What is a Solo 401(k)? Requirements, Rules and Contribution Limits
Self-employment has numerous benefits – you are your own boss, have more flexibility in your work schedule, and have absolute control over your finances. However, the one prominent drawback of self-employment is that you do not have access to an employer-sponsored retirement plan. While retirement schemes are often associated with salaried personnel working for an employer, a well-rounded retirement plan is a prerequisite for even those who are self-employed, ranging from freelancers to sole proprietors.
This is where the solo 401(k) comes into the picture. A solo 401(k), also known as the self-employed 401(k) or an individual 401(k), is a savings plan that is designed specifically for self-employed persons such as small-business owners. If you wish to learn about how a solo 401k works, its pros and cons, contribution limits, and more, reach out to a professional financial advisor who can guide you on the same.
Read below to learn more about solo 401(k)s.
What is a solo 401(k)?
A solo 401(k)is similar to a traditional 401(k) but removes the employer from the equation. It provides you with all the benefits of the standard retirement plan, such as tax savings and maximum annual contribution, among other benefits. Since you are your own employer, there is more flexibility when setting up a plan based on your requirements and the range of contributions you prefer. In doing so, a solo 401(k) presents itself as an efficient way to plan one’s retirement.
Also see: What is a 401(k), and how Does a 401(k) Work?
Who is eligible for a solo 401(k)?
There are no income or age restrictions to enroll for a solo 401(k), except that the self-employed participants must have no employees working for them. Even if you are a business owner with one employee, you cannot enroll in this retirement plan.
As per the solo 401(k) rules, the only exception is the individual’s spouse. For a spouse to qualify and contribute, both the individual and the spouse must work actively in the business that is adopting the solo 401(k). You have three options to make your spouse a part of the solo 401(k) plan. In the first scenario, you can be the sole business owner, and your spouse is the sole employee. In the second case, the two of you can file for a partnership where you both receive a share of the profit or loss. A third option presents itself as a ‘Qualified Joint Venture.’ It is used when both spouses separately report income gains and losses and contribute to the business materially. In all cases, the spouse should be a compensated member.
However, if you are a small business owner with a few employees, you may opt for options such as the SEP IRA or SIMPLE IRA. While being self-employed is a prerequisite to opening a solo 401(k), you can also have a full-time job. Your solo 401(k) plan will only apply to the side job.
How does a solo 401(k) work?
A solo 401(k) works as a standard 401(k) for the most part, implying that it mimics much of the functionality of a Roth 401(k) or a traditional 401(k). A 401(k) plan allows employees to contribute a section of their salary toward a retirement account. If your solo 401(k) plan is designed to enable tax-deductible savings, it will work as a traditional 401(k).
But there are other options provided under the solo 401(k) plan. You can also opt for the Roth solo 401(k) variant, which offers more flexibility to business owners compared to SEP and SIMPLE IRA plans. Here the tax benefits are not provided at the time of income contribution; however, the withdrawals after retirement are tax-free. Ultimately, the solo 401(k) plan you choose depends on your financial plan and personal circumstances. If you can afford to pay the taxes now, a Roth may be a better option. On the other hand, if you are concerned that your income will reduce in retirement, you can choose to save taxes today by opting for a traditional 401(k).
What are the solo 401(k) contribution limits?
While much of the solo 401(k) rules and regulations mirror those of the standard 401(k), there is a difference between the contribution limits in the two plans.
The solo 401(k) contribution limit is unique because a single party plays the role of the employee and the employer. As per the Internal Revenue Service, the contributions can go up to $61,000 in 2022 or $66,000 in 2023. In addition to this, if the contributor is 50 or older in 2022, an additional $6,500 catch-up contribution is allowed. Similarly, an additional $7,500 is permitted in 2023.
The IRS limit for a solo 401(k) is considered for both employee and employer contributions per individual. So understand the limits that apply to your contributions in each capacity.
