NOTE: Consult a tax professional and IRS guidance documents for up to date and accurate information about deferring taxes with an Individual 401k.
Gather round, self-employed people. If you’re not contributing to an Individual 401(k) (also called a Solo 401k) and your goal is early retirement, I am about to change your life.
Massive Tax-Deferred Space
An Individual 401k is a retirement account consisting of a self-employed person and sometimes, his or her spouse or partner. This business may be structured as a Sole Proprietorship, an S-Corp, or a C-Corp.
The single biggest reason to employ an Individual 401k is the outsized ability it offers you to squirrel money away tax-free. Put simply, as a self-employed person, you are both your own employer and your own employee. That might seem a little self-evident, but bear with me. If you are the employee, then you are entitled to save up to $18,000 per year (as of 2015) tax free in a 401k. If you are the employer, then you are entitled to contribute to an employee’s 401k through a profit sharing program.
If you’re getting a slightly giddy feeling in your stomach, then you’re definitely understanding what I’m saying. Per the IRS, a Sole Proprietorship or S-Corp may contribute up to 25% of profits to the 401k as the employer’s profit sharing contribution. Consider this example:
Paulo earns $100,000 as a self-employed software developer. He maxes out his Individual 401(k) employee contribution. He owes $14,130 in self-employment taxes, half of which ($7,065) is deductible.
OK, the calculation gets a little confusing at this point. In essence, Paulo takes the amount he wants to contribute as the employer (let’s say the full 25%), and divides it by 100 + that percentage. That is:
25 / (100 + 25) = .2
The result of this calculation is multiplied by his business profit to get the maximum employer contribution.
$100,000 Net Income – $7,065 Self Employment deduction = $92,935 Profit
$92,935 Profit x .2 Multiplier = $18,587 Maximum Employer Contribution
Paulo can contribute $18,000 as the employee, then contribute $18,587 as the employer, for a total of $36,587 tax deferred.
If someone is extremely highly paid, they can scale this contribution up all the way to a maximum annual combined contribution of $53,000 (as of 2015). I don’t need to explain how huge a deal this is for prodigious savers interested in early retirement.
Greater Contributions as an S-Corp
So far we’ve covered how this affects a sole proprietor, but what about and S-Corp or a C-Corp? In the same scenario as the above, since self-employment taxes are not included in the calculation, your corporation can make a $25,000 contribution as the employer, for a total tax-deferred contribution of $43,000 on $100,000 in net income.
Get Married for Even More Deferral
Your spouse can also contribute to your Individual 401k so long as he or she earns income from your business. Remember that the $18,000 employee 401k contribution limit (as of 2015) is across all employers, so if your spouse contributes to another 401k, make sure he or she only totals $18,000 in employee contributions per year. The Employer contributions, on the other hand, are not combined. Your spouse’s employer can contribute as much as they would like, and your business can still max out the employer portion of the contribution for your spouse. This means that in cases of extremely high income, it’s possible to save up to $106,000 tax-free into an Individual 401k per year.
If your Individual 401k includes your spouse, you must both receive the same exact percentage of employer contribution.
Note that involving your spouse (or a partner, which is also permitted) starts to make the tax calculations a little more tricky, so definitely consult a tax professional if you decide to go this route.
My Experience Setting Up an Individual 401k with Vanguard
My experience setting up an Individual 401k with Vanguard was really positive (I’m a sole proprietor). First, I went down to my county office and registered my business with a fictitious business name. This cost me $35 (plus another $20 or so to fulfill a publication requirement). Then, I got on the IRS website and got an EIN for 401k purposes, which took me about five minutes. Both pieces or information are required in order to establish your account with Vanguard.
Finally, I called up Vanguard and asked for help in setting up the account. They emailed me the documents and patiently stayed on the phone, walking me through filling out each page. This was incredibly good customer service, and the gentleman on the line really knew his stuff. You’ll want to know which funds you want your plan to make available. This is one way where the 401k administration site differs from the personal site. You can’t simply select from all the funds- you have to have set up the ones you want to use in advance. It’s not hard to add more, but it requires a phone call, so it’s easier to just have a pretty solid understanding of where you want to invest before calling in.
After you complete the paperwork, you have to send the paper copies in for the account to be fully established. I overnighted the paperwork on a Monday and the account was completely set up by the end of the week.
If you want to track your investments easily and using an attractive report interface, consider setting up a free Personal Capital account. It helps to support this site, and is a free and excellent way to keep an eye on your growing assets.
401k plan administration at Vanguard has its own portal. It’s barebones, but not difficult to use. You input how much you want to transfer, then you allocate it to each fund, for each employee, as either employer or employee contribution. It’s really as simple as that.
The Individual 401k has changed my life. It has given this formerly-errant saver a huge opportunity to catch up and get ahead. What’s more, many employers are willing to negotiate higher hourly rates since they don’t need to pay for your benefits, taxes, or payroll. If you can get away with relatively few self-funded benefits, there’s a chance to make even more money.
What do you think of this awesome opportunity to save towards retirement? Do you have an Individual 401k? Did I miss anything? Let me know!