The IRS says you can contribute up to $53,000 in your tax-deferred Self-Employed 401(k) for 2016. If you’re at least age 50, then you can make an additional $6,000 catch-up contribution, which increases your limit to $59,000. That’s $18,000 or $24,000 (age 50+) for the employee contribution and up to $35,000 for the employer contribution for a total contribution of $53,000 or $59,000 (age 50+) per year.
For those of you who are self-employed or side-hustling with a full-time job, this article will help you figure out how much you can contribute to your tax-deferred Solo 401(k) with an example. You can’t just write a check for $53,000 or $59,000. There’s a formula you need to follow based off your operating income. I’m personally shooting to contribute $100,000 a year pre-tax in a Solo 401(k) and SEP-IRA given I am an employee and a freelancer.
Remember, if your employer has you in a 401(k) plan, you can open up a SEP-IRA if you’re side hustling. And if your employer has you in a SEP-IRA, you can open up a Self-Employed 401(k) to contribute more pre-tax dollars to your retirement. If your employer has you in a 401(k) plan, you can also open up a Self-Employed 401(k), but it wouldn’t make sense to do it because the total employee contribution is limited to $18,000 across all your 401(k) plans.
Self-Employed 401(k) Plan Contribution Calculation
A year after I left my corporate job in 2012 I opened up a Self-Employed 401(k) aka Solo 401(k) plan to keep my 401(k) contributions going as a sole proprietor. If you’re an independent contractor with no full time job, no employees, and no company sponsored 401k, I suggest you do the same if you want to defer taxes and save more for your retirement.
Little did I know that contributing the maximum $17,000 in 2012 was not really the maximum. The employee contribution is only one part of the plan. There was also the profit sharing side of the equation from the employer as you see in the chart above and the example below.
Let’s say you make $100,000 in gross income (revenue) as an independent contractor and after $30,000 in expenses, you’re left with $70,000 in operating income before 401(k) contributions and taxes. Here is how much you can contribute.
You can use this example to easily calculate your own contribution amount after you’ve calculated your Operating Profits. Just remember 92.35% X 15.3% X 50% to apply to your operating profits and then multiply by the result by 20% to get your employer profit sharing contribution.
Contributing $31,010 to your Solo 401(k) plan is quite a hefty sum that will quickly add up to a large retirement nest egg over time. You are essentially saving 31% of your gross income or a hero worshipping 41% of your operating income.
Doing some simple math, you need to make an operating income of at least $175,000 after the 1/2 Self-Employed tax deduction to be able to contribute $35,000 in profit sharing + $18,000 employee contribution to equal the maximum $53,000 a year. Easier said than done. But an operating profit figure to shoot for all the same.
Note: The reason why self-employment tax for a sole proprietor is based on 92.35% of self-employment income instead of the whole amount is this:
1. 92.35% = 100% – 7.65% employer’s portion of SE tax (6.2% social security tax + 1.45% medicare tax)
2. Normally, an employer incurs a 7.65% expense on each dollar paid to an employee. However, a sole proprietor does not pay himself a salary so he can’t deduct the 7.65% of SE tax on his Schedule C. The SE tax gets deducted directly on the form 1040 instead of Sch C. But for the sole proprietor the SE tax is a real expense, so that’s why the formula shows a reduction of 7.65% to the SE income.
Don’t Make These Common Solo 401k Contribution Mistakes
1) Only contributing up to the $18,000 maximum by the employee. Don’t forget the profit sharing portion in #2 if you have leftover operating profits.
2) Calculating the profit sharing contribution based off gross income before operating expenses instead of operating profits. Otherwise, you will over contribute.
3) Not deducting from operating income the 1/2 SE tax deduction, which also leads to over contributing.
Excess Contribution Withdrawn by April 15.
