Solo 401(k) accounts from Vanguard, with beneficial illustrations and calculations

One of the great advantages of being self-employed is the ability to open and manage your own small business retirement account. Employed people have to either take or leave their employer’s 401(k) or 403(b) plan offerings, regardless of the quality or cost of the funds it offers, while the self-employed get to choose their own plan provider and pick exactly the assets they want to invest in. Naturally, many choose Vanguard, and since I recently opened a solo 401(k) with them, I thought it would be useful to share my experience.

Opening an account (1): selecting funds

To open a solo 401(k) with Vanguard you have to download and print the “Individual 401(k) kit for employers” from their small business website. The kit is pretty straightforward, although there are a few sections I want to highlight.

In section 3 of the New Account Form you have the option of opening either a traditional, pre-tax account, a Roth, post-tax account, or both.

If you open a pre-tax account, you have to select at least one fund to receive your contributions:

Likewise if you open a Roth account, you have to select at least one fund:

There’s a $20 annual fee charged per fund held in each account, so if you open both accounts you’ll have to pay $20 per fund each year, even if you hold the same fund in both accounts. The $20 fee is waived if you have $50,000 in assets across all your Vanguard accounts (so-called “Voyager services”).

Note that Solo 401(k)’s do not have access to Vanguard’s lower-cost Admiral shares. That matters for two reasons: first, you’ll pay slightly more for funds that you currently own as Admiral shares. That’s bad. But it also matters because when people compare the fees on Vanguard’s all-in-one funds to a “do it yourself” portfolio of Vanguard funds, they are usually comparing the all-in-one fund costs to the cost of Admiral shares. But if you don’t have access to Admiral shares, that’s not the right comparison.

For example, Vanguard 500 Admiral shares have a hyper-low expense ratio of 0.05% — a third the cost of a Target Retirement or LifeStrategy fund. But Vanguard 500 Investor shares, the ones you have access to in a Solo 401(k), have an expense ratio of 0.16%! Suddenly the comparison doesn’t seem so compelling, particularly if it comes with the added $20 per-fund fee and the additional hassle of periodic rebalancing. That’s one reason I chose the LifeStrategy Growth fund for my 401(k), as you’ll see below.

Opening an account (2): designating beneficiaries

Vanguard has what appears to be an extremely straightforward system for designating beneficiaries. First, you select your primary beneficiary:

Then, you select your secondary beneficiary:

This is not, in fact, an extremely straightforward system. As my primary beneficiary, I selected “To the person I’m married to at the time of my death,” and as my secondary beneficiary I selected my partner. About a week later I got a call from Vanguard to clear up their confusion. It turns out that in spite of all logic and reason, you’re only supposed to select “To the person I’m married to at the time of my death” if you’re already married, which seems to me to defeat the purpose of such a checkbox, but what do I know?

Making contributions

Once Vanguard has accepted your plan documents, you’ll receive a barrage of mail from them, including information on configuring your online account administrator access. Unlike the fairly powerful personal investor interface, the small business interface is extremely primitive:

When you select “Make a contribution online” you’re first asked which tax year the contribution is for, and then taken to this screen:

The “Individual 401(k)” contribution fields are for pre-tax contributions, which can be made as employer or employee contributions (more on that in a moment). The “Individual Roth 401(k)” contribution fields are for post-tax contributions, which can only be made as employee, not employer, contributions.

Contribution limits

Solo 401(k) contributions limits aren’t hard, they’re just complicated. I think the best way to think about them is in three parts:

• 100% of net self-employment income, minus half the self-employment tax, up to $18,000. If your net self-employment income from Schedule C is less than $19,491, then you can contribute 92.35% of your net self-employment income in the left-hand “employee” contribution columns. You can split that amount between the pre-tax Individual and after-tax Roth fields however your own tax needs dictate.
• 25% of your remaining net self-employment income, minus half the self-employment tax. If your net self-employment income is $30,000, then after deducting half the self-employment tax ($2,295), you’re left with $27,705. You can contribute 100% of the first $18,000 in the left-hand “employee” column and 25% of the remaining $9,705 ($2,426) in the pre-tax right-hand “employer” column.
• $54,000. The most you can contribute in total to a solo 401(k) plan per calendar year is $54,000 in 2017. To make $54,000 in solo 401(k) contributions you’d need to make $175,419 in net self-employment income. Deducting half the self-employment tax would leave you with $162,000, and after contributing the maximum $18,000 in employee contributions you’d be left with $144,000, 25% of which is the $36,000 in employer contributions you need to reach the maximum.

Note that you do not need to actually make contributions in this order!

This is simply the order that will maximize your contributions for a given level of self-employment income. You can reach the $54,000 contribution cap exclusively from employer contributions. However, the required net self-employment income is much higher: $54,000 is 25% of $216,000, which is almost $234,000 in net self-employment income after the self-employment tax is added back in.

And of course if you want to take advantage of Individual Roth 401(k) contributions those can only be made as employee, not employer contributions.

Adding and exchanging funds

An important benefit of Vanguard retirement accounts is that it’s possible to contribute to funds without meeting the minimum initial investment requirement. In other words, you don’t need to contribute $3,000 in order to purchase shares of a fund that otherwise has a $3,000 minimum investment.

However, this benefit is only extended to contributions processed through the small business investing portal. When you log into your personal investor account, you’ll see your 401(k) account(s) there but won’t be able to transact the funds in those accounts until you meet the minimum investment requirements.

If you want to add a new fund to your 401(k) but don’t want to exchange shares in an existing fund, Vanguard can do this over the phone if you call 1-800-205-6189. The reasons for doing so might be to trigger the minimum investment waiver for future contributions to the account, or simply to diversify your existing funds.

Conclusion

Solo 401(k) plans are a way to defer taxes on a substantial amount of self-employment income and, in Roth accounts, potentially avoid taxes entirely by making Roth contributions in years when you are able to pay little or no federal income tax.

Vanguard’s Solo 401(k) kit makes it just about as easy as possible to get started, given the legal requirements involved. And even if you make a mistake when designating your beneficiaries or selecting funds, their phone personnel have been extremely capable every time I’ve had to speak with them (including researching this post).

And of course, best of all a Vanguard Solo 401(k) gives you access to Vanguard’s suite of low-cost mutual funds!