As a self-employed solo entrepreneur, you need to save for retirement just like everyone else. However, you don’t have the benefit of a 401(k) retirement savings plan offered by an employer. It’s all on you to research, establish, and contribute to your own plan for retirement savings.
Fortunately, the Internal Revenue Service (IRS) offers several options for people in your situation. Most self-employed individuals are familiar with the Individual Retirement Account (IRA), but fewer know about the Solo 401(k). If you’re exploring your retirement savings options, this might be something for you to seriously consider. You might also see the names Solo-k, Uni-k, or one-participant k used to describe the same plan.
Eligibility Requirements to Establish a Solo 401(k)
The concept and rules of a Solo 401(k) are just like those of a traditional 401(k). The main difference is that this type of account is only for self-employed people with no other employees except for possibly their spouse. You can still choose this option for retirement savings if you hire a part-time or temporary worker during the year, but he or she can’t work more than 1,000 hours.
A second eligibility requirement for the Solo 401(k) is that you must earn self-employment income. The IRS does allow you to earn income from other sources as well, but at least a portion of your total earning must come from self-employment. You can have a full-time job for an employer as long as you also have self-employment income and remain eligible for this type of account.
Benefits of Choosing a Solo 401(k) for Retirement Savings
As with a traditional 401(k) offered by an employer, tax savings is the main advantage of a Solo 401(k). All contributions you make are tax-deferred, which means that it reduces your taxable income today. You also don’t have to pay any taxes on the investment gains you make with this account. That means you can re-invest your earnings as you see fit and continue to grow tax-free (until withdrawal) savings. However, you will need to pay tax on your Solo 401(k) contributions and earnings when you withdraw them after retirement.
With a Solo 401(k), the IRS recognizes the participant as both employer and employee. This works to your advantage because you can make contributions in both capacities. For example, you can make an elective deferral of up to 100 percent compensation, also called earned income when describing self-employed individuals. For 2018, the contribution maximum for an elective deferral is $18,500 for those age 49 and under or $24,500 for those who are 50 and over.
You can also make an employer non-elective contribution of up to 25 percent of your compensation as defined under Solo 401(k) rules. When determining this amount, you must deduct your own contributions in addition to half of your self-employment taxes. Even so, both the size of your retirement savings and the immediate tax benefit could be sizable if you earn enough income to reach the IRS maximum contribution limits.
The total maximum contribution for 2018 is $55,000, excluding those age 50 and over making catch-up contributions. As long as you understand how to maximize your contributions to this type of self-employed retirement account, you should find yourself in a comfortable financial position when the time comes for you to retire.
Non-Discrimination Testing for a Solo 401(k) Plan
If you’re a solo business owner and you don’t employ any related employees, the IRS doesn’t require you to complete non-discrimination testing to show that you qualify for this retirement savings plan. That is because no employees exist who could have earned eligibility to participate in a 401(k) offered by your company. If you do hire an employee, you lose this no-testing advantage. Regardless of the name of the retirement savings plan that you ultimately choose, it must meet IRS requirements.
Should you hire employees in the future, IRS regulations require that you include them in the retirement savings plan if they meet eligibility requirements. The IRS then subjects any elective deferrals that they make to non-discrimination testing. The one exception to this is if the 401(k) plan you have in place qualifies as a safe harbor plan or has earned an exemption from testing in some other way. You do have the opportunity to correct the mistake of not allowing an eligible employee to make a deferred contribution by making a qualified non-elective contribution on his or her behalf.
Forms and Filing Requirements
As a participant in a Solo 401(k) plan, you must file Form 5550-SF if your business has $250,000 or more in assets at the end of the previous calendar year. You may be exempt from this requirement if you have fewer assets, but it’s always a good idea to check requirements on the IRS website at www.irs.gov before assuming anything.
Other Self-Employed Retirement Options to Consider
Choosing the most appropriate type of retirement savings as a self-employed individual can be challenging. With no one else making or matching any contributions, you need to carefully consider what will help you build your nest egg the fastest and save the most on taxes. Here is a brief description of other self-employed retirement plans:
- IRA: The IRS allows people age 49 and under to contribute up to $5,500 on a tax-deferred basis to an IRA account. The amount is $6,500 starting the year you turn 50 if you need to make catch-up contributions. The contributions must come from earned income only. You’re taxed on withdrawals, and you phase out of receiving the full tax deferral once your income hits a certain limit.
- Roth IRA: The maximum amount you can contribute to a Roth IRA depends on your filing status and income. You don’t receive a tax deferral on these contributions, but the trade-off is that you don’t have to pay tax when you withdraw. You can also contribute to a Roth IRA past age 70.5, unlike the traditional IRA that cuts off contributions at that point.
- SEP Account: A business of any size, including only one person, can establish a SEP account. It allows you to contribute up to 25 percent of your net self-employment income, and it is often a good choice for businesses with cyclical income patterns. The maximum annual contribution for 2018 is $55,000.
Now that you know more about your self-employed retirement savings options, the next step is to sit down with a qualified financial planner to help you decide which one is right for you. The important thing is that you don’t miss the opportunity to save for retirement and reduce your tax liability.