If you're self-employed or own your own business, you have to take ownership of your own retirement. No outside employer will provide you with a 401(k) to get tax breaks to save -- it's up to you to make a plan.
The good news is, there are plenty of options for small business owners and self-employed entrepreneurs to get tax breaks for retirement account contributions. You just need to know which account is best for your situation.
For those who are eligible for it, a Solo 401(k) is often the best way to save if your goal is to maximize how much money you can contribute to retirement accounts.
Could a solo 401(k) allow you to save more for retirement?
Those who are self-employed can invest in different types of retirement accounts that provide tax breaks for saving and that have higher annual contribution limits than traditional IRAs. Options include a Solo 401(k), a SEP-IRA, and a Simple IRA.
Solo 401(k)s are available only to those who have no employees other than themselves and a spouse. They can be opened at most brokers and financial institutions, although a fee is sometimes charged.
Solo 401(k)s allow you to make tax-free retirement contributions as an employee and employer. Because you can contribute as an employee and employer, you almost always have a higher maximum contribution limit for a Solo 401(k) than a SEP-IRA, which only allows employer contributions.
And, because there are different contribution limits for a Solo 401(k) versus a SIMPLE IRA, a Solo 401(k) usually allows for more tax-advantaged retirement savings than a SIMPLE IRA as well.
This means if your primary goal is to contribute the maximum amount to a tax-advantaged retirement savings account, a Solo 401(k) is usually your best option. Let's take a closer look at why.
Solo 401(k) contributions vs. SEP contributions
There are annual limits to the amount of pre-tax money you can contribute to a Solo 401(k):
- Acting as an employee, you can contribute a maximum of $18,500 in 2018 and can make an additional $6,000 in catch-up contributions if you're 50 or older. Contributions can't exceed your salary, if you pay yourself one, or earned income if you don't. Earned income equals net earnings minus half of self-employment taxes and 401(k) contributions.
- Acting as an employer, you can contribute up to 25% of compensation or 20% of earned income in addition to employee contributions.
Combined maximum contributions as an employee and employer equal $55,000 in 2018, or $61,000 if eligible for catch-up contributions.
When you contribute to a SEP-IRA, on the other hand, you can contribute only as an employer. You're allowed to contribute 25% of salary or 20% of earned income. The maximum contribution for your SEP in 2018 is $55,000, and there are no catch-up contributions.
If you invest in either a Solo 401(k) or a SEP, you have the same contribution limit as an employer: 25% of compensation or 20% of earned income. However, with a Solo 401(k) you also get to contribute up to $18,500 as an employee. The math is simple: 25% of salary (or 20% of earned income) plus $18,500 is a bigger number than just 25% of salary (or 20% of earned income).
There's one caveat. If you're under 50 and have salary or earned income of $220,000 or more, you'd be able to contribute the same amount to a Solo 401(K) or SEP since employer contributions to a SEP -- 25% of $220,000 -- get you to the $55,000 maximum contribution applicable to both.
Once you're over 50, the Solo 401(k) once again has higher contribution limits because catch-up contributions bring maximum contribution to $61,000 instead of $55,000.
Solo 401(k) contributions vs. SIMPLE Contributions
With a SIMPLE IRA, you can contribute as both an employer and an employee. However, contribution limits are lower.
As an employee, you can contribute a maximum of $12,500 in 2018 plus an additional $2,500 in catch-up contributions if you're over 50. As an employer, you can either contribute 2% of eligible compensation, or you can match employee contributions to the SIMPLE, up to a maximum match of 3% of total compensation.
Obviously, these limits are much lower than 25% of compensation plus $18,500.
Which account is right for you?
A Solo 401(k), a SIMPLE IRA, and a SEP-IRA differ in lots of ways. However, if your primary goal is to maximize the amount you can contribute to a tax-advantaged retirement account, a Solo 401(k) is clearly the way to go as long as you're eligible.
The higher contribution limits of a Solo 401(k) mean you can get the biggest possible tax breaks for saving for your future while investing as much as possible with which to enjoy your golden years.