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.
How do you open a solo 401(k)?
There are a few steps to consider when learning how to open a solo 401(k).
Adopt a written plan and establish a trust
The IRS requires business owners to adopt a written plan before opening a solo 401(k), along with establishing a trust with the selected online broker. Brokers who offer solo 401(k)s likely have form templates to help business owners get started. An employer identification number (EIN) from the IRS is required.
Choose a traditional or Roth 401(k)
Individuals must also choose between two types of 401(k)s: a traditional or Roth. The traditional 401(k) allows for annual tax deductions, which can help lower taxes each year. The Roth 401(k) (similar to a Roth IRA) does not allow deductions on contributions; instead, withdrawals made during retirement, including earnings, are tax-free.
Implement a record-keeping system
Once these steps are completed, the business owner needs a record-keeping system to track details such as:
- Earnings and losses
- Plan investments
- Expense and benefit distributions for each account (if a spouse opens one)
Typically a brokerage or plan administrator will help with these records.
Cost of opening a solo 401(k)
How much does it cost to set up a solo 401(k)? That depends on the broker. Some brokers charge a set-up fee and/or an annual fund fee. Others let investors avoid these expenses. Each broker has their own fee structure for trade commissions or management fees based on assets in the account.
Withdrawal rules for solo 401(k)s
A one-participant 401(k) follows the same withdrawal rules as a workplace 401(k).
Penalties and taxes
Penalty-free withdrawals may be made once the account owner turns 59 ½ years old. Before that, a 10% penalty fee will be charged on the withdrawn amount. Income taxes apply to withdrawals made at any age, unless the account is a solo Roth 401(k).
Required minimum distributions
Once the account owner turns 72, they must take required minimum distributions (RMDs). The IRS provides an RMD worksheet to determine the size of the distribution based on age and the solo 401(k) balance. This impacts the individual’s taxes in retirement, as well as earnings growth during those retirement years.
Individuals who have 401(k) plans from previous employers may be able to roll over the funds into their solo 401(k) account. A direct rollover allows the funds to go directly from one account to the other, avoiding any taxes along the way.
The bottom line
A solo 401(k) is a tax-advantaged retirement plan for self-employed individuals that has high contribution limits. Individuals who work with their spouses have the opportunity to collectively contribute even more to their accounts each year.