DYK: Solo 401K

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Are you or someone you know self-employed? If so, at some point you’ve had to think about setting up a retirement plan for your business. Someone may have approached you with the idea of a SEP IRA or a similar arrangement, but did you know that you also have the option to set up your own 401k? Depending upon your situation, this might be a significant opportunity!

To understand why let’s dive a little deeper and compare.  We’ll start with the most common alternative: the SEP IRA. With a SEP IRA, the self-employed individual can make ‘employer’ contributions of up to 25% of their eligible compensation.  There’s a limit to this, though, and it’s capped out at $56,000 (as of 2019). This tends to work well for the business owner who has no employees and earns a high income with little variation from year to year. But what if someone doesn’t make as much money from the business, yet still wants to contribute a high percentage of their income?

A Solo 401k could allow that person to make contributions on two fronts:  as both the ‘employer’ and the ‘employee’. If you’re a savvy reader or particularly well-versed in this from having done this research for your own business, you might be thinking, “But, there’s still the same overall cap of $56,000, so what’s the difference?”

Let’s take a closer look with a couple of hypothetical scenarios:

Scenario 1: Jack, a 50-year old sole proprietor, is making $200,000 per year (net profit). In determining what he could contribute to his SEP IRA, he first has to reduce that figure by a certain percentage (based on IRS guidelines & formulas). For this situation, the end result is an allowable SEP IRA contribution of somewhere around $37,000 for the given year.

Scenario 2: Diane, a sole proprietor who also happens to be making $200,000 in 2019, sets up a Solo 401k. She wants to ensure that the account is funded before December 31st, so she contributes the maximum amount that she can as an employee right away – $19,000. But remember, she gets to contribute as the employer, too.  Once she has a better idea of her tax situation, she funds the account with as much as she can on the employer side.  Now, this puts the total amount just shy of the standard $56,000 limit – already a big difference! However, like Jack, she happens to be 50 years old. As is the case with other/larger 401k plans, a Solo 401(k) has an additional “catch-up” provision that allows people over 50 to contribute more.  This catch-up amount is $6,000, which effectively raises her overall funding limits, as well.

The End Result: A net Solo 401k contribution of nearly $62,000 – roughly 67% more than Jack!

Said differently, Jack funded a SEP IRA with around 19% of his income, while Diane could contribute close to 31% through her Solo 401(k).

Choosing the right retirement plan for your business can be difficult and can involve unforeseen or unintended effects. If working out these scenarios seems tricky, or if you just don’t have the time to work through all of that, it often makes sense to consult with an advisor who has experience navigating this complex landscape.  Doing so will make it easier for you to evaluate options, coordinate with your tax professional, and feel confident that you’re making the right choice for you and your business.


Rhett Garner, CLU®, ChFC®, CFP®
Vice President – Financial Advisor
Heritage Wealth Management Group


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