Retirement planning cannot take a backseat, especially when you are a self-employed professional. There are a few options available for the self-employed to plan their retirement like the SEP IRA, SIMPLE IRA and solo 401k. However, the best retirement plan for the self-employed and small businesses (with no employees), considering factors like the contributions allowed, availability of participant loans, Roth as well as traditional options, is none other than a solo 401k plan.
This guide conducts an extensive analysis of the solo 401k plan. It gives you all the desired information on its features, advantages, disadvantages, contribution limits, eligibility requirements, and how to open a solo 401k plan.
Table of Contents
What is a Solo 401k plan?
A solo 401k plan is a retirement plan for self-employed individuals or small business owners with no employees or owners of businesses which only have partners and no employees.
In Solo 401k spouses of the owners can be included as employees.
A solo 401k is very similar to the 401k retirement plan, sponsored by your employer. Both of them allow you to grow your funds tax-free until you make a withdrawal at your retirement (traditional). Or you can contribute after-tax money and have tax-free withdrawals at retirement.
However, there are differences also. The contributions you can make in the one-participant 401k plan or the solo 401k plan can be higher than an employer-sponsored 401k.
Please note, among all the retirement plans for self-employed individuals (IRAs, SEP IRA, SIMPLE IRA, and solo 401k), the solo 401k plan allows the maximum contributions and the optimum benefits. It is one of my favorites.
Unlike other retirement plans for self-employed and small businesses, the solo 401k allows maximum contributions by allowing you to make contributions as an employee as well as an employer, up to a maximum annual limit (like $66,000 for 2023).
It offers traditional (pre-tax contributions such that the withdrawal is taxed as current income) as well as Roth contributions (after-tax contributions such that the withdrawal is tax-free).
Add to it the additional catch-up contributions ($7500 in 2023) for 50 years or older, which is not offered by other retirement plans for self-employed individuals.
Solo 401k contribution limits
The solo 401k allows you to contribute both as an employer and as an employee.
So, you are the employee as well as the employer in a solo 401k.
As an employee, you can make an elective deferral which is 100% of your salary or $22,500 in 2023, whichever is lower.
As an employer, you can make matching contributions which is 25% of your net compensation.
There is a catch-up contribution also for people of age 50 or more. Check the table below.
|Contribution Limits Solo 401k plan|
|Year||As an employee||As an employer||Catch up contributions (for 50 or more years of age)||Total contribution limit as both employee and employer|
|2022||100% of your salary or $20,500 whichever is lower||25% of the total compensation||$6,500||$61,000|
|2023||100% of your salary or $22,500 whichever is lower||25% of the total compensation||$7,500||$66,000|
Source: IRS Website
Suppose Barry is self-employed personnel in 2023.
He makes $22,500 as an employee (salary) contribution. His net compensation from his business is $200,000.
Hence, his total contribution as an employer (25% of total compensation) is $50,000.
This makes his total contribution as $22,500 + $50,000= $72,500.
But the total contribution limit for 2023 is $66,000.
Hence, Barry’s total contribution allowed for his solo 401k is $66,000.
Now let’s say Barry is 52 years of age (over 50). This makes him eligible for a catchup contribution of $7,500.
Hence, now the total contribution he can make is $66,000 + $7,500 = $73,500.
Solo 401k plan eligibility: Who qualifies for the plan?
A freelancer, a small business owner with no employees (W 2 employees), a business with multiple owners and no employees, and also a couple running a business together, qualify for a solo 401k plan.
There are no age and income barriers in a solo 401k plan.
However, you need to contribute investments that are substantial and regular to keep your account active in the eyes of the IRS.
You can have part-time employees, so long as no one employee exceeds a 1,000 hours of service per year threshold. It is always advisable to consult a tax professional or financial advisor, in case you have any doubts
Pros and Cons
|Greater contribution limit: Solo 401k allows a larger contribution limit than other retirement saving plans like SEP (Simplified Employment Plan). |
This is because you can make contributions both as an employee and as an employer.
|No employees allowed: To be eligible for a solo 401k, you should be a business owner with no employees. |
So, if you do have any employee or plan to have employees in the future, then this plan
is not for you.
|Traditional as well as Roth contributions: It allows Roth contributions in addition to the traditional contributions. |
With Roth contributions, you can have tax-free withdrawals at retirement (post 59.5 years of age).
