Last Updated on February 18, 2021
IRA Financial’s Adam Bergman Esq. discusses the Solo 401(k) contributions rules as an employer and how to maximize your retirement savings.
A Solo 401(k) is a retirement plan designed for the self-employed. It’s regular 401(k) plan, which you can get at most companies, however, only self-employed individuals may utilize it. If you work for yourself, or have an only-owner business (meaning no full-time employees other than a spouse or partner), you can adopt a Solo 401(k) plan for yourself. As you may know, you can contribute to the plan as both the employee (elective deferral) and the employer (profit sharing) up to the annual limits set forth by the IRS each year. In this podcast, Adam Bergman focuses on the profit sharing contribution.
What’s the Difference Between Employee and Employer Contributions?
You probably have experience contributing to a 401(k) plan as an employee. If you work for a company that offers a 401(k) retirement plan, and you have contributed to it, you are making elective deferrals, or employee contributions. You can contribute on a dollar for dollar basis of your earned income up to the IRS limit. For both 2020 and 2021, that limit is $19,500 if you are under age 50 or $26,000 if you are age 50 or older.
On the other hand, if you have a Solo 401(k), you can also make employer contributions, in addition to the employee deferral. However, these are not made on a dollar for dollar basis. Instead, they are based on a percentage of the income generated by the business. To further complicate things, the percentage is different depending on the type of business you have.
The overall limit you can make to a Solo 401(k) is $57,000 ($63,500 if age 50+) for 2020 and $58,000 ($64,000) for 2021. It’s important to keep in mind if you contribute to any other 401(k) plan, the amount you can contribute to your Solo 401(k) is less. For example, if you contribute $10,000 to a workplace plan, you can only contribute an additional $48,000 to your Solo 401(k) in 2021 if you are under age 50.
How Does the Profit Sharing Contribution Work?
As we mentioned, there are two ways to figure out how much you can contribute as the employer. You must know what type of entity your business is.
S or C Corporation or LLC Taxed as a Corporation
If your business is a corporation (or an LLC that is taxed as one) you can contribute up to 25% of the W-2 earnings of the business. Assuming you max out your elective deferral, you can contribute another $37,500 for 2020 or $38,500 for 2021 as the employer. For example, if you earned $100,000 from your business, you can contribute $19,500 as the employer, plus $25,000 as the employer. This means the maximum you can contribute to the plan is $44,500.
Sole Proprietorship, Partnership or LLC Taxed as Sole Prop.
Sole proprietors and partnerships are treated a bit differently. You can contribute up to 20% of “net adjusted business profits.” Essentially, you take you gross self-employment income and subtract your business expenses. Then, you subtract half of the self-employment tax. The IRS has a handy guide to figure out this amount. Again, you cannot contribute more than you earn on the year or exceed the annual limit.
What About a Spouse?
If your spouse also works at the business which sponsors the Solo 401(k), he or she can also make contributions to the plan. Now, if you both take a similar salary, you can make virtually the same contributions. However, if one spouse makes significantly more than the other, you have options.
For example if one spouse makes $200,000 and the other makes $50,000. The higher earner can max out his or her Solo 401(k) contributions. However, the spouse making $50,000 cannot fully max out contributions. Instead, you can combine the two salaries and determine how much you can contribute as the employers. Once you have that number, in this case, it’s $62,500 based on 25%, you can split up the employer contribution between the two spouses. The higher earner can still max out his or her contributions, however, there’s enough leftover for the lower earner to contribute more to the plan.
It’s important to understand the Solo 401(k) employer contribution rules. If you wish to supersize your retirement savings, and you are self-employed, the Solo 401(k) plan is the way to go!
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