If you over-contribute to your 401(k) in 2015, you have until April 15, 2016, to withdraw the excess amount. Your employer must amend your W-2 to show the returned amount as wages, thus your gross income will be higher and you’ll pay more taxes. Assuming your 401(k) portfolio made money in 2015, the earnings from the excess contribution will be taxable income for 2016.
What a pain. This is why I recommend everybody round DOWN the amount they get to contribute to be safe e.g. if the calculations say you can contribute $35,800, just contribute $35,000.
Excess Contribution NOT Withdrawn by April 15
So what happens if you don’t notice that you’ve over-contributed to one or more 401(k) plans until after April 15? In this situation, the excess contribution is taxed twice, once in the year when contributed (2015) and again when distributed (2016). Also, the earnings from the excess contribution will be taxable income for 2016. If the mistake is not corrected, then the IRS may disqualify the entire 401(k) plan retroactive to the beginning of year 1, resulting in the employee’s entire 401(k) account balance to become income to the employee which would have massive adverse tax consequences.
But the main reason why you want to be more conservative in your Solo 401(k) contribution is not the fine, but the stress of getting an IRS audit letter in the mail, and the TIME it will take to amend your tax returns.This process can take hours. I’d much rather miss out on contributing an extra $1,000 in my Solo 401k than go through the torture of dealing with the IRS, especially since the extra money I don’t contribute is still mine, just in my money market account instead.
Remember, when in doubt, round down your self-employed 401k contribution amount.
Deadline To Contribute To A Solo 401(k)?
It’s not too late to make a contribution for your 2015 taxes.The employee deferral contribution must be elected by December 31, 2015. However, some 401(k) third party administrators (TPA) may allow you to set up your 401(k) plan now and backdate your election to 2015.The actual contribution can be made up to the tax filing deadline including extensions.
Therefore, the contribution for your 2015 401(k) can be made as late as October 15, 2016 if that’s the date you file your tax return. To be safe, after your CPA has calculated your self-employed net income, give your financial advisor one month to work with the TPA to set up the 401(k) plan.
When Should I Contribute To My Solo 401(k)?
So long as you have revenue, you can start contributing the employee portion up to $18,000 immediately to your solo 401(k) during the same calendar year. It’s up to you whether you’d like to contribute in bi-weekly, monthly, quarterly, bi-annually, or random lump sum increments.
For the employer profit sharing portion of your Solo 401(k) contribution, you should probably wait until after you do your taxes to figure out your profit and loss. You can always conservatively guesstimate your employer profit sharing contribution if you don’t feel the need to be exact.
Just remember the money you do contribute to your Self-Employed 401(k) can’t be touched until age 59.5. You don’t have to contribute the maximum if your liquidity needs are high.
Start Side Hustling Already
I hope everyone now knows how to calculate what they can contribute to their Self-Employed 401(k) plan. Go over the example a couple more times if you are still confused. Starting your own business or being a rockstar freelancer allows you to contribute much more in pre-tax retirement accounts if you can make a large enough operating profit.
If you are only a W-2 employee, your 401(k) contribution is capped at $18,000 a year + any 401(k) employer match (average is 3% of base salary). Unfortunately, very few employers are generous enough to contribute ~20% of their operating profits to you.
For those who work at startups or money-losing organizations, you are SOL in terms of receiving any profit sharing. You’ll get paid below market rate, have options likely not worth what you hope, and get minimal retirement benefits. At least you’ll be doing exciting work that you enjoy. Do not underestimate the many benefits of having a steady day job. If you work at a money making organization, you should inquire about your employer’s 401(k) match and profit sharing plans.
Readers, how much are you contributing to your pre-tax retirement plans this year? Have you opened a Solo 401(k) or SEP IRA yet? Anybody out there with multiple tax-advantage retirement accounts?
A special thanks to Financial Samurai reader, Brian Chong, CPA from Chong Tax & Financial Services in Santa Clara, CA for reviewing this post and providing helpful insights for all of us financial freedom seekers!
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