How-To: 401(k)s for the Self-Employed
Being self-employed is, candidly, my Millennial dream come true.
In my ideal self-employed day, I rise at 7 a.m. (instead of my current 5:30 a.m. wake-up call) and pad around the kitchen in an impossibly chic matching silk pajama set. After an hour-long morning routine that consists of matcha lattes, transcendental meditation, and a leisurely stroll around the block, I finally sit down at my Pinterest desk to put in a few light hours of reading and writing before retiring to the den for my afternoon nap.
Of course, this fantasy produces a minimum of $1,000 per day, my hair is shinier, my teeth are whiter, and I am a happier, less stressed version of me.
For those of you who are self-employed, I’m sure you’re having a hard time reading through your twitching left eye and uncontrollable laughter.
That’s obviously not what self-employment actually looks like.
Though, for what it’s worth, the women I’ve interviewed who left traditional jobs to pursue their own paths seem to find it very rewarding.
Two obvious gripes are most common among the self-employed people I talk to:
Healthcare and access to retirement accounts.
While I don’t have any answers for you on the healthcare front, I actually think the self-employed have a distinct advantage when it comes to tax-advantaged retirement investing.
While the corporate robots (read: me) get hot and bothered about a dollar-for-dollar match and the ability to contribute up to $19,500 per year to our 401(k)s, the savvy self-employed of the world are low-key trouncing us with their ability to contribute to pre-tax investment accounts.
Am I talking about the Roth IRA?
No! Of course not. At $6,000 per year, the Roth IRA is a great (post-tax) vehicle for both W2 employees and the self-employed (and if you don’t have one, I’d go open one immediately as long as you’re under the income limit of $140,000 per year; if you’re not, I’ve got a loophole-frenzied guide to contributing to a backdoor Roth IRA here).
Takeaways, upfront:
I still think you should read the post because it gets into the tax nitty-gritty of all this shit, but the main takeaway I had was this:
If you’re truly self-employed (no income from W2 jobs or access to employer-sponsored plans), you’re probably better off with the Solo 401(k).
If you’re self-employed AND have a “regular” full-time job with a 401(k) (in other words, a side hustler), the SEP IRA is going to be the better route.
Introducing: The SEP IRA and Solo 401(k)
I honestly felt like the personal finance world had been holding out on me when I found out about these magnificent accounts. Let’s focus on the SEP IRA first, because it’s (generally) easier to set up.
SEP IRAs
The maximum you can contribute to a SEP IRA is – are you ready for this? I hope you’re sitting down – $58,000 per year in 2021.
The catch is that, in order to contribute the full $58,000, it must represent no more than 25% of your self-employment income. In other words, in order to contribute the full $58,000, you’d have to make $232,000 from your self-employment income streams. For example, if you make $100,000 per year in self-employment, the most you can contribute is $25,000 (25%). These are rough numbers, because it’s 25% of your net income, which ends up being roughly 18% of your gross – more on that below.
Still, this is a hell of a lot better than the $19,500 employee contribution limit that the Corporate Robot Squadron gets (Chief Corporate Robot, reporting for duty! * salutes *).
Technically, a SEP IRA has an “employer-only contribution” setup, but that’s the loophole of working for yourself. You are both the employer and the employee. You’re contributing 25% of your income as the “employer” to yourself as the “employee.” Weird, right?
The super-extra dope thing about that $58,000 (if you’re a high-roller making the full $232,000 per year) is that it’s tax-deductible, which means you don’t have to pay taxes on it. With an income of $232,000, you’d be paying 24% on any amount of income over $172,750, which means a full $58,000 contribution to a SEP IRA would mean a $13,920 tax savings – that is, $13,920 of taxes that you no longer owe Uncle Sam because you’re shielding that income in a SEP IRA.
Increíble! To really drive the point home, you could take that $13,920 you’re saving and invest it in a taxable investing account to double your fun.
You’ve got until the filing deadline to make your contributions, which means (in a normal year) you’ll be contributing from April 15 to April 15 (i.e., tax season to tax season).
This means, if you’re reading this in February of 2021 and you haven’t filed your taxes yet, you can open a SEP IRA, make contributions, and deduct it before you file to save yourself some tax dollars for the 2020 #TaxSzn.
