An Individual or Solo 401(k) is a retirement savings plan for self-employed individuals that do not have any employees. Most people think of or utilize a SEP when it comes to retirement savings of their business income, but in some cases an Individual 401(k) will allow you to save even more than a SEP allows.
The SEP or Simplified Employee Pension is made up of Employer contributions which business owners can contribute up to roughly 25% of net compensation. The Solo 401(k) is made up of a combination of Employee & Employer contributions. Technically, the business owner acts as the employee & employer. Although the 2020 IRS maximum dollar amount of $57,000 (under age 50) is the same between the two plans, there is an income level where it makes sense to utilize a 401(k) instead of a SEP to max contributions.
For Example: John Doe is self-employed with no employees and has net earnings of $228,000. His max contribution to a SEP is $57,000 which is the maximum limit under IRS rules. Any income less than $228,000, the SEP contribution of 25% will be less than $57,000. So how can a 401(k) be more advantageous if income is less than $228,000? The reason is being able to utilize employee contributions in addition to the employer or profit-sharing contribution. The employee contribution limit for 2020 is $19,500 ($26,000 if over age 50).
If John Doe earned $150,000, he’d be limited to $37,500 in a SEP. But in a 401(k) he could deduct $19,500 of employee contributions and contribute a 25% Employer contribution of $37,500 totaling the $57,000 max. If John were over the age of 50, he could contribute an additional $6,500 of catch-up contributions to his Solo 401(k) totaling $63,500 which would otherwise be restricted in SEP plan.
There are many similarities & differences between the two plans and it’s important to understand all the details before implementing. To take advantage of this type of retirement plan it would be wise to consult with a financial planner or tax professional to ensure you have the best retirement plan suited for your business. If you have any questions or would like more information on Solo 401(k)’s, feel free to contact us or visit IRS.gov