Solopreneurs: Unique Needs, Solo 401K, and More!

financial planning for solopreneurs

Solopreneurs are innovative, hard-working, and exciting people. Self-employment can be a really wonderful and rewarding career path. There are many financial planning implications to consider, especially if you are a one-person operation. You have many unique challenges that I’d like to talk about from my perspective as a fee-only financial planner. I wrote an article on Financial Planning Implications for Solo-Practice Owners as a guest post on The White Coat Investor in 2020. However, I wanted to cover this topic again for a broader audience. I’m going to talk about how to integrate a career as a solopreneur with retirement. I’ll cover the most common financial planning implications I see for solopreneurs.

What’s a Solopreneur?

Let’s discuss what a “Solopreneur” is. I define a solopreneur as someone who is a business owner, self-employed, or freelancer that works alone or solo. In other words, anyone who is self-employed in some capacity and doesn’t have any full-time employees.  This means you will usually file a Schedule C with your personal tax return, or occasionally a Schedule E. There are a wide variety of professionals working in this type of capacity. For the sake of simplicity, we’re going to kind of lump all these in together under one term – Solopreneurs.

Options to Organize Your Business as a Solopreneur

The first thing to think about is business entity selection. You can be a Sole Proprietor, an S corporation (S-corp), or a Limited Liability Corporation (LLC) that’s taxed as a sole proprietor.  There’s a bunch of different ways to do this. For example, if you expect your income to be fairly high right away, then an S-corp may make sense for you.

However, the new Qualified Business Income (QBI) deduction from the Tax Cuts and Jobs Act, affectionately known as tax reform 2017, means that you really have to think this through. With the QBI deduction, it may not always make sense to organize as an S corp in this situation. If you have a high income and organize as a sole-proprietor, you may end up paying a little bit more in self-employment taxes, but you could save more by getting the bigger qualified business income deduction. This takes a little bit of math, but how you organize is going to be driven by how much you think you’ll make in the first few years and beyond.

QBI Phaseouts

Speaking of the QBI deduction, you are going to want to try to make sure you don’t get phased out, especially if you’re considered a specified service trade or business  (SSTB). It depends on what kind of business you’re in, but you do want to stay below that threshold of $340,100 for joint returns and $170,050 for other filers (2022 numbers) so you can maximize your qualified business income deduction. If you’re over the QBI limits and are classified as an SSTB, then you might not be eligible for that deduction at all. The QBI income limit is based on your taxable income, so there are personal deductions on your tax return that can help you stay under that threshold. In other words, you may be able to reduce your taxable income using strategies that don’t have anything to do with your business. One of these overlooked areas, especially for solopreneurs is the Solo 401(k). A one-participant 401(k) can actually reduce your taxable income quite drastically. We’re going to talk more about that in a moment.

Estate Planning for Self-Employed – Life Insurance Needs and Buy-Sell Agreements

Let’s talk about life insurance. Please don’t count on the sale of your business to take care of your family if the worst happens. That’s what life insurance is for. Now, if you do have a sort of business that could be sold easily, that’s icing on the cake. Just don’t rely on that to take care of your family. You can get term life insurance, but that’s a separate discussion based on your individual situation.

Related to life insurance is what you would call a buy-sell agreement. A buy-sell agreement is traditionally used if you had a business that had partners. In that case, you would set up a buy sell agreement. That could trigger for various reasons such as disablement or death of one or more partners. Basically, the buy-sell agreement would allow for your surviving spouse and heirs to benefit from the value of the business. While you don’t want to rely on it, you probably do want to set up some sort of buy-sell agreement if there could be value in the business.

Have a Contingency Plan

Even if a buy-sell agreement doesn’t make sense, you still need a contingency plan. This can involve compensation or not. What you can do is consider partnering up with someone in a similar situation – kind of like a buddy system. I would still want to get it in writing even if there is no compensation involved. This way your clients are taken care of if something happens to you. At the very least, you probably want to prepare communication ahead of time to key people. Obviously, I’m not an attorney. Anything involving these sorts of agreements and legal documents is from my perspective as a financial planner. You would want to talk to an attorney and get their advice on these types of things.

Medical and Disability Benefits for Solopreneurs

If you’re a solopreneur, you may be lucky and have a spouse that gets health insurance through work. Maybe you’re over 65 and you can get Medicare. That would work, too. If not, you’ll probably be relying on the either the health exchange or the private market to get insurance.  It’s probably going to be expensive. You could look at opportunities to maximize the subsidy that you could get on the health exchanges. If you employ your spouse you could look into a Sec. 105 plan.

