Solo 401(k): The Solopreneur’s Retirement Account

By Sean Mullaney

Navigating retirement for solopreneurs is not easy–strategically save with the Solo 401(k)

 

If you're self-employed, having enough money to retire might weigh heavily on your mind. Wearing both the employer and employee hats is complicated, and things can get confusing quickly.

 

CPA and financial planner Sean Mullaney cuts through the complexity and boils down what solopreneurs need to know about saving for the future in Solo 401(k). The Solo 401(k) plan allows a self-employed entrepreneur in almost any business to reduce taxes and strategically save for retirement. His guide will educate and empower you to create, navigate, and optimize your own Solo 401(k) plan and shares tax advice you may not have considered.

 

You'll discover:

The many advantages of a Solo 401(k), including more flexibility and higher limits for contributions.

Tax planning strategies offered by the Solo 401(k), like tax-deferred or tax-free growth.

How to establish and maintain a Solo 401(k).

IRS income tax reporting required for Solo 401(k)s.

How Solo 401(k)s can be used to save money in conjunction with other popular retirement income options, such as the Roth IRA.

 

Whether you're self-employed, a side hustler, or a fiscal advisor, this is the educational resource you need to help build personal wealth for the life you or your clients want in the future. Get Solo 401(k) today to learn everything you need to know about the best retirement savings account for solopreneurs. The sooner you start investing in your future, the greater your freedom will be!

• Language: English
• Publisher: Sean Mullaney
• Release date: Oct 4, 2022
• ISBN: 9798986448909

Book preview

INTRODUCTION

If you are of a certain age, you might remember Ron Popeil’s sales pitch for the Showtime Rotisserie & BBQ. Making dinner was as easy as set it and forget it.

In my first career, I had the good fortune of W-2 employment for the Internal Revenue Service and Big Four accounting firms. At these large employers, I had access to the Thrift Savings Plan (at the IRS) and large 401(k) plans. I had no need to establish a retirement plan. Rather, I could go to a web portal, pick where I wanted my money invested, elect how much of my paycheck I wanted to save, and I was done.

My workplace retirement plan was to set it and forget it.

Starting my second career as a financial planner, I became self-employed. No one from HR sends you an email asking you to set up your retirement plan when you are self-employed. There’s nothing to set and forget.

But does that mean the self-employed don’t have retirement plan options? Absolutely not, but none of the options are quite as easy as set it and forget it.

The self-employed face three significant obstacles in their financial lives.

First, being self-employed is a great way to pay a ton of taxes to Uncle Sam and state taxing authorities. Subject to both the income tax and the self-employment tax,¹ a solopreneur’s self-employment income often suffers a higher tax rate than employee W-2 income and other kinds of income, such as interest, dividends, capital gains, retirement plan distributions, and Social Security. Ouch!

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SELF-EMPLOYMENT TAX

The self-employed are subject to the self-employment tax computed on Schedule SE of the federal income tax return. This tax is in addition to the federal income tax. For amounts of self-employment income under $147,000 (2022 number), the taxpayer generally pays a self-employment tax of 14.13%. Here is a brief example:

Roxane’s self-employment income (as reported on

Schedule C): $100,000

Roxane’s self-employment tax: $14,130

The $14,130 of self-employment tax is in addition to the federal income tax Roxane owes on her self-employment income. However, for income tax purposes, Roxane can deduct one-half of the self-employment taxes she owes in determining her taxable income. To determine her taxable income, Roxane starts with her $100,000 of self-employment income and claims $7,065 (one-half of her self-employment tax of $14,130) as a tax deduction.

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Second, saving for retirement is a challenge when you are a solopreneur. Running one’s own business is its own significant undertaking. With running your actual business, advertising it, keeping up with clients, and the millions of other things you have to do, who has time for retirement planning? Layering in saving for one’s own future while self-employed greatly increases the degree of difficulty involved in the financial lives of solopreneurs.

Third, have you seen a tax return? There is plenty of complexity when it comes to being self-employed. Folding retirement savings into that mix amps up the complexity and confusion.

These are three big problems facing millions of Americans who, like me, run their own small businesses. Wouldn’t it be great if there were one tool available to solopreneurs that helps them reduce their taxes and build up retirement savings?

It turns out there is: the Solo 401(k).

I’ll admit it. The Solo 401(k) excites me. As a tax-focused financial planner, I truly enjoy thinking, talking, and writing about retirement saving and tax reduction. Not only do I advise clients on Solo 401(k)s as a financial planner, but I have one myself. I believe the Solo 401(k) represents a unique tax planning opportunity for many self-employed individuals and side hustlers.

In today’s tech-enabled world, I believe we will see a rise in entrepreneurship. For an increasing number of entrepreneurial Americans, the Solo 401(k) will comprise a significant portion of their retirement savings and a primary method of legally reducing tax liabilities.

