Maximizing Savings When Self-employed

have quite a few self-employed clients, and for several years now the retirement-savings plan of choice has been a solo 401(k) plan - also referred to as a self-employed 401(k), or a solo-k. Meaning, a 401(k) plan that just has one participant, or possibly two if both members of a married couple participate. 

It used to be that administrative fees made such small plans too expensive to bother with, but changes in the laws applicable to them allowed custodians to offer solo-ks without that layer of costs. It's now not much different from opening a SEP-IRA or IRA.

As with any 401(k) plan, contributions to a solo-k reduce your taxable income, so usually lower your state and federal income tax bill. That up-front tax savings allows you to invest money that would otherwise be paid out to taxes. The money grows tax-deferred until retirement, at which point withdrawals are taxed as ordinary income - the same as salary or interest. So it isn't that taxes are avoided, they're just delayed until you take money out of the account. But most retirees are in a lower tax bracket than they were during their working years, so the tax hit is often lower than it would have been. And the deferral of tax on income and capital gains on investments in the account, possibly for 20 years or more, helps it grow faster as well. In combination, these tax advantages can lead to having much more for spending during retirement, when compared with saving in taxable accounts.

These potential tax benefits are common to several other retirement-savings alternatives, including Traditional IRAs, SEPs, and SIMPLE IRAs. The reason solo-k plans make sense so often for the self-employed is that you are able to make very large contributions to them. In the typical 401(k) plan at a W-2 job, you have your elective salary deferral, a portion of your paycheck that you decide to contribute. There's an annual limit on that contribution, $18,000 in 2017. Alongside that, the employer can offer a matching contribution or some type of profit-sharing plan. Usually, matching contributions are at a relatively low level, like 3%, following one of the "safe harbors" for meeting legal requirements about the structure and participation rate for 401(k) plans. Employer match is great, of course, but the law allows quite a bit more than is typically provided.

When self-employed, you are both employer and employee. That means you can make that salary-deferral contribution, but you are also able to make an employer contribution. And you can be as generous with the employer contribution as the law allows. In fact, the law allows more savings than most people actually want to do. The cap on the employer piece is essentially 20% of business income, excluding your salary deferral and part of your self-employment tax. For those familiar with SEP-IRAs, the employer contribution is very similar to the SEP contribution, but you're also able to make the employee contribution as well. As with a SEP, your total contribution can't exceed an annual limit - $54,000 for 2017, indexed each year for inflation. In a solo-k that includes both the employee and employer portions.

Here is a calculator that will help you see how much a solo-k plan would allow at different levels of self-employment income.

 

 

For a wide range of income levels, the solo-k provides the highest allowable level of tax-deferred savings.

  • At income levels below about $5,900, the $5,500 allowed for an IRA is higher. But the usual scenario where someone earns only that much and can still save for retirement is a married couple where the other has a full-time job earning a lot more. And if that spouse has a 401(k) plan at work your IRA contribution may not be tax-deductible, as is would be for the solo-k.
  • At income levels above than that, you're in the sweet spot for a solo-k. You'll be able to defer up to $18,000 (in 2017), plus roughly 20% of the remainder. If you only earn $15,000 from self-employment, you will be able to defer most of it...a scenario not too uncommon with a married couple, where one is only doing some part-time consulting.
  • At high levels of self-employment income, it's a wash between the SEP and the solo-k...20% of a very big number is going to hit the annual cap anyway ($54,000 in 2017).

One scenario I've come across many times where a solo-k plan works well is when a married couple has one member currently working, and earning an income high enough that taxes are "noticeable." The non-working spouse wants to return to work on a consulting basis, but factoring in all the taxes, it doesn't look that financially rewarding. One possible solution is setting up a solo-k plan and deferring as much of that income as possible. You wouldn't do that normally, but if the alternative is taking home 60 cents of every dollar you could have put in the plan, it might be the better option.

Every tax scenario is unique, of course, so this is something to talk through. A nice aspect of these plans, though, is that you can set them up and only make the funding decision once you know how your income looks for the year. Speaking of that, here are some details about these plans:

They need to be set up by December 31 of the first tax year in which you want to contribute. Set up means that I fax an account application to the custodian, and they process it.

You need an EIN to establish the plan. Contact me to discuss this, it takes like two minutes to get an EIN.

Your contributions are due by the due date of your tax return, with extensions. This is only true if you are unincorporated and take your income as draw, rather than as a W-2 employee. This means you can conceivably fund your retirement for the prior year as late as mid-October, as long as you set up the plan by 12/31 of that prior year.

Contributions are optional. You can change the amount that you contribute each year, and can choose not to contribute at all.

The solo plans only work for you or you and your spouse. Once you have employees, you'll need to move to something else.

Age 50 by year-end? You can add a $6,000 catch-up contribution, if you have enough income. That's a total of $24,000 in employee deferral, plus the employer contribution.

Organized as an LLC or S-corp? There's a bit more to talk through but the solo-k plans can work just fine for them as well.

Have another job with a 401(k), 403(b), or 457 plan? That $18,000 employee limit is the limit for contributions to all plans, so you may need to reduce your contribution to the solo-k if you are contributing to other plans in the same tax year. But the separate employer rule allows you to contribute the employer portion to each plan independently; the $54,000 cap is per plan, not per taxpayer. This can get complicated, so be sure to talk that through in detail before making any contributions.

I'm just summarizing the high points, so clients let me know if you want to discuss alternatives for saving your self-employment income. But please don't wait until December 30th!

 

Note: contribution limits referenced in this article are for 20172; they are indexed for inflation each year. The calculator embedded in this piece is meant for client use only, in connection with a consultation. Everyone using it should consult with their tax preparer for a definitive calculation of the deferral limits based on your actual self-employment income.