Please note that other retirement plans for the self-employed like SEP IRA, a Keogh plan, or a SIMPLE IRA, only offer traditional contributions.
|Significant and regular contributions: The IRS in the solo 401k plan, looks for substantial and |
regular contributions, to keep the plan active.
Hence, if you are not able to contribute a significant amount regularly to the solo 401k, the IRS treats it as inactivity. Check with your CPA for more details.
|Catch-up contributions: Solo 401k allows catch up contributions for people of age 50 years or older. |
This is $6500 in 2022 and $7500 in 2023.
|Exemption from UBIT: Another benefit of the solo 401k is the exemption it provides to the Unrelated Business Income Tax on real estate. |
If you buy real estate by taking a loan from your IRA, you are potentially bound to pay taxes on the rental incomes and any net profits from the sale of the property.
However, the loan taken from your solo 401k to buy real estate, does not potentially bound you to any taxes.
For more details, please consult your CPA.
|Spousal Solo 401k: If your spouse is working for you as an employee, he/she is also the participant of the solo 401k plan and hence can contribute to the plan to save for retirement.|
Note: Solo 401k can also be opened by people who are working a side gig in addition to their regular jobs. That means, people who already have an employee sponsored 401k plan, can also save their additional income from side hustles into a solo 401k plan.
How does a solo 401k work?
Step 1: Choose a solo 401k provider
The first step is to do some research and choose the best solo 401k provider suited to your needs.
There are free as well as paid brokerage firms to set up your solo 401k account.
For example, you might not be able to invest in alternative and high-yielding assets like real estate and bitcoin.
However, the non-prototype or paid brokerage firms charge you an annual fee and create a customized solo 401k plan suited to your needs. These are My Solo 401k Financial, Rocket Dollar, Nabers Group, Safeguard Advisors and Ubiquity.
You can check both free and paid solo 401k providers here.
Step 2: Get your Employer Identification Number (EIN)
The next step is to get your Employer Identification Number (EIN).
You can simply apply online here from the IRS for your EIN.
Step 3: Fund your account
The next step is to fund your account to start investing.
Depending on the solo 401k provider, you chose, you can fund your account using a wire transfer or writing a cheque.
You can also rollover funds from your previous retirement account (employer-sponsored 401k account or any other retirement account).
Please note that the non-prototype or as we call them self-directed solo 401k providers like My Solo 401k, Rocket Dollar, etc. help you in setting up the solo 401k account.
Generally, they help you in requesting your EIN numbers, rolling over your previous retirement accounts, bank account setup at a bank of your choice, Form 5500-EZ electronic filing, Form 1099-R electronic filing and more.
Step 4: Start investing
Once you have funds in your account, you can start investing in assets. You can invest in traditional asset classes like stocks, mutual funds and bonds.
Or, if you go with a self-directed solo 401k provider, you can even invest in alternative asset classes like Bitcoin and other cryptocurrencies, real estate, precious metals and more.
When does a solo 401k need to be established?
Establishing a solo 401k account is one thing and funding your solo 401k is another. So, basically you can first establish your solo 401k. Once you have established your solo 401k, you can fund it at a later time.
As per the IRS publication 560, you need to establish your solo 401k account, by filling in and signing all the required documents by December 31st of the current year.
In conclusion, the solo 401k plan is an excellent retirement savings option for self-employed people, who desire to maximize their retirement savings contributions and benefit from the associated tax advantages.
It gives business owners an opportunity to increase their retirement savings while also enabling them to invest in a range of assets (especially with the self-directed solo 401k providers).
The Solo 401k plan is an easy alternative for those who wish to take charge of their retirement savings because it is simple to set up and maintain.
Before making any big financial decisions, it is always advisable to seek the advice of a financial professional; nonetheless, for many independent contractors, the Solo 401k plan is a great choice for safeguarding their financial future.