The world continues to change, and much of that change involves shifts away from traditional, full-time employment. For example, a 2019 Bankrate survey reported that 45% of working Americans had a side hustle.² Since 2020, more Americans have started their own businesses because either they had to when they lost their jobs, or they discovered an appreciation for the flexibility offered by full-time self-employment or a side hustle.

The barriers to entry of self-employment (whether full-time, part-time, or as a side hustle) have rapidly declined in a tech-enabled world. In addition, I’m concerned that long-term W-2 employment for knowledge workers in many industries will decline because of technology. Thus, the opportunities for self-employment are increasing while the need for self-employment increases. The result is more Americans making their own ways without a set it and forget it retirement plan. How will these new business owners protect their futures?

The perfect storm in which the Solo 401(k) will rise to prominence as the retirement account for the new workplace is here. There’s no time to wait to tackle it head-on.

According to a recent report from Morningstar, it appears that only 13% of self-employed Americans save for retirement.³ That needs to change. The time has come to raise awareness of the most powerful retirement account for solopreneurs, the Solo 401(k). That’s why I wrote this book.

The workplace is changing. These changes create tax and financial challenges for millions of small business owners. But there are also unique opportunities for you as a business owner. It’s time to educate solopreneurs on the retirement account for the new workplace.

This book aims to do just that. In this book, we’ll cover the Solo 401(k) from a tax planning perspective. As a book about a complex tax topic, it must contain some tax rules. They’re unavoidable. My aim is to provide strategic and tactical lessons on how the Solo 401(k) can be used to lower taxes, increase tax-advantaged savings, and help facilitate retirement planning and financial independence.

A recurring theme in the book will be my plea to my fellow solopreneurs—get out in front of the Solo 401(k). This book will discuss the complexities and nuances of a Solo 401(k). You will be glad to learn that these complexities and nuances are very manageable with some advanced planning, thought, and intention.

I hope this book encourages you to think. It is tempting to want the answer from a book such as this. Give me exactly what I should do. This book does not provide the answer. Rather, it educates and informs. My hope is that this knowledge will help solopreneurs arrive at an informed decision as to what is best to meet their unique goals.

This book challenges you to think, but it doesn’t encourage you to memorize. I hope you keep this book as a reference. If you forget a concept or are confused about a topic, you can turn to the relevant chapter to get a refresher.

It Can Get Complicated

Occasionally, I receive an out-of-the-blue email from someone with a tax question about a specific situation. I have to politely respond that I can’t answer their question over email.

Why can’t I answer such questions with a friendly email response? Well, it turns out this stuff has some complexity. I don’t know who they are and what their business or financial situation is.

I’ll give you an example. Imagine I receive the following email.

Quick question. I contributed $10K to my Roth 401(k) at my W-2 job. I also contributed $6,000 to my Roth IRA. Can I contribute $10.5K to my Solo 401(k) for my side hustle? I’m worried that the $6,000 contribution to my Roth IRA reduces the $20,500 I can contribute to 401(k)s. Thank you for your help.

What’s the answer to the bolded question? The answer is that I have absolutely no idea. Why?

I don’t know whether his side hustle rises to the level of a trade or business. If it doesn’t, he can contribute $0 to a Solo 401(k), regardless of what his or her other contributions to retirement accounts might be. We will explore this issue in greater detail in chapter 5.

I can’t tell if the side hustle has employees such that this person wouldn’t be eligible to participate in a Solo 401(k). This issue will be discussed in more detail in chapter 5.

I don’t know how much income the side hustle made. Perhaps it has a loss, in which case, the maximum contribution is $0. Contribution limits will be discussed throughout the book.

I don’t know if the contribution would be allowed with the timing rules. Is the correspondent asking about contributing for the current year or the previous one? Did they make an election by year-end? Deadlines and timing issues will be discussed in more detail in chapters 6 and 9.

I don’t know if the correspondent is old enough to qualify for catch-up contributions that the correspondent might be overlooking. Contribution limits will be discussed throughout the book.

Lastly, from the email, I don’t know whether this correspondent is considering a traditional or Roth Solo 401(k) contribution, and whether such a contribution is advisable in their situation.

As you can see, analysis is required to answer this question. Rocket science? Absolutely not. But a friendly email response doesn’t suffice.

This book encourages you to do the analysis up front. I’ll provide you with the information you need to weigh out these questions for your own circumstances.

Solo 401(k) planning is manageable. With the right approach, you can build a sizable Solo 401(k), reduce your taxes, and help secure your financial future.

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1 The self-employment tax rate for amounts up to $147,000 (2022 number) of self-employment income (as reported on Schedule C) is, initially, 15.3%, which is 12.4% for Social Security and 2.9% for Medicare. See https://www.irs.gov/businesses/small-businesses-self-employed/self-employment-tax-social-security-and-medicare-taxes (updated April 29, 2022). However, as demonstrated by IRS Schedule SE, in order to avoid paying self-employment tax on self-employment tax, the Schedule C income is multiplied by 0.9235, and then the resulting number is multiplied by 15.3%. As a result, the self-employment tax on these amounts turns out to be approximately 14.13% (15.3% times 0.9235).

