February 2020 – Calling all solopreneurs: you can rock retirement

The Roaring (19)Twenties were an era of economic prosperity marked by mass-produced cars, transatlantic air travel, and Hollywood glitz and glamour.  As we embark on the (20)Twenties, we are staring down self-driving cars, artificial intelligence and the sharing economy which is giving rise to the Side Hustle.

Whether you work for yourself full-time as a consultant, therapist, or personal trainer; you pick up additional income here and there from Uber, Postmates or Rover; or anything in between, you have powerful tax-advantaged retirement savings opportunities available to you. 

Unlike the typically onerous IRS rules, tax laws allow solopreneurs access to retirement accounts – like SEP IRAs and Solo 401(k) plans – that are off-limits to the classic corporate 9-5’er.  Depending on your income and your other existing retirement accounts, you could possibly save thousands more per year on a tax-favored basis. 


The details of these plans and their relative advantages are outlined below.  Some of the rules are technical, but don’t miss these two headlines:

Retirement plan descriptions

First, let’s understand these retirement savings vehicles.

SEP IRAs function much like a traditional IRA, but the contribution limit is higher. For 2020, the employer (you) can contribute the lesser of 20% of your net earnings from self-employment tax1 or $57,000.  These contributions are tax-deductible for you.  You can establish and fund a SEP-IRA for 2020 as late as your tax filing date (April 15, 2021), plus extensions (up to October 2021).  This allows flexibility to settle your year-end finances and then determine the contribution that feels right for your cash flow situation.   Good news: there is still time to establish and fund a SEP IRA based on your 2019 earnings.

Solo 401(k) plans function much like corporate 401(k) plans, though you can open such an account only if you or you and your spouse are the only employees in your business.  Unlike the SEP IRA, you can make contributions as the employee and employer.  Specifically:

  • Employee contribution max $19,500 (or $26,000 if ≥ 50)
  • Employer contribution max 20% of net earnings from self-employment1
  • Employee + employer max $57,000 (or $63,500 if ≥ 50)2

The employee contributions are tax-deferred and the employer contributions are tax-deductible contributions for your business.  Unlike the SEP IRA, you must establish the plan and make the employee contribution by December 31, 2020 for a Solo 401(k); the employer can fund up to the tax filing date (April 15, 2021), plus extensions (up to October 2021).

In the past, advisors steered clients to SEP IRAs because of the higher set-up and maintenance costs of a Solo 401(k).  However, in recent years, the costs have come down to roughly in line with SEP IRAs.  In fact, Fidelity’s Solo 401(k) has no set-up or administrative costs. Also note that when your Solo 401(k) plan exceeds $250,000, you must file Form 5500 with your tax return.  Your accountant may charge a small fee to prepare this extra form.  When you retire, you can rollover the Solo 401(k) to an IRA and eliminate the need for the Form 5500.

For both SEP IRAs and traditional Solo 401(k) plans:

  • distributions from the account are taxable, Required Minimum Distributions (RMDs) begin at age 72, and generally withdrawals prior to age 59.5 incur a 10% penalty; and
  • you can invest the money in standard investments like stocks, bonds, ETFs, mutual funds, etc.; and
  • the Tax Cuts and Jobs Act of 2017 (Trump’s tax cuts) may make the employer contribution even more valuable, as staying below certain income thresholds will allow you to take advantage of the new 20% pass through tax break.

Plan selection

Now, let’s explore which plan will best serve you.  If your self-employment income is your sole income source, generally, you can save more with the Solo 401(k). For example, let’s assume you are under 50 and you have a business with no employees. Your net earnings from self-employment are $100,000 for 2020 and you have no other retirement plans.

  • SEP IRA max contribution: $20,000 (20% of $100,000)
  • Solo 401(k) max contribution: $39,5003
    • Employee: $19,500
    • Employer: $20,000 (20% of $100,000)

On the other hand, if you also have a “day job” where you contribute to a corporate 401(k) plan, your aggregate employee 401(k) contributions (corporate + solo) are limited to the $19,500 (or $26,000 if ≥ age 50).  So if you max out your employee contributions in your corporate 401(k) plan, you may opt for the SEP IRA which relies just on employer contributions.

That said, there are additional advantages to a Solo 401(k) over a SEP IRA.

  • Roth 401(k) plans: Not all corporate 401(k) plans allow for Roth 401(k) contributions.  If that is true for you, consider directing a portion of your employee contributions to a Solo Roth 401(k) plan4. Diversifying your retirement savings vehicles – across Traditional 401(k)/IRAs, Roth 401(k)/IRAs, Health Savings Accounts (see related article), and taxable accounts – will maximize your flexibility in retirement. Remember that taxable income (including RMDs from Traditional 401(k)/IRAs) will impact:

a)    the amount of Social Security which is taxable (0%, 50% or 85%) and b)    Medicare Parts B and D premiums (means-testing surcharges). 
You fund Solo Roth 401(k) plans with after-tax dollars, so it will not reduce your taxable income; but in the future, distributions from Roth 401(k) plans are not taxable. 

  • Backdoor Roth contributions: By keeping your Side Hustle savings in a Solo 401(k), you preserve the flexibility to make unencumbered backdoor Roth contributions; whereas SEP IRAs could trip the pro-rata rule possibly causing an expensive tax bill for such contributions.
  • After-tax contributions (little known gem): Many corporate 401(k) plans do not allow for after-tax contributions. If that is true for you, consider making these contributions to a Solo Roth 401(k) plan.  You can make a $19,500 ($26,000 if ≥ age 50) employee contribution into the Solo Roth 401(k), forgo the employer contribution, and make a $37,500 after-tax contribution which you immediately roll into a Roth IRA.  In total, you can save $57,000 (or $63,500 if ≥ age 50) into Roth vehicles and take advantage of the tax-free growth for the rest of your life.  This planning opportunity has some complexities and should be analyzed in more detail for your specific circumstances before proceeding.

It’s natural for entrepreneurs to want to invest their profit back into the business, but we recommend saving at least a portion of it for retirement.  Think of it as paying your future self.  Saving just $5,000 annually, compounding for 30 years, will reasonably grow to $400,0005.

The nuances of these plans can get tedious.  To set you up for a rocking retirement, we are happy to discuss these plans in greater detail and help you apply them to your individual circumstances.  Happy savings!

This information is not intended to be a substitute for individualized tax advice. As always, we encourage you to include your CPA in tax-related decisions. 

[1] The IRS rule states 25% of ‘eligible’ earnings which is equivalent to 20% of (your business profits minus the deduction for one-half of your self-employment tax). [2] Limited to your net earnings from self-employment. [3] You could save up to $57,000 (or $63,500 if ≥ age 50) if you also make after-tax contributions. [4] Check that the Solo 401(k) provider offers a Roth 401(k) feature. Also note that only the employee and 50+ catch-up contributions can be Roth contributions. The employer contribution must be made as a traditional contribution, which means you will be accruing two accounts – one Roth and one Traditional – in the Solo 401(k) plan. [5] Assumes 6% growth rate.

Julie Zawislak