The IRS refers to the Individual 401(k) as a one-participant 401(k). Also known as a Solo-k or Uni-k, the Individual 401(k) is the basic retirement account for the self-employed individual who has no employees.
Eligibility requirements
- You must be self-employed and own your own business
- The business may be structured as a Sole Proprietorship, a Partnership or a corporation (such as S-corp or C-corp)
- The business must generate income to contribute to the 401(k) plan
- You must not have any employees, other than your spouse
- No nondiscrimination testing is required for a Solo 401(k). These tests are the IRS’s way of figuring out if all employees are getting commensurate benefits. They do not want employers to get an unfair advantage of being able to put in more into qualified retirement plans than their employees. But since there are no other employees, testing is not necessary.
- If you hire other employees who are eligible to participate in the retirement plan, you must change the individual 401(k) to another qualified plan which includes them and make sure to meet all nondiscriminatory plan requirements.
Individual 401(k) contribution limits
As a business owner, you are both an employEE as well as an employER of the business. So you get to contribute to the Solo 401(k) in both buckets.
The total you can contribute towards the plan, both buckets included, is $57,000 for 2020.
Employee Contribution
- As an employee of your own business, you get to contribute “Elective deferrals”. You can contribute up to 100% of your compensation, up to a maximum of $19,500 for 2020.
If you are 50 or older, you get a $6000 catch-up contribution. Both of these values are adjusted annually.
Please note, this is the maximum you can contribute as an employee towards all 401(k) plans that you may have access to. Say you also have an employed position, as a W-2 physician, and contribute to a 401(k) plan through your work there. Then you’ll get to contribute only the difference to make up the total to $19,500 towards your individual 401(k).
If you contribute $19,500 at your work 401(k), then you may not contribute any more towards your individual 401(k).
If you only contribute $10,000 at your work 401(k)- maybe to get an employer match- then you may contribute $9500 in your solo-k to make up the total to $19,500.
Employer Contribution
2. The second bucket is referred to as “non-elective contributions” or the “Profit Sharing” component. It is your contribution to the individual 401(k) as an employER.
Profit Sharing can range from 0-25% of plan compensation, but staying within total contribution limits. For 2020, if you are maxing out the employee contribution at $19,500, then the max you can put in for profit sharing is $57000-19,500= $37,500.
Plan compensation is defined by net earnings from self employment after deducting both:
- One half (the deductible portion) of self-employment taxes (from Line 14 of Form 1040) as well as
- your contributions to the plan (on Line 15 of Form 1040)
So it’s a bit of a Catch-22. You need to know your compensation in order to calculate your contribution. And you need to know the contribution in order to figure out your compensation.
Trust the IRS to keep it simple.
Sole proprietor versus S corp
As a sole proprietor, you don’t pay yourself a W2. So your compensation is the same as net business profit reported on Schedule C, i.e., gross income minus business expenses.
Adjusted net business income = Net business income (-) 1/2 SE tax
Self Employment Tax includes Social Security Tax of 12.4% on the first $137,700 you make + 2.9% of Medicare Tax on your entire income.
0.9% Additional Medicare Tax on income more than $200,000 is not included among SE Tax.
You get to contribute 20% of adjusted net business income towards the Profit Sharing/employER portion of your Individual 401(k), as a sole proprietor.
If you elect file taxes as an S-corp, you take some of your compensation in the form of W-2 wages from your business. The rest you take as distributions. For purposes of contributions to the individual 401(k), only the W-2 wages count. The distributions do not.
And the employER contribution is a maximum of 25% of W2 compensation.
Online Calculators
I have found these calculators to be most helpful:
- For Sole Proprietors, Mike Piper’s calculator at The Oblivious Investor.
- For S corp, use the one at Solo401kCalculator.com or Solo401k.com
- If you have W2 employment, and a side gig for which you are contributing to a solo-k, use The Finance Buff’s very useful spreadsheet.
If you like math enough, IRS Pub. 506 has a worksheet for it.
Contribution Limits: Sole Proprietor versus S corp
If you play around with these calculators, you will find that at lower income levels, you get to contribute different amounts towards the profit sharing component, depending on whether you are a sole proprietor or an S corp.
For example, if you have $100,000 in net business income (gross income – expenses) as a sole proprietor, you are able to contribute a max of $18,587 towards profit sharing (20% of adjusted net business profit)
If you have the same $100,000 in S corp wages, you get to contribute $25,000 as profit sharing (25% of compensation).
We typically do not encounter this issue since most people do not elect to file as S corp with lower income.
Once income hits the level needed to max out 401(k) contributions, ie., $198,699 for 2020, this difference disappears.
The exact amount of contribution also depends on other income you have. Based on this, you may have maxed out Social Security Tax on your other wages and it may not apply to your self-employed income.
General characteristics of Individual 401(k) Plans
- Plan contributions are generally tax-deferred. This means that you get to take a tax deduction on your contribution for the year of contribution. Once part of the plan, these funds grow tax deferred until withdrawal.
- You may also choose to designate part or all of your contributions as Roth contributions. In this case, you do not get an upfront tax deduction. You are putting in post-tax money, which will not be taxed again, at least the way current laws stand.
- You may have a custom plan that lets you make optional, after-tax, non Roth employee contributions. The total contributions should still be $57,000 or under (for 2020).
- You need an EIN for the business in order to set up a solo-k.
- The 401(k) plan must be started before December 31 of the year you wish to contribute.
- The actual contributions can be made anytime before tax filing deadline that is, generally April 14th of the following year. This is helpful because business earnings often become clear after the year is over. Also, contributions (towards 2020) made the following year (say, March 2021) can be recharacterized for that calendar year (2021). This is easier than trying to correct an over-contribution made during the tax year (2020).
- You may withdraw plan funds without penalty any time after you turned 59 1/2. Unless they were designated Roth contributions, you pay ordinary income tax on the withdrawals.
- Please note, for year 2020, the CARES Act lets you withdraw 100% of your 401(k), up to $100,000 if you have been affected by COVID.
- Plan documents may be set up to allow loans or withdrawals from the account.
- Your plan may allow incoming rollovers from previous pretax accounts.
- Once the funds inside the plan reach $250,000, you need to file Form 5500-SF annually for reporting purposes.
Other qualified plan options for the self-employed
Instead of an individual 401(k), you may choose to open a SEP IRA as your business retirement plan. The two downsides with this are:
- You need a higher income to max out the SEP IRA than you need for a 401(k) because a SEP IRA doesn’t let you make employee contributions.
- The SEP IRA also precludes you from doing a Back Door Roth IRA annually.
Similarly, a SIMPLE IRA is also suboptimal because it lets you contribute a lot less than the Individual 401(k).
Where to Open an Individual 401(k)
- Vanguard is a fine option if your other accounts are located there too. But a Vanguard solo-k does not let you make incoming rollovers. So, if you have an old 401(k) from another job that you want to now rollover into your individual 401(k), you will have to find another option.
- ETrade is the next best option.
- Fidelity is good, too- and does allow incoming rollovers. But for some strange reason, they do not allow online fund transfers. So, every time you want to make a contribution, you have to mail in a paper check. If this has recently changed, please let me know.
I hope this is helpful. Please let me know if you have comments or questions below!
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