One weird tax caveat that I don’t all-the-way-understand, but mostly get it (sue me!)
Technically, it’s not quite as baller as it sounds, because you’ve got to pay your self-employment taxes on your net income (profits – expenses) before you can calculate your 25% contribution. That is: It’s not 25% of your gross self-employment income (the money on those #checks), but 25% of your net income less half your self-employment taxes. * plays tiny violin and begrudgingly hands back some of my Stripe funds from spreadsheet sales *
I found some old blog from a wealth management company that had a glorified Algebra II problem to describe this; as soon as I read, “Solving for x would indicate in line (e) that…” I had too much PTSD to continue and I skipped to the bottom to find out that it actually ends up being about 18.6% of your gross income. (Just kidding – I did read it all the way through – but just know that your allowed contribution and deduction will be less than 25% after you pay your self-employment taxes of 15.3%.)
What if you’re a big side hustler and you’ve got a 401(k) through your employer and a side business?
First of all, I’d love for you to flip your hair and smack your own ass as I congratulate you on being the Ultimate Millennial Hustle Culture Workhorse! We love to see it. From one achievement-obsessed 26-year-old to another, I salute you (lots of weird military references in this post; I’m sorry).
And beyond all the hair-flipping and ass-slapping, you’re in luck!
You can still open and contribute to a SEP IRA even if you’ve already got an employer-sponsored 401(k) through traditional, full-time work.
The same rules more or less apply; you’re the employer in the SEP IRA situation, so you’re making employer contributions to yourself as the employee.
You could theoretically max out your 401(k) with your regular salary at $19,500 per year, then turn to your SEP IRA and contribute 25% of your self-employment income and defer that as well (defer = make it tax-deductible and “hide” it from the federal government).
But don’t take it from me – take it from the good ole’ boys at the IRS in this screenshot:
Straight from the federal horse’s mouth!
How to open your SEP IRA
Well, you know what I’m going to say: Betterment offers one. They’ll walk you through the process, including providing the IRS form you need to fill out and keep for your records in order to be in the clear.
A little fuzzy on how much, exactly, you can contribute? The IRS provides this “calculator” (you can probably guess why I’m using quotation marks if you’ve ever done your taxes before) that’ll help you figure it out down to the penny.
I’ll be honest: I tried to follow their instructions, and I found it pretty confusing. I’m a big fan of the 80/20 rule; that is, 20% of your effort drives 80% of the results. Put another way: Get the most juice for the least squeeze. Efficiency, people.
Rather than trying to figure out the exact amount I could contribute, I’d probably play it safe and contribute 15-16% of my gross income and call it a day.
Legally, you don’t need an EIN to open a SEP IRA, but I’ve read that most brokerage firms require it (more on EINs below, because they are required for Solo 401(k)s.
So where does the Solo 401(k) come in?
Solo 401(k)s work a little bit differently, and are definitely better for truly self-employed people than “traditionally” employed people with side hustles.
With a Solo 401(k), you make contributions as an employee and an employer (vs. just as the employer, as in the SEP IRA) for a total contribution of $58,000 (just like the SEP IRA).
You can contribute (please read this in a robot voice) up to $19,500 as the employee, and then an additional employer contribution of up to 25% of your net income less half the self-employment taxes and your $19,500 contribution (that’s right – you have to subtract the $19,500 from your net income in addition to the taxes; they really get you both ways).
The hairy thing for side hustlers with the Solo 401(k) is that 401(k) contribution limits are determined per PERSON, not per plan – which means if you’re already contributing $19,500 to your employer 401(k), you can’t also contribute $19,500 to your Solo 401(k). Your total maximum contribution across all 401(k)s is $19,500.
They make more sense for self-employed with only self-employment income, since your $19,500 contribution is irrespective of your total net income less all the tax mumbo jumbo (in other words, it doesn’t matter how much you make; as long as you make more than $19,500, you can contribute $19,500). In order to contribute $19,500 to the SEP IRA, you’d have to make more than $78,000 (roughly).
