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Self Employed with a Solo 401(k) and Loving It – more for the “Yacht-less”

I like to walk my neighborhood and see the businesses that have stayed the course, popped-up and who has moved on with the times.

Self Employed with a Solo 401(k) and Loving It – more for the “Yacht-less”

Walking down Atlantic Avenue, Brooklyn, you see the cabinet maker and fine woodwork shop (he must have been there some time as his workshop is at street level), then there is the fine art framer whose main clientele are museums, the new coffee, and Wi-Fi spot, the brownstone building still with its 1859 “Sale Makers - Canvas Goods” decal, now home to Urban Outfitters, the corner bodega, the real estate agent always with fresh apartment pictures, and the wine and spirit store owner a master of wine regions with endless adjectives for taste. Then there is the restaurant owner who sold up his Paris restaurant of 16 years and is now in Brooklyn. And don’t be surprised to recognize a face from a movie or TV show. When I these business storefronts I can feel the business owners’ passion, they are doing what they believe in.

So, what do I, the financial planner for the “Yacht-less”, think is on the minds of these entrepreneurs? - no doubt they are always thinking about how they can do it better, then things like - cash flow, meeting payroll, increasing sales, competition, promotional material, and plans, their suppliers, technology, taxes, licensing and regulations, the weather, inventory, and the landlord. How does saving for “retirement” (do entrepreneurs ever retire?) get on their radar?

Here comes the SEP IRA

A SEP IRA is a qualified retirement plan that is exclusively for self-employed[1]. It’s easy to establish (usually free of charge) and can be established and contributions made post-tax filing year (i.e. you can set it up in 2019 and make payments that will be tax-deductible in 2018). The maximum contributions, 2019 limit is - $56,000. The maximum contribution is reached at $270,000 of income and contributions are limited to 20% of profits for sole proprietorships after self-employment tax. That all sounds great.

Here comes the Solo 401(k)

Like the SEP-IRA a Solo 401(k) is also a qualified retirement plan that is exclusively for business owners and their spouses (Not available to business owners with full-time employees). It combines the benefits of a typical 401k plan without the administrative requirements of a large 401k plan with employees. It’s easy to establish and unlike the SEP-IRA must be established during the tax filing year, i.e. it must be in place, ready before year-end, contributions can be made post-tax filing year. Some investment platforms offer Solo 401(k) plans free of charge as long as you use their platform to invest (e.g. TD Ameritrade, Vanguard). In a Solo 401(k) the business owner is both the employee and the employer for the purposes of the plans. Maximum Employee Contributions (2018 limits): $18,500 (under age 50), and $24,500 (age 50 or older), in addition to the maximum employer contributions (2018 limits): $55,000 (under age 50), $61,000 less the employee contribution. Employee contributions can be Pre-Tax or Roth. The employer contributions must be pre-tax. Employer contributions are limited to 20% of profits for sole proprietorships and partnerships, 25% for S and C Corporations.

How does a Solo 401(k) compare to a SEP IRA?

Let’s assume we are a sole proprietor age 55 with $195,000 Net Business Income in 2018. Our SEP-IRA Maximum Contribution would be $36,885, compared to a Solo 401(k) Maximum Contribution of$61,000. That’s a big difference! I didn’t mention this before, but you can take a loan from a solo 401K, but not a SEP-IRA. The maximum loan is 50% of plan value or $50,000, whichever is lower (e.g. If plan assets are $80,000 my maximum loan is $40,000 if plan assets are $100,000 or more my maximum loan is $50,000). Also, as noted above, the employee contributions can be designated as Roth contributions. So, my 55-year-old sole proprietor with $195,000 in income can contribute $24,500 to their Solo employee account as a Roth and the balance, $36,500 ($61,000 less $24,500) as the employer contribution, pre-tax. (“Back-door” Roth IRAs with Solo 401(k) are possible, but not with a SEP-IRA). Real Estate Investment is allowable with a 401(k)’s and it may be leveraged; this is not possible with SEP IRA. Caveat - This will require custom 401(k) plan documents (not available free of charge) and there are complex rules involving IRS “prohibited transactions”. Violating “prohibited transactions” may result in severe tax penalties. Please consult an attorney and a CPA before considering this.

Conclusion – Focus on what you can control.

A Solo 401(k) has all the benefits and more of a SEP IRA, and we noted that the sole proprietor reached their contribution limit with far less income. It also can provide valuable working capital to a business owner. Each and everyone planning for retirement has a unique set of circumstances requiring careful evaluation. I always conclude my blogs with a focus on the things you can control and impact your investing and financial planning experience. When evaluating your retirement vehicle and financial plan ensure:

  1. the financial plan fits your needs and your risk tolerance, now and is flexible if circumstances change.
  2. the financial plan is structure across dimensions of return.
  3. the plan investments are diversified.
  4. expenses and taxes are known and managed.
  5. the plan will keep you disciplined through market swings and dips.

This is an important topic for the self-employed and where some expert financial advice can go a long way, and help you to keep your focus on building and growing your passion.

Any questions?

I hope you found this blog helpful and that it steers you to the best option for your needs. Each week I allocate time to answering questions I receive on my blogs, so if you have questions, please let me know at This email address is being protected from spambots. You need JavaScript enabled to view it.. I do my best to get back to you within 48 hours.   If you have a Facebook or LinkedIn account, you can click on the little "Facebook" or “LinkedIn” icon and share this article. That way more people will be able to find it and hopefully, more people will benefit.

[1] If you have employees you can set up a profit-sharing plan for the employees, this is not common.

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