
After you’ve made the contributions to the accounts, the final step is to select investments. These can be mutual funds, exchange-traded funds (ETFs), individual stocks or bonds, or other assets allowed by the financial institution to be held in the account. Which investments you choose depends on many factors, including risk tolerance, taxes, age and personal preference. You can make the investment decisions on your own or consult a Certified Financial PlannerTM.
If you are a business owner and want to boost your retirement savings, you should strongly consider the Individual 401(k). If, after reading this blog article, you want to learn more about the Individual 401(K) and how it can supercharge your retirement, please reach out to our team. We can discuss with you how the Individual 401(k) fits into your other retirement savings, investments, tax situation, and financial plan.
Jonathan Harrington, CFP®, MSFP, MST is an advisor at Milestone Financial Planning, LLC, a fee-only financial planning firm in Bedford NH. Milestone works with clients on a long-term, ongoing basis. Our fees are based on the assets that we manage and may include an annual financial planning subscription fee. Clients receive financial planning, tax planning, retirement planning, and investment management services, and have unlimited access to our advisors. We receive no commissions or referral fees. We put our clients’ interests first. If you need assistance with your investments or financial planning, please reach out to one of our fee-only advisors.