An individual or “solo” 401(k) plan is a type of employer sponsored retirement account that may be opened by individuals who are the sole full-time employee of either a business that they own or as independent contractors with self-employment income.

Solo 401(k) participants are allowed to contribute to the account in the same way as other 401(k) participants. They can elect to defer up to the employee elective deferral contribution limit to a traditional pre-tax side of the plan or, if the plan document allows, to a post-tax Roth side of the plan. In 2021, the employee deferral limit is $19,500. Also, participants who are older than age 50 are permitted an additional $6,500 catch-up contribution limit on top of this.

Optionally, you can include an employer match or a profit-sharing portion into which you, as the employer, can make contributions for yourself as long as you have net earnings (compensation) from the self-employment in the trade or business for which the plan was set up.

The IRS website provides the following contribution limits in a one-participant 401(k) plan.

Contribution limits in a one-participant 401(k) plan

The business owner wears two hats in a 401(k) plan: employee and employer. Contributions can be made to the plan in both capacities. The owner can contribute both:

• Elective deferrals up to 100% of compensation (“earned income” in the case of a self-employed individual) up to the annual contribution limit:
  • $19,500 in 2020 and 2021, or $26,000 in 2020 and 2021 if age 50 or over; plus
• Employer nonelective contributions up to:
  • 25% of compensation as defined by the plan, or
  • for self-employed individuals, see discussion below

Total contributions to a participant’s account, not counting catch-up contributions for those age 50 and over, cannot exceed $57,000 (for 2020; $58,000 for 2021).

Contribution limits for self-employed individuals

You must make a special computation to figure the maximum amount of elective deferrals and nonelective contributions you can make for yourself. When figuring the contribution, compensation is your “earned income,” which is defined as net earnings from self-employment after deducting both:

• one-half of your self-employment tax, and
• contributions for yourself.

The “Self-Employed Individuals – Calculating Your Own Retirement-Plan Contribution and Deduction” page on the IRS website explains this further.

Plan compensation for a self-employed individual
To calculate your plan compensation, you reduce your net earnings from self-employment by:

• the deductible portion of your SE tax from your Form 1040 return, Schedule 1, on the line for deductible part of self-employment tax, and
• the amount of your own (not your employees’) retirement plan contribution from your Form 1040 return, Schedule 1, on the line for self-employed SEP, SIMPLE, and qualified plans.

This means a self-employed participant over age 50 and earning $100,000 can contribute $49,233.75 total to their solo 401(k) from a $19,500 elective deferral, a $6,500 catch-up contribution, and a $23,233.75 employer contribution.

The employer contribution in this example is calculated by reducing the $100,000 earnings by 1/2 of the self-employment tax deduction ($14,130 * 1/2) or $7,065 = $92,935 multiplied by the plan contribution rate of 25% = $23,233.75.

While the employer match should be added alongside elective deferrals, profit-sharing contributions are due by the tax-filing deadline (plus any extensions) for sole proprietors or the tax-filing deadline of the business (plus any extensions) for incorporated business owners.

While most 401(k) participants need to complete their 401(k) contributions within 15 days of the end of the tax year, business owners, such as solo-401(k) participants, have longer to contribute their contributions. As IRS Publication 560 states:

Elective deferral. An elective deferral is the contribution made by employees to a qualified retirement plan.

• Non-owner employees: The employee salary reduction/elective deferral contributions must be elected/made by end of the tax year and deposited into the employee’s plan account within 7 business days (safe harbor) and no later than 15 days.
• Owner/employees: The employee deferrals must be elected by the end of the tax year and then can be made by the tax return filing deadline, including extensions.

While all 401(k) participants must decide how much they are going to contribute by the end of the year, business owners have until the tax-filing deadline to complete their elective deferral contributions.

IRS Publication 560 also states:

When Contributions Are Considered Made

You generally apply your plan contributions to the year in which you make them. But you can apply them to the previous year if all the following requirements are met.

1. You make them by the due date of your tax return for the previous year (plus extensions).
2. The plan was established by the end of the previous year.
3. The plan treats the contributions as though it had received them on the last day of the previous year.
4. You do either of the following.
   1. You specify in writing to the plan administrator or trustee that the contributions apply to the previous year.
   2. You deduct the contributions on your tax return for the previous year. A partnership shows contributions for partners on Form 1065.

This implies that both profit-sharing and elective deferral contributions can be applied to the previous year as long as all of the above requirements are met.

If you are self-employed and looking for help starting an individual 401(k), we’d be happy to help you get started as a client.

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