- In your role as an employee, you can pay up to $20,500 in 2022 and $22,500 in 2023. Else, you can pay 100% of the compensation, whichever is the lower amount. In this category, you can contribute an additional $6,500 in 2022 and $7,500 in 2023.
- In the capacity of the employer (albeit your own), an additional contribution of 25% of business profit/net self-employment income can also be made. This equals the net profits minus half the self-employment tax and the plan contributions you made for your participating spouse (if any) and yourself.
Consider a scenario in which you are a business owner making $200,000. As an employee, you can pay $20,500 (maximum), and as a business owner, you can contribute an additional $25,000. This amount would be based on your compensation after accounting for business overheads, taxes, and other expenses. With that, you are saving 45,400 per annum towards retirement. If you have a participating spouse, you could double the amount you contribute to retirement savings per year.
If you have a full-time job with an active 401k plan and have opted for the solo 401(k) plan for a side job, there is a critical IRS rule to keep in mind. The solo 401(k) contribution limits are considered per person and not per plan. So the contribution limit will apply to your 401(k) plan and solo 401(k) plan as a whole.
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How to open a solo 401(k)
You can enroll with financial planners or brokers to simplify the onboarding process for this plan. You will need your Employer Identification Number to open a solo 401(k). If you need this number, you will need to contact the IRS. With the Employer Identification Number, you can proceed with the plan adoption agreement and account applications. Furthermore, several online brokers are available to kick-start this process and help you open a solo 401k.
What is the role of solo 401(k) providers?
Once you fund the solo 401(k) account, you must decide how to invest your money. A broker or solo 401(k) provider can guide you in this regard by suggesting investment options. Some options available include (but are not limited to) mutual funds, stocks, and bonds. The payment for these solo 401(k) providers can differ based on the provider itself or the individual’s requirement. For instance, you may have to pay a one-time fee to set up the plan. Some brokers may also extend the service of overseeing the solo 401(k) plan for a specific period or until the client’s retirement. However, since only minimal maintenance goes into a solo 401(k) plan, most business owners can keep track of their investments without much hassle.
With a solo 401(k) plan, business owners can choose from a wider range of assets. However, selecting a solo 401(k) broker who is experienced when it comes to your requirements can be beneficial. For instance, some providers may offer either standard solo 401(k) or Roth solo 401(k) options but not both. So study your options carefully before zeroing in on the broker.
What are the advantages and disadvantages of a solo 401(k)?
The benefits of solo 401(k) are diverse, making it easy to manage and implement for small business owners and new investors. Let’s read more about the pros and cons.
Benefits
1. Tax benefits
As mentioned above, a solo 401(k) allows you to tailor the tax advantage to your benefit. The contributions are tax-free in the standard solo 401(k) format, but the sum received upon retirement is taxable. The exact opposite happens under the Roth solo 401(k) format, where there are no tax savings at the time of contribution, but the retirement distributions are tax-free.
2. Easy to manage
In a solo 401(k) plan, at any given point, only a maximum of two beneficiaries are involved, making it relatively simple to maintain.
3. Provision for loan
A majority of providers also allow participants to take loans from the solo 401(k) account. Ensure that you speak to the providers to understand the latest criteria for loan issuance and repayments.
Drawbacks
1. Penalties and taxes
Like the 401(k) plan and its variants, you will be hit with tax penalties if you wish to withdraw money from your solo 401(k) before reaching the age of 59.5. This usually is a 10% early withdrawal penalty along with income tax payments based on your plan.
2. Paperwork and scrutiny
Additionally, the paperwork can be more detailed, with you providing a tax ID and the services of a broker or a brokerage account. While account management is relatively straightforward, you will have to keep an eye on the investments to ensure that you are on the right track.
To conclude
As a freelancer or the owner of a uni-participant business, a solo 401(k) is a useful retirement plan that is flexible and allows you to take maximum advantage of the 401(k) tax savings structure. It offers you the chance to pick between a Roth or a traditional account, in addition to allowing the maximum annual contribution among retirement plans focusing on tax-advantaged practices.
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