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The Value and Rules of a Solo 401K

Back when my wife changed her employee status to a stay at home mom one of the biggest negatives was the loss of her 401K tax advantaged space. For the better part of a year we have missed out on contributing to this tax advantaged space. Now with my wife becoming a contractor new avenues have opened up. Today I want to explore one of these avenues, the solo 401k.

What is a Solo 401K?

A solo 401K is essentially a 401K for a self employed individual. The only rule for eligibility for such a plan is that you have self employed income, no employees (other than potentially a spouse), and you open the plan before the end of the calendar year. (No waiting until March of 2018 to open a plan for 2017) Just like an employer 401K it has an employee deferral limit of $18,000 per year. In a way this comes out ahead of our formal employer 401K plan. In the case of my wife’s employer they limited her 401K contribution to 50% of income. No such rule exists for a solo 401K. Essentially up to the $18,000 a year limit you can contribute 100% of Earned Income.

What is Earned Income?

Before we go further lets defined Earned Income. As always revenue minus costs give you standard income numbers. To this initial value must be subtracted the portion of medicare and social security tax that belong to the employer. For those that understand our tax code when you work for an employer 7.65% of what you make is paid for by your employer to support social security and medicare. Another 7.65% appears in your paycheck but by contributing to a 401K you can defer this portion of the contribution. The same applies to a solo 401k. You must still pay the 7.65% which is often termed as half of self employment tax. The remaining 7.65% can be deferred along with any income tax up to certain limits. So essentially your earned income is your income numbers multiplied by (1-7.65%) or the amount of money remaining after paying the tax.

Employer Contributions to a Solo 401K

So the first 18,000 of earned income can be dumped into a solo 401K. But the analysis does not end here. Also just like your employer plan a solo 401K can have an employer contributions in the form of a match. The key difference is you are the employer, so you can choose the match, within reason. The IRS limits the employers ability to provide a match to 20% of your earned income for sole proprietorships and 25% for corporations. As my wife is currently operating a sole proprietorship she can essentially contribute 20% of her business income as an employer. That is way more then my current employers 6%.

Calculating Solo 401K Contribution Amounts

Now the part that was not clear to me when I started learning about these plans is how the employee contribution of $18,000 and the employer contributions interact. After some reading here is what I have found. First you as the employer contributes 20% of your earned income. Then you can elect to defer the remaining funds up to 18K a year. The Total limit for the two numbers cannot exceed $53,000/yr. So essentially your total contribution allowed is

Earned Income= Net Income * .9235
Employer Contribution= Earned Income *.20
Deferral= Lesser of $18,000 or (Earned Income * (1-.20))
Total Potential Contribution = Employer Contribution + Deferral
Actual 401K Contribution = Minimum of $53,000 or Total Potential Contribution

Even for a side hustle a Solo 401K is a good deal

Given we already live off my Salary and save 1x expenses this opens up considerable tax advantaged space. Essentially the first 18K of what my wife makes will become a 401K contribution with employer matches beyond that. She will not hit the $53,000 limit but it still should result in a massive positive impact on our tax advantaged space. In fact this has all gotten me thinking of how someone with a side hustle might also take advantage. The $53,000 dollar limit and the $18,000 deferral limit apply across my employer plan and anything you do as a self employed individual. Still even if you are maxing your employer contributions if you have space under the $53,000 your self employed income can still contribute as an employer match. So as a sole proprietorship 20% of your Earned Business Income can go into a solo 401K on top of your employers contributions. This presents a great opportunity for those with W-2 income and a side hustle.

Hypothetical Examples of Solo 401K Usage

So let’s do a hypothetical example. Imagine you have business income of $20,000. After half of your self employment tax (7.65%) you are left with Earned Income of 18,470. Of this the employer contribution can be 20% for a sole proprietorship or $3,694. For a side hustle you can put this in your solo 401k along with any w-2 employer/employee contributions so long as combined they are less than $53K. For those like my wife who only does contracting this leaves you with remaining income of $14,776. So ultimately in the case where all you do is contracting you can contribute $18,470. Thats a pretty large chunk of change on which you can defer taxes, and if you recall I heavily favor deferring taxes.

Tools to Determine Solo 401K Contribution Limits for your Situation

Historically F2F has only had W-2 income and investment income. This change in my wife’s employment has opened me up to the possibility of saving way more in tax advantaged spaces. Along the way I found this nice calculator  that can help with determining which solo plans make the most sense. There are others of course like the Solo IRA. Just plug your numbers in and it will give you contribution amounts and help you make a decision based on your income. It does seem to have a few bugs primarily when calculating self employment tax, so I would do your own math to determine how much you can contribute.

You can signup for a Solo 401K with no account fees at either Fidelity  or Charles Schwab.  Note: These are not affiliate links.  

Do you have a Solo 401K based on a side hustle or self employed business? Do you have a different type of tax advantaged Self Employment account I might not have considered?

Full Time Finance is not an accountant and this post is for entertainment purposes only.  Any decisions made by you on your finances are yours and yours alone.

 

11 Comments

  1. Chris
    Chris July 10, 2017

    I do have the solo 401K. What I have found challenging is the conflicting IRS Rules.
    So for the employER side you can do 25% of the “income”. Many self employed people take a % as salary and a % as distributions. I have decided to do 25% of my salary which limits me a bit, but I whenever I lookup up the regulations, I find conflicting information, so I lean toward the more conservative. Been self employed 12 years now, don’t think I will ever go back.

    • fulltimefinance
      fulltimefinance July 10, 2017

      Sounds like your more setup as an S Corp then a sole proprietorship as we are. I did note those rules are a bit vague.

  2. Good notes. I don’t have a side hustle, so I don’t have this opportunity – yet. That is one of the things I need to work on.

    Excellent article, however, and it demonstrates the tremendous benefits of deferring taxes.

    • fulltimefinance
      fulltimefinance July 11, 2017

      Are you considering any specific hustles?

  3. Mr. Need2Save
    Mr. Need2Save July 10, 2017

    I’m definitely in the defer taxes camp. We only have W-2 income, so we just get the combined $36,000 401(k) between the two of us. If we ever have a side business, I would definitely take a serious look at a Solo 401(k).

    • fulltimefinance
      fulltimefinance July 11, 2017

      No better time then the present.

      • Mr. Need2Save
        Mr. Need2Save July 12, 2017

        Just not willing to commit the time right now. We’ll see how the next few years go, although I’m thinking of some part-time teaching at our local community college. Not sure if that would end up as W-2 or 1099 income

  4. Mustard Seed Money
    Mustard Seed Money July 11, 2017

    My wife and I are hoping to set up a solo 401k in the future. Right now my wife has a business and have been pouring the profits back in so we haven’t set up the 401k b/c we didn’t want to take out any money. But we will hopefully start making some more money and push it into the 401k in the future. So this is super helpful 🙂

    • fulltimefinance
      fulltimefinance July 12, 2017

      Out of curiosity what type of business?

  5. Bryan Arnold
    Bryan Arnold July 12, 2017

    How would you compare this to a SEP IRA? I have my own consulting company and been doing 25% of my salary each year based on the SEP IRA rules but now I guess I need to research to see if I can do both.

    • fulltimefinance
      fulltimefinance July 14, 2017

      In general the solo 401k comes out ahead if you have not maxed your employee 401k contribution with your employer. The sep allows 20% of your earnings. The solo allows 18000 as an employee plus 20% as an employer. Otherwise they are equal. There is no advantage to doing both.

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