In one of our previous posts, we talked about the SEP IRA, which has some incredible tax benefits.
Like being able to deduct up to $58,000 on your taxes and put that money in an investment vehicle to fund your retirement.
Well, today’s post is all about the Solo 401K, which allows you to do the same exact thing and MORE!
So keep on reading for all of the pros and cons of the Solo 401k to determine if this is a good tool for you.
Today, we want to help you do this by taking advantage of Solo 401ks.
By the end of this post, we want you to know everything about it so you can start reaping the tax benefits and taking advantage of compound interest.
With that said, let’s discuss what it is.
What is the Solo 401K?
The Solo 401K is just a one-participant 401K plan.
Traditionally, 401K plans are offered by an employer to its employees to help them save for retirement.
But a Solo 401K plan just applies to one person who typically wears both hats – the business owner.
If you are self-employed with no employees, then this plan was designed for you.
Because you are the Employer and the Employee in your business, you get to reap the tax benefits of both sides.
As of 2021, you can contribute up to $58,000 in a Solo 401K account.
For comparison, that’s $52,000 more than you can in a traditional IRA or retirement account. Normally, you can only contribute up to $6,000 per year in a traditional IRA.
To make this even better, you can deduct your contributions from your tax return.
So for example, if your taxable income is $200,000 with an effective tax rate of 25%, you’d owe $50,000 in taxes.
But if you contributed $50,000 to your plan, then your contribution would lower your taxable income to just $150,000.
This means that instead of paying $50,000 in taxes, you’d only pay $37,500 in taxes, which is 25% of $150,000.
Not to mention the fact that you will be putting the $50,000 you contributed into an investment vehicle that will compound over time to be worth much more in the future.
So that’s how a Solo 401K is – a retirement plan that allows self-employed individuals to take advantage of both, Employer and Employee contributions into a retirement account.
With that being said, let’s take a look at the pros and cons of it. Let’s start with the Pros.
Pros of Solo 401K Plan
1. Tax Benefits
In our opinion, there is no other retirement plan that has more tax advantages than a Solo 401K. The contribution is so high that it’s hard to avoid.
2. You Can Borrow Money from Your Solo 401K
You can borrow up to $50,000 or 50% of your solo 401k plan value, whichever is less.
And guess what? There are no penalties for doing this.
There are no tax fees or tax penalties associated with taking out this loan. However, you may have to pay interest.
3. You Can Make Roth Contributions
Sometimes it may make sense to use after-tax dollars to contribute to your retirement.
For example, you might choose to make Roth contributions if you think that the tax rate in the future is going to be higher.
Or maybe you think your income will be higher in the future, which would put you in a higher tax bracket, so you want to take advantage of a smaller tax bracket today.
Even if you do nothing, just knowing that Roth contributions is an option associated with this plan is a huge benefit.
Cons of Solo 401K Plan
1. More Administration
It’s a little bit more complicated to set up than other retirement accounts.
As you can imagine, with all of the things you can do with it, it makes sense that it is more complicated to set up. You will likely need to go through a firm to set up your 401K.
2. More Fees
Because of additional administrative work, there are more fees involved with it.
You might encounter administrative fees, investment fees, legal fees, and more. But of course, fees will vary based on who you choose to do business with.
And those are the things that relate to the cons of the Solo 401K.
In our opinion, the tax benefits of the contributions and the flexibility to take advantage of Roth contributions or take loans when you need money outweigh the cons here.
So let’s talk about some of the eligibility requirements.
Eligibility Requirements of 401K
To qualify for the Solo 401k plan, you must be self-employed and generate some form of self-employment income.
So basically, you can’t just create a business and use money from your job or another business to fund your account.
You must generate actual income from your business which is used to fund your plan.
You also must not have any full-time employees involved in your business. This plan is designed for one-participant businesses.
Therefore, if and when you hire employees, you will need to offer a different 401K plan that applies to yourself and all of your employees.
However, there is an exception to this. If you have business partners involved in your business, then they are not considered full-time employees.
Also, if your spouse works with you in the business, she is not considered a full-time employee for purposes of the Solo 401K plan.
If you meet those requirements, then you’re set.
How Do You Contribute to a Solo 401K?
The next thing you need to know is how contributions work with this plan.
The contributions in this plan work in 2 ways.
Remember, you can contribute as both, an Employee and an Employer.
So as an employee, you can make what is called “elective deferrals. You contribute up to 100% of your earned income up to $19,500.00.
Then as an employer, you can make additional contributions based on the total compensation.
According to the IRS, you can contribute up to 25% of compensation as defined by your Solo 401K plan.
Here’s a simple example.
Let’s say you made $100,000 in earned income.
Off the back, you can contribute $19,500 of your earnings into your Solo 401K.
Then you can contribute up to 25% of the $100,000 in earnings into your Solo 401K as the Employer, which would be $25,000.
That would be about $44,500 contributed into your plan, and also deducted from your taxable income when tax time comes.
How Does the Solo 401k Compare to the SEP IRA?
There are a few things you need to know about how a Solo 401K compares to a SEP IRA.
1. The SEP IRA has more simplicity.
SEP IRAs are very easy and simple to set up.
This is the only reason we would choose a SEP IRA over a Solo 401k. If you want the fastest and easiest way to invest in your retirement, then a SEP IRA may be best for you.
2. The Solo 401K contribution limits are easier to take advantage of.
While the total contribution limit is roughly the same with a SEP IRA and Solo 401k of $58,000, the contributions are easier to take under a Solo 401K.
This is because the SEP IRA does not allow the initial elective deferral of up to $19,500.
You’re limited to about 20-25% of your total compensation in a SEP IRA, while the Solo 401K gives you that plus another deferral of up to $19,500.
In other words, in order to take advantage of the full $58,000 contribution in a SEP IRA, you’d have to be making over $200,000.
While on the other hand, you can make less than this and max your contribution in a Solo 401K.
3. The Solo 401K has more flexibility.
The things we talked about earlier – like the ability to take loans from your account or do Roth contributions are not possible under a SEP IRA, while it is possible to do this with a Solo 401K.
So although a SEP IRA is easier to set up, it provides much less than a Solo 401K.
Ultimately, if you’re interested in saving more money on your tax bill while putting more money towards your retirement, a Solo 401K can be a great tool to use.
And if you want to know how you can save more on your business taxes or want to invest your money wisely, LYFE Accounting can help you with that.