Self-employed individuals don't have access to a traditional 401(k) through an employer, so they may want to consider other vehicles to invest for retirement. The SEP IRA is one such vehicle; a solo 401(k) is another. As with any tax-deferred retirement plan, there are plenty of rules and regulations to know when opening a solo 401(k), making contributions, and planning withdrawals.
What is a solo 401(k) and how does it work?
A solo 401(k), also known as a self-employed 401(k) is a type of tax-deferred retirement account made available to employed individuals. As with a standard workplace 401(k), annual contributions may be made with pre-tax dollars. Withdrawals may be made at age 59 ½, but are subject to income tax. Early withdrawals will incur a 10% penalty.
Who qualifies for a solo 401(k)?
The IRS refers to a solo 401(k) as a one-participant plan. To qualify, the individual must be a sole proprietor, and their business cannot have other full-time employees, with the exception of their spouse, who may qualify for the plan. Here’s who frequently uses this type of plan:
- Small business owners who only employ their spouses
- Sole proprietors
- Freelancers (independent contractors)
Solo 401(k) contribution limits
Self-employed individuals are able to make two types of contributions to their solo 401(k): employee contributions and employer contributions. Each has its own set of contribution limits.
- Employee maximum contribution. This must be the lesser of $19,500 or 100% of one’s net self-employment income. Individuals 50 or older may make an additional $6,500 catch-up contribution.
- Employer maximum contribution. This must be up to 25% of one’s net self-employment income (compensation). Income is considered net after deducting half of one’s self-employment taxes and one’s employee contribution to the 401(k). There is a compensation limit of $290,000 in 2021.
The absolute maximum total contribution amount across both contribution types in 2021 is $58,000.
Note that a spouse who contributes to the business and earns income may also contribute to their own account. Additionally, the business owner may make employer contributions to their spouse’s account. These must be the same percentage as the employer contribution to the plan.
Using this strategy, married couples under 50 can effectively double their annual contribution limit to as much as $116,000 a year. If both spouses are 50 years or older, each may contribute an additional $6,500 for a collective total of $129,000.
5 tax advantages of a solo 401(k)
- Higher contribution limits. A solo 401(k) allows for significantly higher tax-deductible contributions compared to an employer-sponsored plan. That’s because contributions can be made as employer and employee.
- Separate IRA limits. Solo 401(k) owners may still contribute to a traditional IRA or Roth IRA. However, they need to meet the income limits to earn the tax deduction on a traditional IRA or to qualify for Roth IRA contributions.
- Spousal 401(k) could increase contribution limits. Married couples who work on the business together can double their annual contribution limits.
- More investment choices. Individuals can choose any type of investments for their solo 401(k)s, rather than being locked in by the choices available through a traditional employer. They can determine their own asset allocation, or use a robo-advisor or online brokerage to create an automated portfolio.
- 401(k) loans may be available. Some brokerages allow investors to take out a loan from their solo 401(k). The loan amount can be up to $50,000 or 50% of their account value, whichever is less. There is no 10% withdrawal penalty as long as funds are repaid in five years.
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