When it comes to running a business, you have to make a lot of decisions. Most of them involve how you’re going to run and grow that business.
One of the decisions you probably never thought about as an employee (but changed when you became a business owner) has to do with your retirement plan.
When I was working a regular W-2 job, I contributed to a 401(k) plan. I set a percentage of income, so I could get the employer match. I chose some funds, and I moved on.
When I started working for myself, I remember my business accountant asking me where I was going to put my 401(k). I naively replied – “Oh, I already rolled it over to Vanguard after I quit,” – thinking she meant my old 401(k) plans.
Nope. She meant the retirement plan for my business. And I hadn’t picked one because it completely slipped my mind.
It turns out that picking the type of plan can have a big impact because all the rules are different.
When I thought about it some more, I only had two criteria:
- It has to be easy to set up
- I’d really like to open it with Vanguard (where I keep nearly all of my investments)
In the end, I settled on a Solo 401(k) over a SEP IRA and a Simple IRA. Here’s why:
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What is a Solo 401(k)?
Simply put, a Solo 401(k) is a 401(k) for a business with just one employee – the business owner. It’s sometimes called a Self-Employed 401(k) or an Individual 401(k).
Technically, you can have two employees – the business owner and his or her spouse. If you have any additional employees, you aren’t eligible to open a Solo 401(k).
Contribution Rules: You’re allowed to contribute $61,000 in 2022 or 100% of earned income, whichever is lower. This amount is broken up into two parts.
- Employer Contribution: As an employer, you can contribute up to 25% of your compensation. If you are a sole proprietorship or a single-member LLC, you can contribute 25% of net self-employment income (profit minus half of your self-employment tax and plan contributions).
- Employee Contribution: As an employee, you can contribute up to $20,500 or 100% of your compensation, whichever is lower. If you are over 50, your employee limit is increased by $6,500 as a catch-up contribution.
The limits for the Solo 401(k) are, per person, shared across all 401(k) plans. If you are contributing to a 401(k) outside of your business, you need to adjust your limits for contributions to account for those.
For example, my wife has two 401(k)s – one from her primary employer and one from our business. Her employer doesn’t offer any 401(k) match, so for simplicity, we only contribute to our business’ Solo 401(k). If her primary employer offered a match, we’d contribute as much as needed to maximize that match and then reduce her contribution to the business Solo 401(k).
What about a SEP IRA?
A SEP IRA was a close alternative and it’s structured similarly to a Traditional IRA with similar contribution limits as the Solo 401(k).
Contribution Rules: As the employer, you’re allowed to contribute $61,000 in 2022 or up to 25% of compensation (or net self-employment earnings). The contribution is tax-deductible, and your distributions are taxed as income. You don’t make any contributions as an employee.
If you have employees, you (as an employer) must contribute an equal percentage for each employee. If you, as an employer, contribute 5% of your salary to a SEP IRA, you have to contribute 5% of every eligible employee’s salary to their SEP IRA.
Lastly, there is no catch-up contribution for the SEP-IRA (because there’s no employee contribution).
What about a SIMPLE IRA?
A SIMPLE IRA is available to companies with 100 employees or fewer. SIMPLE stands for “savings incentive match for employees” (they really bent over backwards to make that work!).
The hallmark of a SIMPLE IRA is that the employer must offer an incentive to contribute to the plan. The employer must match employee contributions, dollar for dollar, up to a maximum of 3%. Alternatively, the employer can contribute a flat 2% of the employee salary without the employee having to contribute anything.
For example, in a SIMPLE IRA that matches up to 3%, an employee earning $100,000 must contribute $3,000 to the SIMPLE IRA to get the maximum match from the employer. The employer matches dollar for dollar up to 3% of their salary. Alternatively, the employer could set up the plan such that it offers a 2% flat contribution for that employee. In that case, they get a $2,000 contribution to their SIMPLE IRA without any participating requirements.
The difference is, with a SIMPLE, the employer must offer a match. With a 401(k), the employer has the option. Besides this distinction, it operates similarly to a 401(k) in that contributions are pre-tax, and there’s a 10% penalty if you withdraw funds before age 59 1/2. The penalty is 25% if you withdraw the money within two years of signing up for a plan.
- Employer Contribution: The employer can match an employee’s contribution dollar for dollar up to 3% of their salary or a flat 2% of their salary, with no employee participation.
- Employee Contribution: For 2022, you can contribute up to $14,000. Workers who are 50 and older can contribute an additional $3,000 more as a catch-up contribution.
Which is Best For Your Business?
If you have employees, besides you and a spouse, you’re limited to a SEP IRA or SIMPLE IRA. If it’s just you, then the Solo 401(k) is an option.
Of the three, the Solo 401(k) allows you to defer the highest amount of income because you can contribute as both an employee and an employer. It shares the same employer contribution limit as the SEP-IRA, but it adds the employee contribution component, which results in a higher total deferral. The Solo 401(k) is only available for those without employees.
The downside is that the Solo 401(k) requires more paperwork including potentially an annual filing of Form 5500. I didn’t know about this filing for the first few years of the plan and faced a stiff penalty for not filing this (relatively) simple form.
The SEP-IRA is difficult if you have employees and want to maximize your deferred income because the employee contribution must be the same for all employees. The SIMPLE IRA is a good option if you just want to set up a run of the mill retirement plan for your employees and aren’t looking to minimize income.
Also considering a Roth? Here are the differences between a Roth and 401(k) and when to use each.
Vanguard Individual 401(k)
We ended up going with the Solo 401(k) at Vanguard and have been happy with it.
The plan charges $20 a year for each Vanguard fund held within the 401(k) account. They usually don’t charge a maintenance fee if you opt for electronic statements. This $20 per fund fee is only waived if at least one participant is a Voyager, Voyager Select, Flagship, or Flagship Select client (in other words, once you have $50,000 in assets at Vanguard).
As a reference, if you open a SIMPLE IRA at Vanguard, this fee is $25 per fund in each account (also waived under the same terms).
When it comes time to file the Form 5500, which you must do if plan assets exceed $250,000, they send you a brochure on how to do it (including inserts for your amounts). The first time is tricky because you have to sign up for EFAST2 and navigate the form, but after that, it’s fairly trivial.
Fidelity offers a self-employed 401(k) plan that has no similar account or overarching fund fee. There’s no cost to open, close, or maintain a Solo 401(k). I don’t know about the support for Form 5500 or the entire account experience since I went with Vanguard.