The other day I was talking to my wife about where she might have financial management issues if something were to happen to me. The only item that kept comming to the forefront was how to contribute to a Solo 401k. To that end she asked me to write a post she could use should the worst ever occur.
What is a Solo 401k?
A quick refresher on the solo 401k. The solo 401k is a retirement vehicle for the self employed. It allows a self employed individual to contribute to a 401k in two distinct ways. As an employee subject to the 401k standard employee contribution level of 19.5K (as of 2020). Second, as an employer a certain percentage of your profits can be contributed.
Managing a Solo 401k
It is more complex then it sounds. The first thing to understand is a solo 401k is just a 401k where the only employees of a company are the owner or spouse. If employees are ever added things become much more complex in terms of recording and rules to follow.
A note, my wife is a one person consultant or freelancer depending on how you want to classify her. As such there is a near zero liklihood of employees ever being added to her business. For that reason this post will focus on the situation relevant to us, the Owner only or Owner plus spouse business.
The first thing to understand before we get started is a solo 401k requires more diligent record keeping then most other retirement accounts. As laws and policies change you are required to keep a copy of participant signed acknowledgements of these changes. Without that filing the 401k could be deemed illegitimate resulting in all types of penalties.
Keeping track of these rule changes and documentation needs on your own would be a major undertaking. Thankfully some companies will help you manage these processes. There are providers that will manage the paperwork while your money sits somewhere else like solo401k . Also there are providers that manage both paperwork and money like Schwab or Fidelity.
I would recommend you never try to create a 401k without one of these companies as there are too many gotchyas. We currently manage with one of the big dual money and paperwork organizations. That means dealing with policy changes in our case is as simple as collecting new requirements via mail from the company. Then sign, date, and file the change in a folder. It is critical you follow this.
Features of a Solo 401k
The second thing to understand is solo 401ks come with different features. Some support loans, roll overs, or even Roth versus traditional 401k. Typically you can have a basic traditional solo 401k for no fees. The more exotic the options the more likely things are to cost money.
My wife currently has a traditional solo 401k. However if I did it again I would go with a Roth 401k. The reason is the changes in tax laws. . With the tax changes of 2019 business profits are reduced by a QBI deduction of 20% for many (but not all businesses). When you contribute to a solo 401k it reduces the amount used to determine the QBI deduction. A Roth 401k meanwhile does not. Meaning the Roth 401k gets both the Roth contribution and the QBI deduction, an added value. We qualify for QBI.
*Note: In theory you could also use a traditional solo 401k to qualify for QBI should your business income be near the limits of claiming. Or at a low income use a traditional IRA contribution. Anyway the combinations are endless but we fall somewhere in no mans land where neither the threshold nor the traditional IRA are possible. So the question here is more of Roth 401k or traditional 401k.
Why I don’t Have a Roth Solo 401k
I have not switched to a Roth 401k however for two reasons. One, I expect the QBI deduction to not survive very long. It already has a sunset provision where it automatically disappears in 2025. But I also suspect when politics change in congress it will be amongst the first things to get changed.
Changing Solo 401k Plans Is A Multi Step Process
Meanwhile changing a Solo 401k plan provider is not a simple manner of just clicking a button or two. There are multiple pieces of paperwork and potentially account close out fees depending on your provider. I have decided the effort to change is not worth my time for what to many will be a 800 dollars a year change in todays dollars(assume tax rates don’t change then 19500* the 20 percent QBI deduction * by whatever your tax rate, in this case I assumed 22% based on odds that is the readers tax rate compared to the full rate when withdrawing the funds decades from now.).
It is also important to understand that when you contribute to a Solo 401k traditional we are giving up a 20 percent tax deduction now for the benefit of tax free growth going forward and tax deferred income. So we don’t necessarily want to put every dime for which we are eligible into a solo 401k.
What Can You Contribute to a Solo 401k?
Before we proceed we should discuss what you are eligible to contribute to a solo 401k. To start let’s calculate profit. Profit is simply all the revenue minus all the expenses of the business. That new piece of operating expense or capital expense, that reduces business expenses. For capital expense items that cost may be taken in a single year currently (using accelerated depritiation) or expensed over multiple years depending on the type of expense. For the puposes of simplicity our business is small enough that I just accelerate everything that is eligible. If anything ever were to happen to me I would suggest a business accountant on the cheap for this part of the equation.
Remove Social Security and Medicare Expenses from Your Profits
Anyway, after the profit is calculated there is one more expense to consider. That is the money that goes in for social security and Medicare. In general this is 15.3 percent of wages. That 15.3 is actually split in half with half paid by the employer and half by the employee. I know, your saying but as the owner I am both the employer and employee. Very true..
But the ramifications of this distinction still matter. To calculate the starting point of determining contribution limits you need to first remove the actual expense of the employer portion of social security and Medicare. That removal actually includes a deduction itself for the employee portion of social security and Medicare. Or stated otherwise Profit * (1-(15.3/2*(1-(15/3/2)) is your starting point for 401k contributions.
