My brother recently asked me to help him figure out how much he can contribute to his Solo 401k. He has a pretty successful business in which he’s a sole proprietor – last year, he made well over six-figures in net revenue. When you have a business that makes that much, it’s really important to take advantage of whatever tax-advantaged savings you can get.
Luckily, as a sole proprietor, the government gives people like him a ton of ways to save compared to your average W-2 employee. Indeed, unlike most people who can only put away $18,500 in their employer-sponsored 401k (as of 2018), someone like my brother can put away as much as $55,000 in a self-employed retirement plan like a Solo 401k. That’s a massive difference that can obviously make a huge impact when it comes to reaching your financial independence goals.
For the most part, I think the mechanics of a Solo 401k are pretty straightforward. The part that I always have trouble with is calculating how much you can contribute in a given year. Unlike your normal employer-sponsored retirement plan, where it’s just a matter of putting away the salary from your paycheck until you hit your yearly contribution limit, a Solo 401k requires a little bit more thought – you can’t just take whatever you make in your business and put it away. Instead, there’s a calculation that you have to follow to figure out exactly how much you can contribute to it. Personally, I don’t think it’s a very intuitive calculation (and it’s not really one you can just do in your head either).
As I tried to explain this calculation to my brother, I thought it might be helpful to share this info with you in what I hope is a simple and easy to understand read. What follows is a post explaining exactly how to calculate how much you can contribute to your Solo 401k, and importantly, why the numbers are what they are.
A Brief Introduction To A Solo 401k
As a brief bit of background, a Solo 401k is what is known as a self-employed retirement plan. When you think of retirement accounts, the first ones that probably come to mind are those that you get by virtue of your employment – a 401k, a 403b, maybe even a 457. These are all retirement plans that you do not create – your employer creates them and you are eligible to contribute to them only because you work for your employer.
Self-employed retirement plans, like a Solo 401k, are different. They’re a creation of you, made for people who have their own businesses and that do not get paid by an employer for that particular stream of income. To be eligible to contribute to a Solo 401k, you need two things:
- Earn self-employed income. Self-employed income is essentially any income that you earn outside of normal employment that is subject to social security and Medicare taxes.
- Have no employees. In other words, you have to be the owner of your business and the only employee for that business.
You’re eligible to contribute to a Solo 401k even if you have a normal, 9-5 job, which means that if you’re doing any side hustling as an independent contractor, you basically get access to a bonus retirement account.
I think the easiest way to conceptualise a Solo 401k is to imagine yourself as your own little company where you’re both the owner and the only employee. Any money you earn in your business can be contributed in one of two ways – as an employer contribution (i.e. essentially, like you’re giving yourself an employer match) or as an employee contribution (i.e. just a normal salary deferral like you would with your regular paycheck).
Think of a Solo 401k as looking like the diagram below:
How much you can contribute to each part will depend on what your net revenue is and whether you’ve made employee contributions to any other 401k plans. I’ve written in the past about Solo 401ks, so be sure to check out the following posts for more in-depth explanations about what a Solo 401k is and how you can easily set yours up:
- The Solo 401k: The Side Hustler’s Bonus Retirement Account
- Fidelity Solo 401k: A Step By Step Guide To Setting Up Your Self-Employed Retirement Plan
How To Calculate Your Solo 401k Contribution
As of 2018, the maximum amount that you can contribute to a Solo 401k is $55,000. That sounds simple enough, but like anything having to do with taxes, there’s more that goes into it than that. There are five main numbers we need to think about if we want to calculate our Solo 401k contribution:
- Net revenue (this is your revenue after taking all of your expenses into account)
- Net revenue subject to self-employment taxes (this is the amount of your net revenue that you have to pay self-employment taxes on)
- Total self-employment taxes
- 1/2 of self-employment taxes
- Self-employment income
The number we ultimately need to figure out is your self-employment income (this will be the most important number for you to calculate). You might think that your self-employment income should be the same as your net revenue, but in fact, it’s not.
The reason for this has to do with the fact that all working income is taxed at 15.3% to cover social security and Medicare taxes (otherwise known as FICA taxes). When you’re a regular employee, you pay 7.65% of your income towards FICA taxes. Your employer pays the other 7.65% out of their pocket, which they can then deduct from their net profits. On the other hand, when you’re self-employed, you’re both the employer and the employee for your own little business. As a result, you are responsible for paying both the employer and the employee portion of your FICA taxes (called SE taxes when it’s self-employed income).
It’s having to pay both portions of your SE taxes that’s important to your net-profit calculation. The amount of your net revenue subject to SE taxes isn’t 100%. The IRS takes into account that you’re paying the employer portion too at 7.65%. As a result, the IRS actually only taxes you on 92.35% of your net revenue (100% minus 7.65% = 92.35%).
Let’s run through the following example:
- You earn $10,000 in net revenue. First, the IRS will only tax you on 92.35% of that. So, your net revenue subject to SE taxes will actually be $9,235, not $10,000 like you’d initially think.
- From there, we have to calculate the total SE taxes owed. We take the $9,235 that is subject to SE taxes and multiply that by 15.3%. That will give us total SE taxes due of $1,412.955, which we can round up to $1,412.96.
