As a self employed professional you have the obligation to save for your own retirement. Fortunately there are several good options for a self employed professional to save and invest for retirement in a tax advantaged way. These include the solo (or individual) 401k, SEP IRA, SIMPLE IRA, and defined benefit plan.
This post will focus on the solo 401k for the self employed professional, along with some of the advantages and disadvantages of using the solo 401k vs. a SEP IRA to save for retirement for the self employed professional.
The Solo 401k
The solo 401k (also referred to as an individual 401k, or a single member 401k) is essentially the same plan as any other 401k you may have had from an employer. The difference is that the solo 401k will have only one member (you) and therefore will have slightly different rules for the self employed professional than for an average employee of a company.
One key advantage of having a solo 401k as a self employed professional is that you will be able to tailor the eligibility requirements and contribution rules (such as accepting after-tax and Roth contributions) to fit your specific tax planning goals.
Who is Eligible?
The strategies discussed in this post are intended for a self-employed professional with no employees operating a single member 401k. These strategies could also apply to a self-employed side gig. Make sure to consult with your trusted tax advisor to apply these ideas to your individual situation.
Sole Proprietors and Single Member LLCs can set up and fund their plans up until their tax filing deadline including extensions. S-Corps and C-Corps must set up their plans by the end of the year, but can fund the plan up until their tax filing deadlines.
Contributions To a Solo 401k
The solo 401k will allow the self employed professional significant flexibility in the type of contributions made to the plan in alignment with your tax goals. Unlike other plans (such as a SEP IRA) you can make contributions both as an employee and employer (vs. only employer contributions in a SEP IRA). This may allow you to contribute more overall to the solo 401k than other plans, especially if your income is below $345,000 in 2024.
The maximum contribution is the same as other retirement plans ($66,000 for 2023, and $69,000 for 2024).
The types of contributions you can make to the solo 401k:
- Pre-tax salary deferrals
- After-Tax Roth salary Deferrals
- After-tax non-Roth salary deferrals
- Employer (pre-tax) contributions
Pre-Tax Salary Deferrals
For 2024 you can contribute 100% of your salary up to $23,000 into your solo 401k. If you are age 50 or older you can contribute an additional $7,500 for a total of $30,500. These salary deferrals are fully tax deductible and will be reported on your W2. These contributions will grow tax-deferred until you distribute them in retirement.
These funds will be fully taxable when they are distributed in retirement and there is an additional 10% early withdrawal penalty for most distributions taken prior to age 59 1/2. Required Minimum Distributions (RMDs) are required to begin when you are 73.
After-Tax Roth Salary Deferrals
As long as your plan allows (remember you get to decide what your plan allows) you can choose to make salary deferrals to the Roth portion of the 401k. The Roth 401k salary deferrals are not tax deductible. The contributions can be withdrawn any time without tax or an early withdrawal penalty and importantly the growth of the funds can be withdrawn tax-free in retirement!
There are currently no Required Minimum Distributions (RMDs) for Roth 401ks.
You can contribute all of your salary deferrals to the Pre-Tax or Roth portion, or you can contribute to both. In any case the total between the two cannot exceed $23,000 in 2024 plus the age 50+ catch-up contributions.
Pre-Tax Employer Contributions
In addition to regular salary deferrals the self-employed professional can also make employer contributions. After all, you are the employer! For a self-employed professional the employer contributions max out at 20% of your net self-employed earnings. To calculate net self employed earnings you would look at your total net profits as reported on Schedule C of your tax return, and subtract one half of the self employment tax, and your contributions. IRS Publication 550 contains a worksheet and chart you can use to make sure you are calculating the allowed profit sharing amount correctly.
The ability to contribute both employee and employer contributions to the solo 401k plan will allow most self employed professionals to contribute more to the plan than other self employed plans such as the SEP IRA (which only allows employer contributions up to 20%).
For example assume a 45 year old self employed professional attorney (with no employees) has earnings from self employment of $200,000 in 2024. Utilizing a SEP IRA the attorney could contribute 20% ($40,000) to the SEP IRA. However, in a solo 401k plan the attorney could contribute $23,000 (as pre-tax or Roth salary deferrals) and make a profit sharing contribution of $37,373 (calculated on net earnings from self-employment using IRS Publication 550) for a total of $60,373!
In any case the maximum for all types of contributions is $66,000 in 2023 and $69,000 in 2024.
After-Tax Employee Contributions
The Solo 401k also has the option to accept after-tax employee contributions. These are contributions above and beyond the regular (Pre-Tax or Roth) employee contributions and are deposited into their own separate account. There is no tax deduction for these contributions, the growth is tax-deferred, and taxes on the growth are due upon distribution. Importantly, these after-tax contributions can be eligible for Roth conversions inside the plan. This is known as a “backdoor Roth 401k” strategy and can result in significant tax savings.
So, the attorney in the example above may also be able to add an additional $8,627 in after-tax contributions to get to the maximum $69,000 for 2024.
It is important to note that the dollar amount maximums ($66,000 in 2023 $69,000 in 2024) still apply, so employer contributions can reduce the amount of after-tax contributions allowed.
Backdoor Roth 401k Strategy
The backdoor Roth strategy or “super or mega backdoor Roth strategy” as it is known with a 401k can allow significant dollars to be taxed as a Roth (tax free growth on eligible distributions and no RMDs) beyond straightforward contributions to a Roth IRA or the Roth salary deferrals in a Solo 401k.
As long as your Solo 401k plan allows it, you can convert the after-tax contributions to a Roth 401k inside your plan. This is an advanced tax strategy and should be done in consultation with a tax advisor.
Investment Options
The Solo 401k contributions can be invested through a custodian in a variety of investment options such as mutual funds, ETFs, stocks, bonds, etc.
How To Set Up a Solo 401k as a Self-Employed Professional
Step one is to select a custodian such as Schwab, Fidelity, or Vanguard (there are many others) for your plan. Make sure to choose a custodian who will allow for Roth and after-tax contributions, and in-plan Roth conversions if you are trying to accomplish that type of tax planning.
Next you will fill out an adoption agreement, which will be supplied by the custodian. This is where you will determine the eligibility of the plan and select whether the plan will allow Roth and after-tax contributions.
The custodian will also supply a plan document which includes all of the features and rules of the plan.
Finally, you will need to open an investment account with the custodian for each type of contribution you plan to make to the Solo 401k (pre-tax, Roth, and after-tax).
When you’re ready to make contributions the custodian should have a form to indicate how to make out the check and whether the funds are going to the pre-tax or Roth portion.
What Happens When I Hire an Employee?
Once you hire an eligible employee you no longer have a solo 401k. The plan will be subject to discrimination testing and other rules. While the strategies in this article will still mostly be possible, it is important to understand the implications of having an employee and that you carefully comply with all rules and regulations.
Make sure to do plenty of research and as always do not rely on a blog post for specific tax advice. Especially the employer and after-tax contribution amounts can be tricky to calculate. Your individual situation may have nuances not discussed in this article. A CPA or other tax planning professional can help you make sure you are complying with the tax code.
The Solo 401k plan is more complicated to administer for the self employed professional than other plans such as a SEP IRA. However, the potential for higher contribution amounts and the ability to make Roth contributions can make the Solo 401k a solid choice for retirement savings for the self employed professional.
Further Reading
IRS Information on the Solo 401k Plan (IRS.gov)
IRS Publication 550 to help make sure you are calculating self-employed net earning correctly for the employer contribution (IRS.gov)
A helpful worksheet from Fidelity to help calculate your employer contribution (Fidelity.com)