As an Employee What Can You Contribute to a Solo 401k
Now if you recall I mentioned there is a 19.5K employee contribution. Like your normal 401k that 19.5K contribution reduces your income. As such it is not subject to the second half employee portion of the Medicare Social Security tax Any other profit you make gets that applied.
*Another note: In fact if you contribute to any other 401k the 19.5 employee contribution is an aggregate between the accounts. So if you had a W2 job and your business you can contribute to both 401ks, but only up to 19.5K as the employee portion. The employee contribution limit also allows for the over 50 catchup provision as well. This w2 income would not impact the employer contribution discussed next so long as they are distinct entities. Social security tax limits and contributions via other income also impacts self employment tax limits.
Our Process for Employee Contributions
My wife has no other source of income, so we have taken the tact of contributing up to that 19.5k limit before evaluating the tax impact. So essentially each time we get paid I evaluate the total amount of income. I subtract out the expenses and multiply by (1-(15.3/2*(1-(15/3/2)). Then up to 19.5K I contribute that amount. I usually leave a bit of a gap in case I forget any expenses. Don’t forget the home office expense or utilities!
As an Employer What can I Contribute to a Solo 401k?
Anyway, as noted after the 19.5K comes the employer contribution to the solo 401k. Now here is where things get interesting. The amount you can contribute differs by business structure. This money is essentially considered profit sharing and can be 20% of profits for your sole proprietorship or 25% for a corporate structure. This money is currently allowed up to $37,500.
To do the calculation essentially take your original profit number – the employer portion of social security/medicare as shown 4 paragraphs ago. Then subtract your employee deferral. Now of that number you take your .25% for corporate or .2% for sole proprietor ship. That is your contribution as the employer up to 57k – what you contribute as an employee.
One More Rule that Governs What you can Contribute to a Solo 401k
To all this we add one more rule. The maximum of your 401k employer contribution must be the lower of your overall limit or your (profit minus your 1/2 Medicare/social security – employer contribution) /2. We’ll see how this all plays out in the below examples.
Examples of Contributions At Different Profit Points
So imagine I have $100K in business profits. Your solo 401k contribution as a sole proprietorship would be limited by $100k* (1-(15.3/2*(1-(15/3/2)) = $92,935 in profit after employer social security and medicare. If you contribute the max as an employee of $19,500, then that leaves the lesser of $73,435/2= $36,717 or $18,587 ($92,935*.20) as employer contribution. So with $100K you can contribute $19.5K+$18.6K for a total of $38.1K to an individual 401k.
Conversely if I have $50K in profits then $46,467 would be the number after employer social security and Medicare.. Consider contributing $19,500 then that leaves the lesser of $46,467*.2=$9,293 or ($46,467-$19,500)/2=$13,483 for your employer contribution. So with 50K in profits you can contribute $19.5K+$9.3K for a total of $28.8k.
Finally if I have just $25K in profits then $23,233 after Medicare and Social security. So $19500 for employee and the lesser of $23,233*.2=$4,646 or ($23,233-$19,500)/2=$1,866. So $21.3K is your contribution limit. A great calculator can be found here.
When do I Contribute to a Solo 401k
So now you understand the how. So when do I make my wife’s contributions? Frankly my goal is to contribute the maximum employee contributions every year and then evaluate our cutoffs for various tax cliffs before determining how much to do for employer contributions. This allows us to decide whether to use the QBI deduction to a larger extent or defer more funds.
Also the IRS has a well defined process for recalling over contributed employee contributions. So if I put in too much I just fill out a form and redo things. That process is less well defined as an employer contribution. As such it is best for any potential math problems not to make the employer contributions until things are clear. Finally your deadline for employee contributions is December 31, but as an employer your deadline is tax filing
Save the Employer Contribution to a Solo 401k for Tax Filing.
For all these reasons I contribute the employee portion throughout the year based on each paycheck. When we get to the employer contribution I file the money in a savings account until I do my taxes. Then I know the exact additional amount I should push to the employer contribution based on tax cliffs, profits, etc.
Want a great example of where the delay might be beneficial? Imagine you qualified for the stimulus but were on the borderline. A reminder the stimulus has an income phaseout starting at $150K. One way to edge under the limit by contributing more to your employer contribution. Or you could contribute more to get closer to that line to take advantage of more QBI. Doing your taxes gets you more clarity on these types of questions. Another way to do this could also be to crack open a version of turbo tax or other program before the year ends and play with the numbers. Although you risk the software not being fully compliant with any last minute tax changes.
Anyway, I have so far been inconsistent on whether we contribute the max to the employer portion of a solo 401k based on our situation each tax year.
And there you have it.
As always this site is for entertainment purposes only. Consult an accountant if you choose to act on this advice..