A solo 401k, often referred by various names such as self-directed Solo 401k plan, self-directed 401k or solo K, allows for various types of contributions as described below.
- Employer profit sharing contributions
- Pretax employee salary deferral contributions
- Roth designated employee contributions
- Employee voluntary after-tax contributions
Total Contribution Limit
Each contribution types have separate limits, and, when combined, cannot exceed the maximum solo 401k contribution amount which is $57,000 per year or $63,500 for those 50 or older in 2020. For tax year 2021, the maximum contribution that can be made to a solo 401k pan is 58,000 plus $6,500 if you are age 50 or older.
Solo 401k Contribution Types Explained
Employer profit sharing contributions
- In accordance with IRC Sec. 404 the profit sharing contribution cannot exceed 25% of income derived from business activity (earned income NOT passive income).
- Salary deferral contributions are not included with profit sharing contributions when calculating the 25 percent deductible contribution.
- If the owner-only business participant has enough net income from self-employment activity, she can treat the entire contribution as a profit sharing contribution which is fully tax tax deductible. Note, however, that employee contributions are not part of the employer profit sharing contribution source; therefore, the catch up contribution applicable to those participants age 50 or older cannot be treated as am employer profit sharing contribution.
Example: Janice wants to make profit sharing contributions to her solo 41k for tax year 2020. Janice is age 56, has already made the full employee contribution of $19,500 to her day-time job 401k, and wants to maximize her employer profit sharing contribution to her solo 401k which she setup for her self-employed business. Janice had a good year being self-employed under her S-corporation and received $250,000 in W-2 wages from her self-employed business so she wants to reduce her taxable income for the year by making profit sharing contributions. Based on $250,000 of W-2 wages from her self-employed business, the maximum profit sharing contribution that Janice may make to her solo 401k for 2020 is $57,000. Because the catch up contribution of $6,500 falls under the employee contribution source not the employer profit sharing contribution source, she cannot make the catch up contribution to her solo 401k plan unless she elects to treat it as an employee contribution which she can technically elect to do since she did not make it to her day time job employer 401k.
- Profit sharing contributions are not required to be made each year.
Pretax employee salary deferral contributions
- Pretax employee salary deferral contributions found under IRC Sec. 402(g) permits business owners to contribute up to 100 percent of compensation not to exceed $19,500 to the solo 401k plan for 2020, or $19,500 for tax year 2021.
- The rules also allow for catch-up contributions provided you are age 50 or older. Per IRC Sec. 414 (v), if the business owner has the applicable self-employment earned income, she can make additional catch amounts of $6,500 for 2020 or $6,500 for tax year 2021 if age 50 or older.
Roth designated employee contributions
- Since 2006, the self-employed have been allowed to treat all or some portion of their salary deferral limit (the $19,500 in 2020, or $19,500 in 2021 ) as designated Roth solo 401(k) contributions.
- The designated Roth solo 401k contributions are outlined in IRC Sec. 402A, and treated as after-tax contributions (that is, you cannot take a tax deduction on your taxes for the contribution).
- The flip side is that all earnings resulting from the Roth solo 401k contributions can be distributed tax-free.
- Roth solo 401k annual contributions cannot exceed the $19,500, plus the $6,500 catch-up contribution if age 50 or older for 2020. For 2021, the Roth solo 401k contribution is $19,500 plus the $6,500 catch up contribution for those age 50 or older.
Employee voluntary after-tax contributions
- With the exception of the catch up solo 401k contribution which can be made by those age 50 or older, the solo 401k participant can elect to treat part or all of her solo 401k contributions to as voluntary after-tax solo 4o1k contribution. Therefore, if you have enough earned income from self-employment activity, regardless if you already make contributions to your day-time job 401k plan, 403b or 457 plan, you can contribute the full $57,000 allowable contribution to your voluntary after solo 401k bucket for tax year 2020, or $58,000 for tax year 2021.
- Jut like Roth solo 401k contributions, voluntary after-tax solo contributions are not excluded from income and the owner only business participant cannot deduct them on his or her tax return.
- The voluntary after-tax solo 401k bucket only allows for employee contributions not employer profit sharing contributions.
- Making voluntary after-tax solo 4o1k contributions is a good way to indirectly super charge your Roth funds whether Roth IRA or Roth 401k funds. Reason being, the voluntary after-tax funds can immediately be converted to a Roth IRA to internally to the Roth solo 401k bucket.
Solo 401k Annual Contribution Tidbits
- All solo 401k contributions cannot be subject to a vesting schedule so are always 100 percent fully vested.
- Rollover contributions are also always vested.
- Provided a triggering event occurs such as age 59 1/2 and no longer being self-employed, Roth solo 401k contributions can be transferred to a Roth IRA or a full-time employer plan such as a Roth 401k, Roth TSP, Roth 457b, and Roth 403b.