Let’s suppose you have a side business earning $20,000 per year. You also have a regular job where you make $40,000 per year. Your regular job has a 401(k) plan and you can contribute up to the annual maximum to that 401(k) plan (2016: $18,000). On top of that you can also contribute 25% of your W2 (from your side business) as well. If your W2 income for the side business is something like $14,000 you can contribute up to $3,500 to a Solo 401k. This can act as yet another tax advantaged bucket for taxpayers.
Solo 401K – Roth Upside
One of the big advantages of the Solo 401K over the SEP IRA and the Simple IRA (other reasonable options for saving toward retirement for the self employed) is that the Solo 401K has a Roth option. This is particularly good if you think that tax rates are likely to increase in the future or if you expect to be making substantially more money in the future.
The biggest caveat with the roth option is that profit sharing contributions (that’s you when you’re wearing the owner hat) cannot be roth contributions. They can only be made pre-tax. If you wish to have a Roth solo 401k that’s something to keep careful eye on.
This is pretty simple if your side business employs only you. If you have other employee’s then the solo 401k is no longer allowed. Most people I know with side businesses generally aren’t also employing folk, so this might not even come up in your situation. Additionally, anecdotally Solo 401k plans seem to be more expensive in terms of administration. It doesn’t help to have slightly better tax savings if you end up giving it all away on the other end. The setup is also somewhat more complicated and its important to check with your tax professional.
The contribution limit on the employer end of the SEP-IRA (stands for Simplified Employee Pension, though why you’d want anything other than the acronym rattling around in your brain-box is beyond me) is the same as the Solo 401k. The important thing to note here is that contributions made wearing your employee hat count towards your IRA limit. If you’re looking at doing this for your side business and you can already contribute to a 401k then this probably doesn’t matter a lot for you, you still have the same amount of total tax advantaged space.
Not having a Roth option can kinda suck if you are on the lower end of the tax bracket spectrum, or if you believe that you will be in a higher tax bracket post retirement.
But What About the Simple IRA?
Why didn’t I bring up the simple IRA? Well, if you have another line of work that allows a retirement account you simply (hardy-har-har) can’t do it. I try not to worry about stuff that isn’t an option for me, an approach which I heartily suggest. If you are a freelancer or aren’t covered by any sort of retirement plan at your work I’d definitely recommend checking it out. Otherwise research time spent on something that doesn’t work for you is research time wasted.
Solo 401k Wins
The flexibility here just makes it largely better. Unfortunately, this may mean slightly more administration. Fortunately, there are a few providers which will manage a solo-401k plan without a setup cost and without maintenance fees. (Fidelity in particular comes to mind). If you’re young you’re probably not in your peak earning years, but you could very well be in your peak saving years. The Roth option here is too nice to pass up.