I nearly began this article by saying I read investing books for fun. But that wouldn’t be entirely true.
The truth is that since I’ve been self-employed, I haven’t had access to an employer-sponsored retirement plan. So if I wanted any chance of retiring, like, ever, I figured I should probably learn about investing. (And the fact that I’ve actually found learning about this stuff kinda fun just happens to be a bonus.)
I know investing isn’t necessarily my only option and there are other ways of “saving” money for retirement. A couple I knew in San Francisco told me they were such terrible savers that the only way they wouldn’t spend all of their money (and we’re talking a lot of money since they earned about $500,000/year) was if they plowed their excess funds into real estate. And because they happened to live near some of the most expensive and in-demand locations in the country (Carmel by the Sea, Napa Valley and San Francisco, California) their method seemed to have worked out nicely for them. (Some people say real estate shouldn’t really be considered an investment but in my case it’s irrelevant, anyway, since I already know I’m not very well suited to home ownership.)
So basically in my case I felt most comfortable saving for retirement by stashing cash in some kind of retirement account. The question was, what were my options?
Self-Employment Retirement Accounts
At my first job out of college I participated in an employer-sponsored 401(K) retirement plan that was already set up and easy to contribute to. But ever since I quit that job it’s been entirely up to lil’ ol’ me to figure out what to do. And lemme tell you, that is an extremely intimidating prospect when you’ve never been taught a single thing about investing – not in school, not at home, nowhere.
So I did some research to determine what was available for the self-employed, and I narrowed it down to these two options:
Solo 401(K) – Also known as a One-Participant or Individual 401(K) (and similar to what you’d have access to working for someone else)
As I read more about each of these plans available to the self-employed, I learned SEPs were the easier of the two to set up and maintain. But it was the Solo 401(K) I found more appealing.
Solo 401(K)s, while a bit more complicated to set up and maintain, give you the potential to save far more than you could with any other plan given the same earnings.
Without going into too much detail (I’ll provide links to additional information below) with a Solo 401(K) you can make an employer contribution (or profit sharing) of up to 25% of your net earnings from self-employment PLUS you can make employee salary deferrals of up to $18,000 (as of 2015).
The best way to illustrate the differences in how much you can save with a Solo 401(K) versus a SEP is by showing you some examples using a Solo 401(K) calculator.
Let’s say you’re 35 and have $10,000 net earnings from self-employment. If you plug this into the Solo 401(K) calculator, you’re given the following tables comparing the different amounts you’d be able to save with each of the different retirement plans:
(NOTE: I included the top-most table in this image to show you why you’re not allowed to calculate your contributions from the entire $10,000 income – basically you need to account for deductions first as the top paragraph explains.)
With a SEP, you can contribute a total of $1,858.70 (which is the profit sharing amount or “employer contribution”). But with a Solo 401(K), you can contribute a total of $9,293.52 (which includes the same $1,858.70 for the profit sharing PLUS $7,434.82 for the employee salary deferral). If your self-employed income happens to be from a side job and you have another job that pays the bills, this extra savings can add up quickly.
The difference in how much more you can save is even more profound as your earnings grow. Now let’s say your net earnings are $25,000 from self-employment. Here’s a table showing you how much you can save at this level:
You’ll see in the table above that with a SEP you can contribute a total of $4,646.76. But with a Solo 401(K), you can contribute that amount in addition to $18,000 for a total of $22,646.76. That’s a difference of $18,000!
Now you don’t have to contribute that much, of course, but the main point is that you can.
Solo 401(K) Considerations
In my case, I couldn’t find any compelling reasons not to choose a Solo 401(K) over a SEP, but here were some things you may want to consider.
As far as I could tell, Solo 401(K)s are not as widely available as SEPs. And some of the details (like account fees) will vary, so just be sure you know what you’re getting into before committing.
I got my Solo 401(K) with Vanguard because generally they have the lowest fund fees, that’s where all of my investments are and I want to keep it as simple as possible. Plus, because I already have enough assets invested with them, I didn’t have to pay any account service fees.
If you open an account with Vanguard you need to kick it old school and submit physical papers to open up your Solo 401(K) as opposed to just opening an account online (not sure if other companies are like this). The required paperwork is a little lengthy, but I didn’t find anything terribly difficult to understand, and it was easy to call and get help with any questions I had.
For Solo 401(K)s, you’ll also have to file an annual form with the IRS once you have at least $250,000 in your account. But that’s it for the required paperwork. Not too bad.
Types of Shares
If you go with Vanguard, they don’t allow you to invest in their Admiral shares (not sure why) so this means you will be paying slightly higher fees for the Investor shares (but these fees are still lower than most places charge).
Deadline to Open
You must have your paperwork submitted and approved by the end of the year you want to be able to contribute for. This is different from the SEP where you can wait until practically the last minute to create an account and contribute for the prior year.
Whether or not I max out my Solo 401(K) every year, I at least know I can save much more towards my future retirement than if I chose a SEP. And this extra savings can really help supercharge my retirement bucket and put me in a more secure financial situation down the road.
I spent many hours poring over lots of different articles learning about Solo 401(K)s and have included some of my favorite resources below. Hope they help and happy saving!
Solo 401(K) Calculators
- Beacon Capital Management (the one I used for the screenshots above)
- AARP (I know, it’s a site for retired people but I like their Results Summary breakdown)
Other Helpful Articles
- 7 Things to Know about 401(K)s by Good Financial Cents
- SEP vs. SIMPLE vs. Solo 401(k) by Oblivious Investor
- Understanding Individual 401(K) Plans by 360 Degrees of Financial Literacy
- Solo 401(k) lets self-employed shelter more of their income by the LA Times
Disclaimer: I’m not an expert on investing and hold no fancy money-related credentials. This article is for entertainment purposes only and I just thought it might be helpful to share my decision-making process when opting to invest in a Solo 401(K) as a self-employed person. That is all. :)