Most are familiar with 401k accounts which allow for tax-deferred contributions through our employers. This post is about Solo 401k’s which healthcare professionals can use to defer taxes on a little over $50,000 every year.
401k’s can be had by a self-employed individual as well. If you earn self-employment income (as a per diem or independent contractor) then you can start a 401k. These are called Solo 401k’s or Individual 401k’s, or Personal 401k, or Single 401k (lots of terms for the same thing).
In this post I discuss the following:
- what is a Solo 401k?
- how to calculate how much you can contribute?
- how to qualify for a solo 401k?
Self-Employed vs Small Business Owner
The IRS cares about this distinction so we need to address it. Even though the terms are used interchangeably, it makes a difference in this case.
A moonlighting urgent care provider or a per diem would be considered self-employed.
- you’re considered a sole proprietor
- you can be an independent contractor
- you can be a business partner
- you have a part-time business
- you don’t have employees and you don’t have contractors working for you
Small Business Owner:
The owner of a small medical practice or the owner of a medical consulting firm with employees would be considered a small business owner.
- you make payments to someone else who is an employee or independent contractor
- you have a business license from the state
- your employees have to be part-time
- you would need an EIN (employer identification number)
- you’re not a sole proprietor but a registered business entity
Moving forward I’ll focus on the self-employed individual because that applies more to healthcare professionals. If you have a small business and want to offer a 401k to yourself and employees then I would think it’d be wise to discuss that with your lawyer since specific rules apply.
Self-Employed 401k Contributions
As the self-employed individual you can contribute to a solo 401k in both of these ways:
- employee contribution: maximum of $18k for 2017 (aka salary deferral)
- employer contribution: 20% of “adjusted net profits” (aka profit-sharing)
The IRS lets you treat your self-employment income in the 2 ways mentioned above. They are basically saying that you can be the employer and employee all in one.
There is a slight difference between net profits and adjusted net profits which I’ll discuss below.
Adjusted Net Profits
There are 2 terms to distinguish here: “net profits” and “adjusted net profits”.
- Net profits: the profits from your business after deducting expenses.
- Adjusted net profits: net profits minus 1/2 of self-employment taxes
Self-employment tax (SE tax) is also sometimes called payroll taxes. It’s comprised of medicare taxes and social security taxes.
When you’re employed, your employer pays 1/2 of the entire SE tax. The other half gets deducted from your W2. They add up to 15.3% together.
As a self-employed individual you pay the entire 15.3%. 1/2 of SE tax comes out to 7.65% and that’s the amount you would subtract from your net profits to obtain adjusted net profits.
Up to 20% of adjusted net profits can be contributed as the employer portion of the solo 401k – the profits sharing portion.
Adjusted net profits = ((net profits) – (7.65%*net profits))
Examples of Solo 401k Contributions
Dr. Mo does some per diem work and gets paid as an independent contractor.
He didn’t incorporate, he’s not an S-corp, he’s not an LLC. He never registered for a business license and he has the 1099 made out to his actual name by the various medical groups he works for. He’s not considered a business owner.
He is a sole proprietor.
He grosses $100,000 in 2017 as a self-employed individual. He spent $40,000 on various expenses in order to earn this $100k. The $40k would constitute his business expenses and are reported on a Schedule C.
The Schedule C then spits out his net profits.
His net profits are $60,000.
His adjusted net profits are $55,410 = ($60k – (7.65%*$60k).
Dr. Mo contributes $18,000 as the employee of his sole proprietorship.
Dr. Mo can contribute another 20% of his adjusted net profits as the employer. Or, $11,082 = (20%*$55,410).
In total, Dr. Mo can contribute $29,082 to his solo 401k ($18,000+$11,082).
You can use the Bankrate calculator to come with a similar value. Though I needed to torture you through the whole process to help make sense of the math.
Power of A Solo 401k
Of course, $29,082 is only what I could contribute, not what I have to contribute. I may have spent most of the money on living expenses before hitting this max. But it goes to show you how powerful a solo 401k is.
That means that I can defer taxes on nearly 50% of my net earnings. I would only owe income taxes on half of my net earnings.
First, this allows me to defer taxes into the future and thereby lower my tax bill for the given year.
Second, I get to have my investment grow tax-free until the age I decide to pull the money out.
Solo 401k Limits
The maximum amount I can contribute as the individual portion of my self-employment venture is $18k (employee portion).
The total maximum contribution per individual for a 401k is $54,000 per year (employer + employee contributions).
That means that the maximum amount that $36,000 is the max employer contribution (the profit-sharing).
Solo 401k Timing
You must have the solo 401k funded before the end of the calendar year (December 31st). If you don’t have the money to max out your solo 401k, you can move money from another account into it and replace that later.
Even though you file taxes in April of the following year, you cannot wait until then to make your contributions.
Solo 401k & Real Estate Income
The rent income from a rental income property is considered passive income and therefore cannot be used to establish a solo 401k.
Some may even establish an LLC in order to collect the rent. However, despite this LLC designation, the rental income isn’t “earned” income and therefore the LLC cannot be used to establish a solo 401k.
Solo 401k Fees
Fidelity charges a simple $4.95 per trade of each fund you purchase in your solo 401k.
Vanguard charges $20/year per fund you own. If you hold more than $50,000 in your solo 401k then this fee is waived. There is no transaction cost.
Regardless of the account fees, each mutual fund you hold will have its own fees.
Holding a Solo 401k is quite simple and no ongoing paperwork is needed other than what you’ll report on your taxes. Once you exceed $250,000 in your Solo 401k, you will need to file an annual IRS form 5500.
IRS form 5500 is easy to fill out if it’s a one-participant solo 401k (you and your spouse). It’s 2 pages long and it’s referred to as form 5500-EZ (pdf).
25% vs. 20% Employer Contribution
There is a slight confusion online as to the employer contribution portion. Is it 25% or 20%? Business owners can contribute 25% and sole proprietors can contribute 20%.
You are a business owner if you pay yourself an actual W2 income or even have part-time employees. As such, you would use the 25% rate to calculate the profit-sharing portion. You would multiply your net profits by 25% and that’s your employer contribution portion – easy.
If you are a self-employed individual who is a sole proprietor and you don’t actually pay yourself a salary then you would use the 20% rate. The math is a little trickier as we saw above. You have to first deduct 1/2 of SE taxes from your net profits to come up with the adjusted net profits and multiply this amount by 20% to come up with the employer contribution portion.
Business Entity Terminology
There are various business entity terminologies which can get confusing:
- sole proprietor
- independent contractor
- business owner
There is a lot of terminology when it comes to generating your own income. Let me give you a quick breakdown of these terms and what they mean.
From these terms, the only structured entity is the business owner. This person has applied for a business license with their state and has an EIN. If the owner is also the employee, they actually cut themselves a W2 paycheck.
The other terms (sole proprietor, self-employed, and independent contractor) just refer to an individual who earns their own income without an employer.
All these entities will report their taxes on a Schedule C.
A sole proprietor is the default setting when you go solo. Anyone can be a sole proprietor. Buy wholesale bottles of water and sell them individually at a sporting event and you are now a sole proprietor. You would deduct your expenses from your income on a schedule C and pay taxes on your net earnings (profits).