Self Employed? Consider a Solo 401(k)

By Britt Erica Tunick

Despite the absence of company-sponsored perks such as healthcare and 401(k) plans, more and more people are gravitating toward non-traditional employment that provides them with greater independence and flexibility –whether working for themselves, or as freelancers, or as contractors. Fortunately, choosing to be self-employed doesn’t mean the need to sacrifice retirement savings –especially if you are eligible for a Solo 401(k) plan.

A Solo 401(k) plan, also known as an Independent 401(k) plan or a Self-Employed 401(k) plan, is a qualified investment vehicle that provides self-employed individuals with the ability to both save for retirement and to recognize tax benefits for doing so. Just like with Individual Retirement Accounts (IRAs) and Simplified Employee Pension (SEP) IRAs, there are two types of Solo 401(k) plans available, each providing different tax benefits. With traditional Solo 401(k) plans, contributions made to the plan are done so on a tax-free basis, meaning the distributions you take at the time of retirement are taxed at that point as ordinary income. This approach allows you to reduce the amount of your taxes, though it means less money in retirement, whereas, the money contributed to Roth 401(k) plans is taxed just like ordinary income, but the distributions you take at the time you retire are then tax-free. Both have their benefits and the approach that makes the most sense for you will depend on your overall income as well as your anticipated financial needs during retirement.

Though opening a Solo 401(k) plan is a bit more complicated than opening a SEP IRA (another popular retirement savings vehicle catered to the self-employed), there are additional benefits of doing so –such as the ability to contribute as both the “employer” and the “employee,” which allows for larger annual contributions. For 2019, individuals have the ability to contribute a combined maximum of $56,000 per year to a Solo 401(k) –up to $19,000 as an employee, with the ability to contribute up to $37,000 more as the employer through a profit-sharing contribution. In the case of the employer contribution, the amount is limited to up to 25% of your net self-employment income.

Individuals who are 50 or older are able to invest an additional $6,000 each year through catch-up contributions, bringing their maximum possible investment to $62,000. Comparatively, SEP IRAs limit a self-employed individual’s contributions to 25% of their annual salary and contributions max out at $56,000 in 2019 and there are no catch-up contributions for individuals 50 or older.

If a Solo 401(k) plan is an attractive option for you, just make sure to open one before the end of the calendar year. As with SEP IRAs, you can still contribute up until the point when you file your taxes –even if you file an extension, but only if your account is already opened and established prior to the end of that calendar year. As long as you have your own business with no employees (the one exception being a spouse) and a federal Employee Identification Number (EIN) from the Internal Revenue Service, you are eligible to open and contribute to a Solo 401(k).