So your employee contributions can go up to $19,500, but your “employer” contributions can still equal that 25% chunk of what’s left – which means if you can manage to contribute more than $19,500 of your income, you can (and should) up to 25% of the “net income minus half self-employment taxes minus $19,500 contribution.”
Let’s do an example, because I can physically feel your eyes rolling into the back of your head
The Solo 401(k) makes more sense for the truly self-employed unless said person earns more than $232,000 in self-employment income per year. Here's why:
Because the SEP IRA is structured to only allow "employer" (read: you) contributions of up to 25% of your net income, in order to contribute the maximum allowable ($58,000 per year), you'd need to make 4x that (roughly, in order for 25% of your income to equal $58,000), remember? That's $232,000.
Since the Solo 401(k) allows you to contribute $19,500 as the "employee" and 25% of whatever's left as the employer (also you!), you have the opportunity to double-dip.
Consider an example of someone who makes $150,000.
25% of $150,000 is $37,500. That's pretty good, right? That'd be roughly their allowable contribution in a SEP IRA.
But what if they chose a Solo 401(k)? Then, they can contribute their initial employee contribution of $19,500, and then 25% of whatever's left.
$150,000 - $19,500 = $130,500, and 25% of $130,500 (or their allowed "employer match" as their own employer) is $32,625.
$19,500 (their "employee" contribution) + $32,625 (their "employer" contribution) = $52,125.
The SEP IRA would only allow them to contribute $37,500, whereas the Solo 401(k) allowed $52,125, simply because of the way the account contributions are structured.
The only reason the SEP IRA makes more sense at $232,000 is because 25% of their income is $58,000 maximum. In pretty much every other case, the Solo 401(k) will allow for more money to be contributed.
Now, that being said, the Solo 401(k)s:
Do have higher administrative burdens from a paperwork standpoint
Are really only tenable for people who are fully self-employed, as your employer 401(k) will basically make it useless to you
So it's not like it's always the best way to move forward, but if you're a high earner (who doesn't make quite $232,000) and you're intending to sock away as much money as possible into this account, the Solo 401(k) will allow for more than the SEP IRA in most cases (until, of course, you hit the point where your Solo 401(k) contribution hits $58,000, which is around $196,000 in income).
Other fun tax caveats because the federal government loves to make things complicated
You need an EIN to open a Solo 401(k), which is the number you get when you start a business and register it legally.
While your SEP IRA contributions run April to April, Solo 401(k) contributions have to be made by Dec. 31 (in other words, they run on a calendar-year basis). This means if you’re trying to capitalize on this February post timing before filing your 2020 taxes, the Solo 401(k) won’t help you (but the SEP IRA will). Of course, contributing to a Solo 401(k) now WILL help you when you file your 2021 taxes in 2022, but you won’t feel any immediate benefits.
Betterment doesn’t offer a Solo 401(k) and there are a few more forms involved, but I think most major brokerage firms do offer them. If you have an EIN and think you’ll be able to make the full $19,500 contribution, I’d go for it.
If I ever leave the workforce and become a full-time self-employed person, I’ll open one and write about the experience for you. Is that enough incentive to go buy a Wealth Planner? #MakeMoneyWithKatieFullTime2021
Let’s return to our order of operations
You may be wondering now how the f*** to incorporate this new blitzkrieg of information into everything you already know. Let’s create a funnel, shall we? This is the order you should be contributing to your investment accounts. If I list anything that you don’t have (read: can’t have), just skip to the next thing. Easy!
Employer-sponsored 401(k) [full-time corporate employee with a side hustle] or Solo 401(k) [full-time self-employed] up to $19,500
Roth IRA [everyone!] up to $6,000 per year
SEP IRA [full-time corporate employee with a side hustle] up to 25% of your net side hustle income, less half self-employment taxes up to $58,000 per year
Taxable investing account [regular ole’ investing with no fancy stipulations or limits, but the highest tax burdens – called “General Investing” in Betterment]
If you were to max out the first three, you’d be contributing $83,500 to tax-advantaged retirement accounts. Anything beyond that could go into your taxable investing account.
Easy, right? Just go out and earn hundreds of thousands of dollars and master tax law, and you’re good!
(Just kidding, but we are all in this together, figuring it out one tax loophole at a time.)
