You may have started gig working to raise some extra cash, to explore self-employment part-time, or to improve your work-life balance. But did you know you can also use your self-employment status to tackle the goal of securing your retirement? As a gig worker, you are likely eligible to open and use a solo 401(k), which is one of the more powerful tax-advantaged retirement accounts available.
The big advantage of solo 401(k)s
The solo 401(k) functions much like a standard 401(k) in terms of tax advantages and contribution limits. What's different about the solo 401(k) is that you have two roles to play. You are both the employee and employer, and you can contribute in either capacity -- which makes for a very high contribution limit. The maximum employee and employer contributions in 2021 is $58,000 annually. If you are 50 or older, you also qualify for an additional $6,500 in catch-up contributions.
Solo 401(k) employee contributions
Unfortunately, you can't just drop $58,000 in your solo 401(k) and call it a day. You have to play within some extra IRS rules governing contributions. First, the employee-funded solo 401(k) contributions are treated as elective deferrals from your pay. As such, you can't contribute more than you make in earned income. Earned income is defined as self-employment earnings after deducting half of your self-employment tax and the employer-funded contributions you make for yourself.
You're also subject to the annual employee contribution limit, which is $19,500 in 2021, or $26,000 including catch-up contributions if you're 50 or older. In other words, you can contribute up to those limits, but never more than your earned income. If you make $15,000 in self-employment income this year, that's the most you can contribute as an employee.
Note, too, that these employee contribution limits apply to your cumulative deposits made to all 401(k) accounts. If you also have a regular job and put $10,000 in a workplace 401(k), for example, the most you can contribute to your solo 401(k) for the year is $9,500, or $16,000 if you are 50 or older.
Solo 401(k) employer contributions
When you contribute to your solo 401(k) as the employer, the maximum is 25% of your earned income. This part gets tricky because, as noted, earned income is your self-employment earnings after deducting half of your self-employment tax and your employer-funded contributions. That means your earned income and allowed employer contributions depend on each other.
In true IRS form, there's a special worksheet and calculation to resolve that circular reference, and it involves discounting the plan's contribution rate. Follow the math and the true maximum ends up being somewhere around 20% of your net business earnings.
Maximum 401(k) contributions
To reach the $58,000 cap, you'd need to make the full $19,500 employee contribution and then another $38,500 in employer contributions. That would require self-employment income of nearly $200,000. If you can afford to do that today, congratulations. If not, you can see that the solo 401(k) gives you plenty of room to grow into those high-dollar contributions.
How to open a solo 401(k)
You can open a solo 401(k) if you have self-employment income, a federal tax ID number, and no employees. If you don't have a federal tax ID number, you can apply for one for free at IRS.gov.
Brokerages and mutual fund companies offer solo 401(k)s, but the fee structures and investment options can vary. TD Ameritrade, for example, has no setup or maintenance fees but may charge commissions and service fees for certain actions you take in your account. Your investment options would include exchange-traded securities and mutual funds. A Vanguard solo 401(k), on the other hand, allows you to invest only in Vanguard funds. Most trades are commission-free, but Vanguard does charge $20 annually for each mutual fund held in the account.
You could also choose a provider with a self-directed solo 401(k). This type of account will have higher fees, but it holds a wider range of asset types, including real estate. A Rocket Dollar self-directed solo 401(k), for example, will hold any asset class that's allowed by the IRS -- but you'll pay $360 to open the account and then $15 a month in maintenance fees.
Contribute and invest
Opening up the account is the easy part. What will be more challenging is making those regular contributions, particularly if your income is inconsistent from month to month. To the extent possible, automate at least a small monthly contribution. Then set calendar reminders to yourself to make a larger deposit quarterly from your available cash.
Make sure, too, that you are investing those contributions. You might start out with an S&P 500 index fund as your primary holding, along with a small position in a U.S. Treasury ETF for stability. Or, if you have another 401(k) through an employer and you're happy with its performance, see if you can mimic that portfolio in your solo account.
You have what it takes
Saving for retirement relies on the same traits required to be successful as a gig worker: discipline and motivation. Add a solo 401(k) to the mix and you have everything you need to create a comfortable, financially secure future for yourself.