Blog

[Prefer to listen? You can find a podcast version of this article here: E232: Solo 401(k) Contributions – EmployEE vs EmployER]

As a self-employed individual or small business owner, you have unique retirement planning opportunities.

Enter the Solo 401(k), a powerful retirement savings vehicle designed specifically for you. Also known as an Individual 401(k) or Self-Employed 401(k), this plan offers flexibility and high contribution limits that can give you powerful tools for your retirement savings.

So, who's eligible for a Solo 401(k)? Any business owner with no full-time employees other than themselves and their spouse can use a Solo 401(k). This includes sole proprietors, independent contractors, freelancers, and small business owners who meet this criterion.

If you're running a side hustle or a full-time business without employees, you might be the perfect candidate for a Solo 401(k).

What makes the Solo 401(k) particularly attractive is its unique dual contribution structure. Unlike traditional employer-sponsored 401(k) plans, a Solo 401(k) allows you to contribute to your retirement savings in two capacities: as an employee and as an employer. This dual role can significantly boost your ability to save for retirement, potentially allowing you to contribute more than you could with other self-employed retirement plans like SEP IRAs or SIMPLE IRAs.

This distinctive feature (among others) of the Solo 401(k) makes it an attractive retirement savings vehicle for business owners.

Employee contributions to a Solo 401(k)

As an employee in your Solo 401(k) plan, you have the opportunity to make substantial contributions towards your retirement. These contributions, known as elective deferrals, are similar to those you'd make in a traditional employer-sponsored 401(k) plan.

For 2024, you can contribute up to $23,000 of your earned income as an employee. If you're 50 or older, you can make an additional catch-up contribution of $7,500, bringing your total potential employee contribution to $30,500.

One of the key advantages of employee contributions to a Solo 401(k) is their tax treatment. These contributions can be made with pre-tax dollars, meaning they're deducted from your income before taxes are calculated. This can significantly reduce your taxable income for the year, potentially lowering your overall tax bill. For example, if you earn $100,000 and contribute $20,000 to your Solo 401(k) as an employee, your taxable income would be reduced to $80,000.

Many Solo 401(k) plans offer a Roth option. With a Roth Solo 401(k), your employee contributions are made with after-tax dollars. While this doesn't provide an immediate tax benefit, it allows your money to grow tax-free, and you won't pay taxes on qualified withdrawals in retirement. This can be particularly beneficial if you expect to be in a higher tax bracket in retirement or if you want to diversify your tax exposure in retirement.

Calculating your employee contribution is straightforward - it's simply the amount you choose to defer from your salary (or your business income if you are a Schedule C business), up to the annual limit. However, it's important to remember that if you have multiple jobs or participate in other employer-sponsored retirement plans, your total employee contributions across all plans cannot exceed the annual limit.

Employer contributions to a Solo 401(k)

Now, let's look at the employer side of Solo 401(k) contributions. As a business owner, you have the unique opportunity to contribute to your retirement plan as both an employee and an employer.

Employer contributions to a Solo 401(k) are calculated differently from employee contributions. Generally, you can contribute up to 25% of your compensation as an employer (this would be your salary if you are taxed as an S-corp). However, if you're a sole proprietor or single-member LLC, the calculation is slightly different - it's 20% of your net self-employment income.

This is because the contribution itself is tax-deductible, which reduces the effective percentage. It's important to note that these employer contributions are in addition to your employee contributions, potentially allowing you to save significantly more for retirement.

One of the most attractive features of employer contributions is their tax deductibility. These contributions are considered a business expense, which means they can be deducted from your business's taxable income. This can result in substantial tax savings, especially for high-earning self-employed individuals.

However, it's important to remember that there's an overall limit to combined employee and employer contributions. For 2024, this limit is $69,000, or $76,500 if you're 50 or older and eligible for catch-up contributions.

The flexibility of employer contributions in a Solo 401(k) allows you to adjust your savings strategy based on your business's performance and your personal financial goals. In years when your business is thriving, you can maximize your contributions to reduce your tax burden and boost your retirement savings.

Conversely, in leaner years, you have the option to scale back without penalty. This adaptability makes the Solo 401(k) an excellent tool for self-employed individuals looking to balance their current financial needs with long-term retirement planning.

Maximizing Solo 401(k) contributions strategies

Now that we've explored both employee and employer contributions, let's discuss strategies for maximizing your Solo 401(k) contributions.

Consider this scenario: You're a self-employed consultant earning $150,000 annually. As an employee, you could contribute the maximum $23,000 (or $30,500 if you're 50 or older). As an employer, you could contribute an additional 20% of your net self-employment income (Schedule C filer). This dual contribution strategy could potentially allow you to save over $50,000 for retirement in a single year, significantly reducing your taxable income while building your nest egg.

Balancing between employee and employer contributions requires careful planning. Start by maximizing your employee contributions. Then, based on your business's profitability and cash flow, determine how much you can contribute as an employer.

Remember, employer contributions offer tax benefits to your business, so consider this when planning your year-end tax strategy. It's also worth noting that you can make employer contributions up until your tax filing deadline, giving you additional flexibility in your financial planning.

When developing your long-term retirement strategy, consider factors such as your current age, retirement goals, and risk tolerance. If you're closer to retirement, you might want to maximize both employee and employer contributions to catch up on savings.

The Solo 401(k) is a great retirement plan for self-employed individuals. The dual option for contributions lets you save well beyond the typical limits and can be a great tool for optimizing taxes.