The gig economy has taken root in corporate America, and millions of people now work as independent contractors on a freelance basis. What gig workers quickly learn is that they have to come up with the benefits that most regular employees get directly from their companies.
One of the most important things gig workers have to think about is saving for their financial future. Many employers use 401(k) plans to help their employees set money aside for retirement. For those who are considered self-employed, a solo 401(k) can offer advantages that far exceed what most employees are able to get from their retirement plans. Below, we'll look more closely at solo 401(k)s and whether they make sense for you.
How solo 401(k)s work
As their name suggests, solo 401(k)s are a type of 401(k) plan. But solo 401(k)s are much simpler than a typical employer's 401(k) for one basic reason: Solo 401(k)s are designed to cover just one individual independent contractor or business owner, along with the option of including a spouse in the plan. If you have a small business with even a single other employee, then a solo 401(k) won't be right for you.
For purposes of saving money in a solo 401(k), you get to make contributions both as employee and as employer if you want. For 2020, the maximum employee contribution to a 401(k) is $19,500 for those under age 50, with those 50 or older getting to set aside an extra $6,500 for a total of $26,000. Your contributions are always limited to your net compensation, so your actual limit could be less if you make less than $19,500 or $26,000, respectively, depending on your age.
Where the big difference comes in is when you consider employer contributions. A solo 401(k) lets you make employer contributions of up to 20% of your net earnings from self-employment. Net earnings for these purposes means the net income from your independent contractor business after accounting for allowed deductible expenses, reduced by half of the self-employment taxes you have to pay on your income.
There's a much higher limit on total contributions -- employee plus employer -- that you're allowed to make to a solo 401(k). For 2020, that limit is $57,000 for those under 50, or $63,000 for those 50 or older. But because the employer portion is limited by income, you generally have to have a very high level of earnings in order to qualify to make the maximum contribution.
Is a solo 401(k) worth it?
Opening a solo 401(k) does come with a cost. You'll formally have to take on the responsibility of being a retirement plan administrator, keeping the necessary documentation and filing the necessary tax forms that come with it. If you don't, the IRS can come back and challenge the tax-deferred status of your solo 401(k). Most of the financial institutions that offer solo 401(k)s will help you out with the required paperwork, but that can sometimes come with added fees.
However, many people like solo 401(k)s because they tend to offer much more flexible investment options than a regular employer's 401(k) retirement plan. Rather than having to settle for mutual funds, many solo 401(k) providers offer full brokerage accounts that let you invest in stocks, bonds, ETFs, and many other types of investments.
Solo 401(k)s can be the best way for gig workers to provide for their future. Especially for those who've found ways to earn substantial sums as independent contractors, the high contribution limits of solo 401(k)s give them advantages over some of the other retirement savings vehicles available to the self-employed.