TaxWatch: When does a solo 401(k) make sense for self-employed people, and what are the contribution limits?

Are you newly self-employed after joining the Great Resignation? Welcome aboard. Given your new status, you need to know about your tax-favored retirement plan options.

Or have you been self-employed for a while, but just haven’t gotten around to setting up a tax-saving retirement plan? Procrastinators like you need to know their options too. Here’s Part 2 our story on this subject. For Part 1, see here.  

Key point: Self-employed means being a sole proprietor, the sole owner of a single-member limited liability company (LLC) that’s treated as a sole proprietorship for tax purposes, a partner, or a member of a multi-member LLC that’s treated as a partnership for tax purposes. If you meet one of those descriptions, this column is aimed at you. Read on. 

The solo 401(k) option   With a solo 401(k) plan, you can potentially make bigger annual deductible contributions to your retirement account than with the two options explained in the earlier column. However, that advantage comes with greater complexity. 

Elective deferral contributions For the 2022 tax year, you can make a so-called elective deferral contribution of up to $20,500 of your net self-employment (SE) income. The elective deferral contribution limit is increased to $27,000 if you’ll be 50 or older as of 12/31/22. The larger $27,000 figure includes an extra $6,500 “catch-up” contribution that’s allowed to well-seasoned account owners.  

Employer contributions On top of your elective deferral contribution, the solo 401(k) arrangement permits an additional contribution of up to 20% of your net SE income. This additional pay-in is called an employer contribution, although there’s actually no employer when you’re self-employed. Whatever. It’s gov-speak. For purposes of calculating the employer contribution, your net SE income is not reduced by your elective deferral contribution.  

Combined contribution limits For the 2022 tax year, the combined elective deferral and employer contributions cannot exceed: (1) $61,000 or $67,500 ($61,000 + $6,500 catch-up contribution) if you’ll be age 50 or older as of 12/31/22 or (2) 100% of your net SE income. Net SE income equals the net profit shown on Schedule C, E, or F for the business in question minus the deduction for 50% of self-employment tax attributable to that business.  

Elective deferral and employer contributions can add up to big numbers To see how elective deferral and employer contributions can add up to big numbers, consider the following examples. 

Example 1: Deion, age 40, operates his cable installation, maintenance, and repair business as a sole proprietorship (or as a single-member LLC treated as a sole proprietorship for tax purposes). In 2022, Deion has net SE income of $100,000 (after subtracting 50% of his SE tax bill). The maximum deductible contribution to a solo 401(k) plan set up for Deion’s benefit is $40,500. That amount is composed of: (1) a $20,500 elective deferral contribution plus (2) a $20,000 employer contribution (20% x $100,000 of net SE income). The $40,500 amount is way above the $20,000 contribution maximum that would apply with a SEP (20% x $100,000 of net SE income). The $20,500 difference is due to the solo 401(k) elective deferral contribution privilege.

Example 2: This time, assume that Deion will be age 50 or older as of 12/31/22. Now, the maximum contribution to his solo 401(k) account is $47,000. That amount is composed of: (1) a $27,000 elective deferral contribution (including the $6,500 extra “catch-up” contribution) plus (2) a $20,000 employer contribution (20% x $100,000). That’s way more than the $20,000 contribution maximum that would apply with a SEP (20% x $100,000 of net SE income). The $27,000 difference is due to the solo 401(k) elective deferral contribution privilege with the extra catch-up contribution.

Solo 401(k) pros * For one-person business owners who hate to leave any tax break on the table, the solo 401(k) option is a sweet deal. Many owners will be able to make much larger annual deductible contributions to solo 401(k)s than to a SEP or SIMPLE-IRA. 

* The solo 401(k) alternative does not require uncomfortably large contributions for years when cash is tight. You can contribute less than the allowable maximum or nothing at all. 

* You can borrow from your solo 401(k) account (assuming the plan document so permits, which should be insisted upon). The maximum loan amount is 50% of the account balance or $50,000, whichever is less. In contrast, you cannot borrow from a SEP account or SIMPLE-IRA. 

Solo 401(k) cons * Upfront paperwork and some ongoing administrative efforts are required, including adopting a written plan document and arranging for how and when elective deferral contributions will be collected and paid into the owner’s account. Fortunately, a number of outfits are prepared to help small business owners set up and operate solo 401(k)s. Several well-known brokerage firms will handle the details at a fairly reasonable cost.

* If your business has one or more employees, the tax rules may require you to make 401(k) contributions for those employees. If so, we obviously won’t have a solo 401(k) plan. Instead, we will have a garden variety multi-participant 401(k) plan with the resulting complications. However, you can exclude employees who are under age 21 and employees who have not worked at least 1,000 hours during any 12-month period from 401(k) plan coverage. You can take advantage of this exclusion rule to employ younger and part-time workers while effectively operating a solo 401(k) that benefits only you. Selfish, but business is business.

* Once your solo 401(k) account balance exceeds $250,000, you must file Form 5500-EZ (Annual Return of One-Participant Retirement Plan) with the IRS each year. In contrast, SEPs and SIMPLE-IRAs are exempt from any filing requirement.

Conclusion on solo 401(k) plans For a one-person business, the solo 401(k) can be the best tax-favored retirement plan choice if:

* You want to make large annual deductible contributions and have the cash to do so. 

* You have substantial net SE income.

* You’re age 50 or older and can therefore take advantage of the extra catch-up elective deferral contribution privilege. However, if you’re in this age category, please read about the defined-benefit pension plan option explained immediately below. 

The defined-benefit pension plan option A defined-benefit pension plan is designed to deliver a target level of annual payouts from your retirement account after you reach a stipulated retirement age. You make annual deductible contributions to fund the target payout. The amount contributed each year must be calculated by an actuary.

Target payouts can be based on a fixed percentage of your average net SE income over a stipulated time period, a flat monthly dollar amount, or a formula based on years of service.

For the 2022 tax year, allowable contributions must be based on an annual target payout that cannot exceed $245,000.

Defined-benefit plan pro * You can make big and perhaps eye-popping annual deductible contributions with the resulting big and perhaps eye-popping tax savings — especially if you’re age 50 or over with less time to fund your retirement-age benefit. 

Defined-benefit plan cons * While making big tax-saving contributions might sound like a great idea, making truly huge contributions might not be affordable unless you have tons of liquid assets laying around. 

* Defined-benefit plans are complicated. A plan document is required, and annual actuarial computations are required to determine how much to contribute each year. However, as stated earlier, there are a number of outfits that are ready to help establish and operate small business defined benefit plans at an affordable cost. These plans have gone mainstream.

* The actuarially determined annual contributions are mandatory. In contrast, contributions to other types of plans that we have covered in this column and the earlier column are discretionary. In years when cash is tight, you can contribute little or nothing. Not so with a defined benefit plan.

* If your business has one or more employees, you generally must cover them too. However, the plan can include vesting and exclusion provisions to help prevent short-timers from taking off with the employer contributions that you paid in.

Conclusion on defined-benefit plans If you fit the profile, a defined-benefit pension plan can be just what the doctor ordered. But you must clearly understand what you’re signing up for. 

The bottom line The solo 401(k) and defined benefit plan options are not so simple. But they can allow you to make bigger annual deductible contributions, as long as you’ve got the cash to make them. 

In the earlier column, we covered the SEP and SIMPLE-IRA retirement plan options, which are the least-complicated ones on the books. 

You are now well enough informed to make a choice, but I recommend seeking professional advice before jumping into a solo 401(k) or defined benefit plan. 

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