MY SOLO 401(k) STORY
The solo 401(k) and SEP IRA are two very popular retirement account options for self-employed individuals. If you’re looking to put away a substantial amount of your income for retirement, both of these accounts can be good options. Both types of accounts technically have the same maximum contribution limit of $56,000 in 2019. But in reality, for most people, the maximum contribution on a given income is not the same for both accounts. Read on to find out why the solo 401(k) actually has a significantly higher contribution limit for most of us.
When I became self employed, I knew I had to find a better retirement account option than the traditional and roth IRA I had used in years past. Back then, I didn’t know anything about self-employed retirement plans, so I researched it. I found that the best, and simplest option for me was a SEP IRA at that time. The SEP IRA allows you to contribute 25% of your self-employment income, up to $56,000 (2019 contribution limit).
During the years when I was contributing to the SEP IRA, my financial situation was changing for the better. I was starting to make more money, and I was working on becoming much more frugal. I went from saving about 20% of my income, to saving well over 50%. I was saving a lot of money for retirement, but I wasn’t able to put as much as I wanted in my SEP IRA due to the contribution rules.
In order to max out my SEP IRA by contributing 25% of my income, I would need to be making about $224,000. My income was well below $224,000, but due to my high savings rate, I would have been able to contribute the maximum of $56,000 if I was allowed to. However, since the rules say that I can only contribute 25% of my income to my SEP IRA, I fell well short of that $56,000 contribution limit. I was missing out on making thousands of dollars of tax deductible retirement contributions.
I can’t stand the idea of paying unnecessary taxes, so I started looking for a more suitable option. That frustrating situation brought me to the solo 401(k).
The solo 401(k) has the same $56,000 contribution limit as the SEP IRA, however, the contribution structure is different, and that makes all the difference.
With a solo 401(k) you can make a employee salary deferral contribution for yourself in the amount of $19,000. Then on top of that, you can make a profit-sharing employer contribution of 25% of your total self employment income, to bring your total contribution up to the maximum of $56,000. This means that you can reach the maximum contribution for a solo 401(k) with an income of about $148,000 as opposed to the $224,000 you would need in order to max out a SEP IRA.
EXAMPLE: Let’s say you have a net self employment income of $100,000. Here’s how the maximum contribution breaks down for a solo 401(k) as compared to a SEP IRA.
Solo 401(k) – Employee contribution = $19,000
Employer contribution = 25% of $100,000 = $25,000
Maximum contribution = $19,000+$25,000 = $44,000
SEP IRA – Contribution = 25% of $100,000 = $25,000
Maximum contribution = $25,000
So you can see how a solo 401(k) lets you contribute significantly more on a given income when compared to a SEP IRA. It’s that $19,000 employee salary deferral contribution that makes the big difference. Your maximum allowable contributions to both types of accounts only become equal when your net self-employment income reaches about $224,000 per year.
In addition to the solo 401(k) advantage described above, individuals who are at least 50 years old can make an additional $6,000 catch-up contribution to a solo 401(k). There is no catch-up contribution available for the SEP IRA.
ROTH SOLO 401(k) CONTRIBUTIONS
So if you’re like me, and you’ve decided that a solo 401(k) is the way to go, it’s important to know that you also have the option of contributing to a roth solo 401(k). Your roth contributions are not tax deductible in the year of the contribution, but your money grows tax free, and when you start making withdrawals in retirement, you pay no tax on the distributions.
Since I have no idea what my income tax rate is going to be in 30 years, I like to contribute to both a regular solo 401(k) as well as a roth solo 401(k). This gives me tax diversification for the future. It also gives me the peace of mind of knowing that I will have a big chunk of tax-free money when I retire.
I have a feeling that when I retire, I’m not going to be analyzing whether or not it would have been a better deal to take the bigger tax deduction by making all non-roth contributions 30 years ago. I’m pretty sure I’ll just be really glad that I have a big pile of tax-free income available to me.
ROTH SOLO 401(k) CONTRIBUTION LIMIT
The rules for contributing to a roth solo 401(k) are simple, but there are a few things you need to know.
Remember: your solo 401(k) contributions are broken up into an employee contribution of up to $19,000, and an employer contribution of 25% of your self employment income. The total of the contributions can’t exceed $56,000.
For roth solo 401(k) contributions: you can only have the roth designation for your employee contribution. So the maximum roth contribution is $19,000.
You can then make the remainder of your contribution as a regular, non-roth contribution. This is your employer contribution. Your employer contribution can be up to 25% of your self employment income. Your total employee and employer contributions to your solo 401(k) can’t exceed $56,000.
And if you don’t want to contribute to a roth account at all, you can have your full employee and employer contributions go into a regular, non-roth solo 401(k) account.