Being self-employed doesn’t mean you miss out on workplace retirement plans. With a solo 401(k) plan, you can sock cash away for your retirement in a tax advantaged savings plan even if you are working for yourself.
Tax Advantaged Savings: Solo 401(k) aka Self Employed 401(k)
A Solo 401(k) plan is defined by the Internal Revenue Service (IRS) as a one-participant plan. These plans operate like a traditional 401(k), except that they strictly cover a business owner with no employees. However, a Solo 401(k) may include the owner’s spouse if they participate in the company.
What You Need to Know to Calculate your 401k contribution
Freelancers, independent contractors, and small business owners without employees can save toward retirement through a Solo 401k. Sometimes called a self-employed 401k, individual 401k or Solo K, these retirement plans offer flexibility because you decide how much to contribute (up to the IRS limit). You don’t have to worry about age restrictions or working a set number of hours. As long as you have self-employment income and have no other employees (other than you and your spouse), you may qualify.
Factors to consider when calculating your Solo (401)k contribution include:
- Earned income
- Self-employment tax
- Annual contribution
- Catch-up contributions
- Company structure
What's the Difference between a Solo 401(k) and a Profit Sharing Plan?
A profit-sharing plan is a retirement plan in which employers allocate a portion of the company's profits to their employees. Companies of any size can use profit-sharing plans. Employers may distribute profits based on a fixed percentage or other factors.
No tax is due when your employer contributes to a qualified profit-sharing plan. However, you pay tax as you take retirement distributions.
Unlike other retirement plans, employees cannot contribute to a profit-sharing plan. Instead, only your employer can make contributions.
Solo 401(k) plans are designed for self-employed individuals or owners with no full-time employees other than themselves and a spouse. With a Solo 401(k), self-employed individuals can set aside funds in a tax-advantaged retirement account just as they could with a traditional 401(k). The Solo 401(k) plan incorporates both an option for an employee contribution and a company profit-sharing feature.
Yet despite these profit-sharing allocations, there are some critical differences between a Solo 401(k) and a profit-sharing plan.
- Contributions: Solo 401(k) plans offer dual contribution capacity whereby you make elective deferrals as an employee and contributions based on company profitability as the employer. Employees can’t elect to have part of their salary contributed to a profit-sharing plan. Instead, only employer contributions are allowed in a traditional profit-sharing plan.
When you are self-employed, calculating contributions based on your company’s profitability can be essentially the same whether you have a Solo 401(k) or a profit-sharing plan. A Solo 401(k) has a slight edge since you can also make contributions as an employee toward your retirement.
- Eligibility: With a Solo 401(k), you can work any number of hours without affecting your eligibility. Whether you're self-employed part-time or full-time, your eligibility remains intact. In contrast, profit-sharing plans often require minimum years or hours worked to qualify.
- Control: When you wear the employer hat in a Solo 401(k), you decide how much of your company's profits to contribute. With a traditional profit-sharing plan, the employer decides how much profit to allocate toward participating employees.
- Transition: Remember that you can only use a Solo 401(k)s when you are self-employed or a single company owner. If your company grows and you hire employees, you may need to switch to a different retirement plan. With a profit-sharing plan, there are no limits on employee participation.
Individual 401(k) Contribution Comparison
Aside from an individual 401(k), you can find other options for saving toward retirement when you are self-employed.
- SEP IRA: With a SEP IRA, you can make employer contributions of the lesser of 25% of your compensation or $69,000. However, you can’t make elective or catchup contributions if you are 50 or older under a SEP IRA.
- Simple IRA: Under a Simple IRA plan, the limit for employee contributions is $16,000. Catchup contributions are limited to $3,500. Employers are required to match up to 3% of your earnings with a Simple IRA.
- If you are self-employed and shopping around for retirement plan options, you may find that a Solo 401(k) offers higher tax savings.
Solo 401k Calculator
With a Solo 401(k) plan, you contribute in two capacities: as an employee and an employer. However, calculating the maximum contributions you can make can be tricky when you are self-employed.
Employee: You can make elective contributions out of your W-2 wages or earned income, which is yourSchedule C net profit if you are self-employed, up to the annual contribution limit. That means you can’t contribute more than the company has made. In 2024, you can contribute up to $23,000 of your compensation. Participants who are age 50 years or older may contribute up to $30,500.
Employers: As the employer, may contribute up to 25% of your company’s net income based on how the entity is organized.
- Sole proprietorships and single member LLCs – 20%
- S-Corporations, C-Corporations and LLCs with more than one member – 25% .
If you are a sole proprietor or the single member of an LLC, you calculate the employer contribution based on your net self-employment income, which is your company’s net income – ½ self-employment tax. When you are self-employed, the IRS limits employer contributions to 20% of the net earnings of your business.
To illustrate, let’s assume you are 40 years old and earn $50,000 as a sole proprietor in 2024.
- Employee contribution: Wearing your employee hat, you may contribute up to $23,000.
- Employer contribution: You calculate the employer contribution by subtracting ½ of the self-employment tax rate (7.07%) from income and then multiplying that difference by 20%, as follows:
$50,000 x 7.07% = $3,535
$50,000 – $3,535 = $46,465.
$46,465 x 20% = $9,293 (the maximum employer contribution)
Based on the above, the total contributions are $32,293
Using the same parameters above, let’s assume you earn $50,000 of W2 income from your single owner corporation. The maximum employee calculation remains at $23,000. However, you calculate employer contributions based on 25% of your net earnings. Since you have W2 income, your net earnings are $50,000. To calculate the employer contribution, multiply $50,000 x 25% to reveal a maximum of $12,500. So the combined Solo 401K contribution is $23,000 + $12,500 or $35,500.
Now assume you are 55 and earn $50,000 in W2 wages from your company. Since you are over 50, you may contribute an extra $7,500. The total allowable contribution to your Solo 401(k) would be $35,500 + $7,500 or $43,000.
Here’s one important factor to keep in mind if you have a day job: The maximum contribution of $69,000 for 2024 is applied by person, not plan. So if you decide to open a Solo 401(k) for your side gig but participate in an employer-sponsored retirement plan at your day job, your maximum contributions are $69,000 across both plans.
Catch up Contribution
Catch-up contributions apply to a Solo 401(k) plan. If you are 50 years or older, you can contribute an additional $7,500 in 2024.
Save money for retirement with a Solo 401k
You don't have to stress out about saving for retirement when you are self-employed or a single-owner business. With a Solo 401k, you have the flexibility and control to decide how much to put away for retirement.
FAQs
Can I make a lump sum contribution to my Solo 401k?
Yes – you can make lump sum contributions to a Solo 401(k) of up to $69,000 in 2024.
What is the maximum Solo 401k contribution for 2024?
In 2024, employees may contribute a maximum of $23,000. The combined employee and employer contribution limit for 2024 is $69,000. Catch-up contributions for 2024 are $7,500 if you are over 50.
How much will a 401k grow in 20 years?
How much you contribute and your plan's earnings influence the growth of your 401(k) balance. Consider using a retirement savings calculator to estimate the future value of your 401(k) like Investor.gov’s compound savings calculator or the AARP’s retirement savings calculator.