If you’re going to be paying a lot anyway, you could use a high deductible health plan. The premium should be a little bit lower. You may pay more out of pocket, but you can use a health savings account (HSA). The HSA is one of the best deals in the Internal Revenue Code.  This is because you can get a tax deduction when you contribute. Then you let the money grow tax-free and pay no tax when you take it out for qualifying medical expenses. This is a strategy for people that don’t need that money to pay for out-of-pocket medical expenses now. This way they can let that money accumulate. They can actually invest the money in the HSA and it becomes a sort of supplemental retirement account. 

Consider Disability Insurance

Disability insurance is also an important consideration for people that are self-employed. You may have had a group disability policy at your prior employer. If you can take it with you, then you should look at the numbers to see if it makes sense. You can also try to get it as a private policy, or individual coverage. If you’re near retirement, you may not need disability insurance. If you’re able to retire, even though you’re choosing not to, then you probably don’t need it. At that point you are, by definition, financially independent.

Disability insurance is based on your income, so it may tough to get the full amount of coverage you need if you aren’t able to show a lot of income starting out. Some professional associations may have some group policies to help you out.

The Solo 401k and Other Retirement Accounts for Solopreneurs

Now we’re going to talk about my favorite part of planning for solopreneurs – the Solo 401k . I think this is extremely overlooked as a planning opportunity for people that are self-employed. The Solo 401k has a lot of flexibility. You can actually put away up to $61,000 ($67,500 if over 50) for 2022 into a Solo 401(k). You can technically do this at an employer plan too. However, there’s several rules that affect an employer plan with employees that don’t apply to Solo 401ks.

Anyone can put in the full amount for a deferral, which is $20,500 or $27,000 if you’re over age 50 (2022 numbers). Above and beyond that, you can make a profit-sharing contribution. It’s a somewhat goofy calculation, but a good rule of thumb is it’s about 20% of your business’s income. So the total max you can put in is $61,000 (full deferral amount plus 20% of your earned income). So if you have high income, this can be great! You can put this money into a Traditional or Roth account. It really allows a lot of flexibility. This comes back to that qualified business income deduction we talked about earlier. If you’re trying to stay under an income threshold for that, this can be a really powerful tool.

After Tax Money

There’s actually a third component called after tax money or after tax contributions for the Solo 401k. This applies to any 401(k) really, but it matters a lot with the Solo 401k. This is money you can put in after taxes. You do not get an income tax deduction, but you can immediately roll it out into a Roth IRA. That’s a way for you to put significantly more into your Roth IRA than the current limit, which is $6,000. Your plan must allow it. If you have a Solo 401k that doesn’t allow it, then it’s time to find a new provider. Having after tax money as an option is a really useful tool.

Plan Ahead for Taxes

Something else that’s really cool under current law is you can actually do your tax return the next year before deciding how much to do as the employer portion. You could prepare a draft of your return in the spring of 2023 for 2022 and then decide how much to put in. The employee portion generally needs to be contributed in the actual calendar year.

Some of you want to do what is commonly referred to as a “backdoor Roth”. In order to do this, you don’t want to have any Traditional IRAs. Creating a Solo-401k and moving the IRA into the 401k would solve this problem for you.

Put More Money Into Tax Advantaged Accounts

The last cool thing about the Solo 401k is the ability to get taxable assets into tax advantaged accounts. Maybe you can’t save as much as you want out of current cash flow, but the earnings qualify you to put way more into a Solo-401k. If that’s the case and you have money sitting there, maybe in a bank account or an investment account, you can use that to fund the plan. This shifts money that is currently taxable to either a tax deferred traditional account or Roth account. That money hopefully saves you taxes over time by not being in a taxable account.

Additional Retirement Accounts to Consider for Solopreneurs

There are other types of retirement accounts such as the Simplified Employee Pension Plan (SEP) and the SIMPLE IRA plan (Savings Incentive Match Plan for Employees). The SEP works very similar to the Solo 401k but can have multiple employees covered. One drawback is that the employer has to contribute equally to all participants. The SIMPLE has lower contribution limits and requires annual contributions for each employee.  You can also contribute to a Traditional or Roth IRA. These are good if your income isn’t very high and you don’t need to save or defer much and you don’t care about Roth. The Roth IRA is a useful tool to have even if you don’t contribute to it directly. It’s a great place to keep money growing tax free and avoid required minimum distributions (RMD) in retirement.

Benefits and Final Thoughts on Being a Solopreneur

I see more and more benefits, both academically and otherwise, of working longer than what people traditionally have.  There have been studies about the social and emotional benefits of working longer beyond just the financial benefits. Obviously, you don’t have to start a business to ease into retirement. You could switch careers, switch companies, or cut hours.  However, I think self-employment is going to become more and more popular as a way to ease into retirement. There’s some really, really cool tax things you can do if you go the self-employed route as we discussed already.

That wraps up some of the solopreneur financial planning opportunities. Obviously, any business owner, solopreneur or not, has a whole lot of issues they have to face.  These are specific to solopreneurs. I hope it was helpful!