2 Amanda Dixon, Survey: Nearly 1 in 3 side hustlers needs the income to stay afloat, Bankrate, June 5, 2019, https://www.bankrate.com/personal-finance/side-hustles-survey-june-2019/.

3 Christine Benz, Retirement Planning for the ‘Gig’ Economy, Morningstar, December 16, 2020, https://www.morningstar.com/articles/751856/retirement-planning-for-the-gig-economy.

CHAPTER 1

THE HISTORY OF RETIREMENT SAVINGS

Before we can discuss the Solo 401(k), we need to think holistically about tax-advantaged retirement savings and their history in the United States.

This brief introduction to some basic retirement saving history and concepts will help us understand the Solo 401(k) and how it can be used as a tax planning and wealth-building tool for solopreneurs.

Defined Benefit Plans

The grandfather of American retirement savings is the defined benefit pension plan. Commonly referred to as pensions, defined benefit plans are funded by employers. The employer sets aside a fixed amount of money and is responsible for growing the fund to ensure there is enough to pay out the promised amount to retirees.

The employee receives a defined benefit. This benefit is usually expressed as a percentage of the average of their highest-earning years, and usually based on having worked a certain number of years. Here’s a quick example:

Joseph participates in Industrial Incorporated’s pension plan. After 20 years of service, he is vested and can receive a pension benefit in retirement. If Joseph does not work for 20 years for Industrial Incorporated, he receives no pension.

Joseph’s annual benefit is computed as two times the number of years he works for Industrial times the annual average of his highest five years of salary.

Let’s say that Joseph works for Industrial Incorporated for 30 years. The last five years there happen to be the best in terms of his salary, and he averages $100,000 a year. His annual pension benefit is computed as two times 30% times $100,000, which equals $60,000.

The employee does not pay tax on the plan until he or she starts collecting benefits in retirement.

Defined Benefit Plan Problems

While there are great tax advantages to defined benefit pension plans, there are also significant drawbacks, which have resulted in them becoming much less prevalent in the private employer landscape.

From the employer’s point of view, being on the hook for retirement benefits payable to former employees makes little financial sense.

From the employee’s point of view, the requirement to work 20 or 30 years for the same employer in order to get benefits is not consistent with the modern employment landscape, where changes in employers (and even careers) can be frequent.

Today, defined benefit plans are no longer available at most nongovernmental employers. Even at government employers, pension benefits have been modified and scaled back in many cases.

Social Security

In the 1930s, America instituted a nearly universal pension type system, Social Security. The idea was to provide a basic level of income to help seniors avoid poverty.⁴

Americans pay into Social Security through payroll taxes. Either payroll withholding (for W-2 employees) or through their self-employment taxes.

Generally speaking, up to the first $147,000 in income (2022 number) is subject to a 6.2% employee tax for Social Security and a 6.2% employer tax for Social Security. The self-employed pay both halves of this tax.

Social Security tracks annual earnings and tax payments. Taxpayers receive credit for having paid into Social Security. In retirement, taxpayers receive a benefit based on the 35 highest years of Social Security earnings. Social Security invests in government-issued debt securities.

Generally speaking, a person cannot collect their own Social Security retirement benefits until age 62. Further, benefits are generally reduced (by 5 to 8%⁵) for every year the person collects prior to age 70. At age 70, the maximum a person can expect to collect in monthly benefits is approximately $4,200 (in 2022 dollars).⁶ One’s benefit may be substantially less than that, depending on the amount of earnings they had during their top 35 years of working and when they choose to collect.

Social Security Problems

There are concerns about Social Security’s future solvency.⁷ That’s another book altogether, but my own take is that the issue is not very troubling. My best guess (and it is nothing more than a guess) is that Social Security will continue to pay out promised benefits for the rest of my lifetime.

While Social Security may very well be solvent for many more years, it has drawbacks, particularly if viewed as one’s entire retirement plan. For many, a benefit of $4,200 or less a month will not be sufficient for retirement.

Social Security has other drawbacks. Want to retire before age 62? You will get $0 in annual retirement benefits from Social Security. Want to draw on Social Security prior to age 70? Your annual benefits are reduced by electing to claim Social Security prior to age 70. Another drawback is that the government, not the account holder, chooses the investments inside Social Security.

Social Security is a good thing. But it’s on the government’s timetable, not on yours. If you’re self-employed, you probably prefer doing big things your own way. Your retirement should be dictated by your own wants—and not Social Security’s investments, payout amounts, and payout schedule.

For most, Social Security should not be viewed as one’s primary retirement plan. Rather, it should be viewed as a complement to one’s primary retirement plan.

Defined Contribution Plans

As defined benefit plans faded, defined contribution plans rose.

It is useful to think about two kinds of defined contribution plans. The first kind is a workplace defined contribution plan. These plans (often styled as 401(k) plans, 403(b) plans, and 457 plans—and there are other types) usually allow for two kinds of contributions. There are both employee contributions and employer contributions into the plan. These plans are offered,