Why anyone with contractor income should be using a Solo 401(k)

If you are an independent contractor, you should be sure to utilize the tax-advantaged plans available to small businesses. Broadly speaking, there are 3 categories of qualified retirement plans: 401(k), SEP IRA, and SIMPLE IRA.

Each plan has its pros and cons, but if you are a single-member company (or co-own with a spouse), the Solo 401(k) is almost always the best choice. Below is a comparison of the three plans to better understand the trade offs.

Overview

Solo 401(k)

A Solo 401(k), also known as an Individual 401(k), is tailored for self-employed individuals or business owners with no employees other than a spouse. It offers substantial tax-advantage potential and flexibility in contributions.

This plan is the usually the best retirement plan for self-employed single-member businesses. It has the highest individual and employer contribution limits of the 3 small business retirement plans. It also permits Roth contributions.

Considerations:

As a single-member business, you contribute to your Solo 401(k) as both an employee and employer. However, note that your employee contribution is shared across all of your employment, so if you contributed $23,000 to your 401(k) at a W2 job, then you cannot contribute more to your Solo 401(k).

The employer contribution is 25% of your compensation or net earnings (after deducting half of the self employment tax and any employee contribution). This limit is not affected by any contributions you made to a W2 401(k) or IRA.

In addition, the Solo 401(k) can easily be set up at many brokerages. At Toups Capital Advisors, we use Charles Schwab, which has free Solo 401(k) accounts. From the account, you can invest in low cost ETFs to keep your overall plan cost low.

The Solo 401(k) does require some paperwork: Effectively 1 form to establish the plan and an additional tax form 5500-EZ if your plan has more than $250,000 in assets.

Best Suited For:

Anyone who has a single member company (or co-owns with a spouse) and earns self employed income.

SEP IRA

A SEP IRA (Simplified Employee Pension Individual Retirement Account) is a flexible retirement plan designed for businesses of any size. One of its attractive features is the high employer contribution limit, which can reach up to 25% of an employee's compensation.

Considerations:

While offering considerable employer contribution limits, the SEP IRA mandates that the same contribution percentage must be applied to all eligible employees. This can significantly increase the employer's financial obligation if multiple employees are earning substantial salaries. For example, if you pay yourself $200,000 and contribute 25% of salary, then you would contribute $50,000 to your SEP IRA. At the same time, if you have an employee you pay $80,000, you would also have to contribute 25% to their SEP IRA account, meaning you would need to contribute $20,000.

SEP IRAs have a relatively expansive definition of employees, including those who are 21 and over, have earned at least $650, and have worked at least three out of the last five years are eligible. However, contractors are excluded.

Best Suited For:

Small businesses with a few employees and those who seek a high employer contribution cap.

Simple IRA

A SIMPLE IRA (Savings Incentive Match Plan for Employees) is geared toward small businesses with up to 100 employees. This plan emphasizes higher employee contribution limits but comes with relatively low employer contribution requirements.

Considerations:

The SIMPLE IRA is an attractive option for businesses looking to offer employees a way to save without incurring substantial costs. Offering higher contribution limits for employees makes it favorable for those looking to set aside personal funds.

However, the limited employer contribution makes it a less appealing option for owners to set aside retirement savings for themselves.

Best Suited For:

Businesses with fewer than 100 employees that want to provide a cost-effective retirement plan with higher employee contribution limits.

Conclusion

If you have any contractor/self-employed income, you should take advantage of the incredibly powerful retirement accounts that the IRS allows. In particular, the Solo 401(k) offers unique benefits with very high contribution limits, low fees, and substantial flexibility.

At Toups Capital Advisors, we can help you establish a Solo 401(k) or any other retirement account. Contact us today to talk through a possible implementation.