- We then take the total SE taxes due and divide that by 2, which gives us 1/2 of our SE taxes. This is the employer portion of our SE taxes that we can deduct from our net revenue. Thus, our final self-employed income in this case, after every deduction is taken into account, will come out to $9,293.52.
- Once we have our self-employed income number, we can work from there.
Are you confused? I don’t blame you if you are – I was also super confused trying to understand this. Below is a breakdown that I think will help show this calculation a little easier. Just follow this step-by-step, from top to bottom.
If you’re really confused and don’t care about this whole step by step process, then just remember this simple formula. Take your net revenue, then multiply that number by 92.35% x 15.3% x 50%. Then subtract that number from your net revenue. That will give you your total self-employment income, from which you can then calculate your Solo 401k contribution amounts.
Solo 401k Employee Contribution Limits
Again, as previously noted, the Solo 401k has two parts: the employer contribution part and the employee contribution part.
The employee contribution portion of a Solo 401k is pretty much like a normal 401k. You’re limited to the same amount that you’re allowed to contribute to other 401k plans, $18,500 as of 2018. This limit applies across all of your 401k accounts, which means that the total amount of your employee contribution is limited to $18,500 total between any 401k accounts that you might have. If you contribute $18,500 to your 401k at work, for example, you cannot make an employee contribution into your Solo 401k.
That’s pretty simple and easy to understand. Let’s look at the example where we have $10,000 in net revenue (which comes out to $9,293.52 of self-employment income). There are basically three situations possible:
- If we have no employee contributions in any 401k plans, we’d be able to contribute the entire $9,293.52 as an employee contribution to our Solo 401k.
- If we already maxed out our 401k at work, we would not be eligible to make any employee contribution to our Solo 401k.
- If we put some money into our work 401k plan, then we’d have a smaller employee contribution limit in our Solo 401k. For example, if we had contributed $17,500 to our work 401k plan, we’d only be able to contribute $1,000 as an employee contribution in our Solo 401k.
Solo 401k Employer Contribution Limits
Your employer contribution is limited to 20% of your self-employment income. Just follow the steps above to figure out your self-employment income, then multiply that number by 20% to get your employer contribution limit.
Using the $10,000 of net revenue example, with a self-employment income of $9,293.52, you’d be able to contribute 20% of that as an employer contribution, or $1,858.70. You’re allowed to contribute this amount regardless of what your employee contributions have been in your other 401k plans. In other words, even if you’ve already maxed out your 401k contributions in your regular, W-2 job, you’re still allowed to contribute 20% of your self-employment income as an employer contribution in your Solo 401k.
Perhaps what is most interesting about a Solo 401k is that the employer contribution amount is not affected by employee or employer contributions made in other 401k plans that you do not own.
Here’s what I mean. If you have a Solo 401k and contribute $18,500 to your Solo 401k as an employee contribution, you would only be able to contribute, at most, $36,500 as an employer contribution. Remember, the max you can contribute to a Solo 401k is $55,000.
But, if you max out your employee contribution in a 401k plan that you do not own (i.e. your 401k plan at work), you can technically still put as much as $55,000 into your Solo 401k as an employer contribution.
This makes logical sense when you think about it – your employer can’t see what your employer contributions are in other 401k plans, so the contributions that your employer puts into your 401k plans are all counted separately from any other plan that it doesn’t own. In theory, if you had multiple employers that were all willing to contribute $55,000 to your 401k, that would be totally fine.
See the IRS example below if you are looking for more info about how this works:
Obviously, since you’re limited to contributing 20% of your self-employed income as an employer contribution, that would require a huge amount of self-employed income to hit the $55,000 contribution mark. It’s an amount few of us will reach, but it’s still an interesting thing to know (and maybe something that the really ambitious among us can strive for).
Important Things To Remember
It takes a little bit of time to understand how much you can contribute to a Solo 401k. The first step is to always figure out your self-employment income. This number will dictate what you can contribute to your Solo 401k.
After you’ve done that, just remember these important things about Solo 401k contributions:
- You cannot contribute more than whatever your self-employment income is. Duh, you obviously cannot save what you didn’t make.
- You need to calculate your self-employment income, not your net revenue, in order to make accurate calculations for your contribution limits.
- Your employee contributions are limited to the statutory maximum across all of your 401k accounts. In other words, for 2018, you cannot contribute more than $18,500 as an employee contribution across all of your 401k accounts.
- Your employer contributions are limited to 20% of your self-employment income and are counted completely separately between all 401k plans that you do not own. If you contribute $18,500 into your employer’s 401k plan, you can also contribute all the way up to $55,000 as an employer contribution in your own Solo 401k. Obviously, though, in order to do this, you have to make a ton of self-employed income.
If you earn any income yourself, you need to be taking advantage of a self-employed retirement plan, like a Solo 401k. It’s an extra retirement account that even your highest paid employee doesn’t get to have. You’ll reach your financial goals faster if you take advantage of every tax-advantaged retirement account at your disposal.
When it comes to tracking your accounts, I recommend using tools like Mint or Personal Capital. The best thing to do is just sign up for both of them and link all of your financial accounts. That way, you can see them all in one place and keep up to date with everything going on in your financial life.
Note that I am not an accountant or CPA, so make sure to double check everything with a licensed professional to make sure that you do things right.