Retirement Planning for the Gig Economy

You may have never heard of it, but there is a feature in the tax code that allows an employee in the gig economy to set up a personal 401(k) plan. It is called a Solo 401(k), although in reality, it is no different than a traditional 401(k) plan except that there is only one employee. Solo 401(k)s are sometimes called Solo-Ks, Uni-Ks, and One-participant-Ks. A business owner with no employees used to be rare, but today the prevalence of consulting and gig work means that many Americans have the option of establishing one of these personal retirement plans.

Why a Solo 401(k) and not a SEP IRA or traditional IRA? A Solo 401(k) allows for several options and the potential to defer up to $57,000 ($63,500 if over age 50) of earnings in 2020. Here’s how.

Employee Contributions. Just like a traditional 401(k), the only employee of your company (you!) can defer up to $19,500 of your earnings ($26,000 if over age 50) as the employee participant in the plan.

Employer Contributions. Your employer (you!) may also contribute up to 25% of your compensation in addition to your employee contribution for a max of $57,000 in total plan contributions in 2020.

Now, here’s where things get interesting. Just like a regular 401(k) plan, you can set up your Solo 401(k) to allow for ROTH contributions from the employee. This means that you can make your employee contribution as a ROTH contribution, which means there is no tax benefit today, but the earnings grow tax-deferred, and withdrawals are tax free in retirement. There are no income limits that preclude employee contributions may not be classified as ROTH like there are for regular ROTH IRA contributions.

And … you can allow employees in your 401(k) plan to make after-tax contributions in addition to the employee contribution. After-tax contributions can immediately be rolled over to a ROTH IRA. This is also known as a mega backdoor ROTH IRA, and it allows you to potentially move up to $37,500 to a ROTH IRA by maxing out the $19,5000 employee deferral, then adding another $37,500 ($19,500 + $37,500 = $57,000 max for 2020) to your Solo 401(k) plan as after-tax contributions. These after-tax contributions can immediately be moved to a ROTH IRA as long as your 401(k) plan allows for in-service non-hardship withdrawals.

The mega backdoor ROTH IRA seems too good to be true, considering that contributions to a traditional ROTH IRA are limited to $6,000 ($7,000 if over 50) in 2020. ROTH IRA contributions are not allowed for single tax filers earning more than $139,000 and married filers earning more than $206,000.

There are a couple of key points to keep in mind. Total contributions to your plan cannot exceed $57,000 in 2020 ($63,500 if over age 50). Employee + Employer + Employee After-Tax Contributions cannot exceed $57,000. You decide, with the help of your CPA or tax professional, how much contribution makes sense in each category. Remember, you may not be eligible for the max contribution if $57,000 is more than 25% of your earnings. If you have consulting work and work for an employer that offers a 401(k), your total contribution limit considers savings in both plans. There’s no doubling up of contributions allowed.

The Covid-19 pandemic has exacerbated many trends in our economy from online shopping to video conferencing. Now that work-from-home is the norm rather than the exception, more Americans may find themselves working gigs as independent consultants. Establishing a Solo 401(k) may be a great way for these solo business owners to save for retirement.

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