What is a solo 401(k)? A great self-employed retirement option

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If you’re self-employed and looking to save for retirement – or to just get an excellent tax break – you really need to have a look at the solo 401(k). It might be the best retirement option for one-person businesses, because of how quickly you can amass money in the plan.

A solo 401(k) gives you all the benefits of one of the big employer-sponsored 401(k) plans – the tax break for savings, the tax-deferred or tax-free growth and a generous annual maximum contribution – but you get to use it even if you’re a small business. However, a solo 401(k) can be even better, because you can set up a plan at the broker of your choice and not be bound by restrictive rules on the types of investments that you can make in a typical 401(k) plan.

These features may make the solo 401(k) better for you than other self-employed programs such as the SEP IRA and SIMPLE IRA. Here’s what you need to know about the solo 401(k).

What is a solo 401(k) plan and how does it work?

A solo 401(k) plan, also called a one-participant 401(k) or a solo K, offers self-employed people an efficient way to save for retirement. There are no age or income restrictions, but participants must be business owners with no employees (apart from spouses).

“The solo K has very high and flexible contribution limits, typically allowing more contributions than SEPs, traditional IRAs and Roth IRAs or SIMPLEs,” says Joe Conroy, CFP and founder of Harford Retirement Planners in Bel Air, Maryland.

One key difference between the solo 401(k) and other self-employed retirement plans is that employees can contribute all of their salary up to the annual maximum contribution. They’re not limited to 25 percent of their salary, as in some other plans. This feature can allow them to minimize taxes, though this contribution doesn’t help them avoid the self-employment tax.

In other respects, the solo 401(k) operates like any other 401(k) plan, whether it’s a traditional 401(k) or a Roth 401(k). If you set up your solo 401(k) to take tax-deductible contributions, it will operate like a traditional 401(k), allowing you to contribute pre-tax money and get a break on this year’s taxes. On the other hand, if you opt for a Roth, you’ll make after-tax contributions, but will benefit from the tax-free withdrawals in retirement.

“If you think tax rates will be higher in the future, like I do, then a Roth can be a very valuable account to reduce your future tax burden in retirement,” Conroy says.

The solo 401(k) also offers advantages over the SEP IRA and SIMPLE IRA due to its Roth option.

“If you want to contribute to a Roth, but exceed traditional income limitations, the solo K is the only option for highly compensated, self-employed individuals,” Conroy says. “Contributing to a Roth solo K is much cleaner and simpler than trying to use a backdoor Roth or Roth conversion.”

Who is eligible for a solo 401(k)?

Solo 401(k) plans are intended for the self-employed. If you have employees and are looking for a retirement plan, then you have other options such as the SEP IRA or SIMPLE IRA, both of which allow you to provide tax-advantaged benefits to your employees. A lesser-known program called a SIMPLE 401(k) also allows businesses to set up retirement plans.

While solo 401(k) plans are intended for one-person businesses, there is an exception. The spouse of the business owner can also participate in the plan. With a spouse in the plan, your small business can really stash away cash for retirement. A qualifying couple could save as much as $114,000 annually in the plan, and even more if they were eligible for catch-up contributions.

Solo 401(k) contribution limits

The plan allows one-person businesses to establish a 401(k) with a participating brokerage and save up to $19,500 annually (in 2020 and 2021) as elective deferrals, in the same way that participants in a regular 401(k) plan can deduct money from their paychecks.

The solo 401(k) also accepts employer matching contributions to the plan. Since the employee is also the business owner, he or she determines how much to match. The business can contribute 25 percent of its profits to the solo 401(k), up to a maximum of $57,000 in 2020 and $58,000 in 2021.

Business profit-sharing contributions are based on your net profits minus half of your self-employment tax and the plan contributions you made for yourself (and any participating spouses). The limit on compensation used to factor in your annual contribution is $285,000 for 2020 and $290,000 in 2021.

Keep in mind that the IRS limit on solo 401(k) contributions considers both employee and employer contributions per individual.

People aged 50 and older may contribute an additional $6,500 in 2020 and 2021 as a catch-up contribution, in line with bonus contributions allowed in other 401(k) plans. That means the total combined employee and employer contributions may not exceed $63,500 for 2020 and $64,500 in 2021.

As we’ve highlighted, the solo 401(k) combined contribution limits could add up to substantial savings, particularly for married couples.

For example, a husband and wife in their 30s operate a business making $200,000 in W-2 wages for 2020 could each contribute up to the $19,500 maximum as employees for a total of $39,000. As business owners, they could each contribute an additional $25,000 based on their profits for a total of $50,000 (after accounting for self-employment taxes and other business expenses). In one year, combined, they would have stashed away $89,000 towards retirement.

Remember that 401(k) contribution limits apply across all plans. So, if you have a full-time job with a regular 401(k) in addition to a solo 401(k) retirement account, the total contribution limit is capped when you reach the maximum allowed amount.

Apart from these benefits, solo 401(k) contributions could make you eligible for additional tax incentives, depending on the legal structure of your business.

Other financial benefits of a solo 401(k)

The solo 401(k) can be an excellent choice for those with a side gig as well, especially if they’re already able to live comfortably on their main salary. With the solo 401(k) you can go above the usual limits of a 401(k).

While you may contribute to multiple 401(k) accounts, your total employee contribution to all types of 401(k)s may not exceed the annual maximum contribution, that is, $19,500 in 2020 and 2021.

But the solo 401(k) can be valuable even if you already have a 401(k) plan and even if you’ve maxed out that other plan for a given year. That’s because you can still make an employer contribution, allowing you to exceed the smaller employee-only contribution amount. So the solo 401(k) allows you to save more with the employer contribution, reducing your business taxes.

Another benefit of the solo 401(k) is that it doesn’t prevent you from taking advantage of other retirement plans such as the IRA. You can still contribute up to the annual maximum there. If you’re an individual looking to set up a traditional IRA or Roth IRA, then you’ll want to look at the benefits of those plans.

Like the typical 401(k) plan, the solo 401(k) also allows you to take out a loan against your account. (Here’s what you should consider before taking out a 401(k) loan.)

“While I generally encourage clients to avoid that strategy, it can come in handy at times,” Conroy says.

Drawbacks to the solo 401(k)

The solo 401(k) has the same drawbacks of typical 401(k) plans, plus a couple others that are specific to itself. Like other 401(k) plans, the solo 401(k) will hit you with taxes and penalties if you withdraw the money before retirement age, currently set at 59½. Yes, you can take out a loan or may be able to access a hardship withdrawal, if needed, but those are last resorts.

In addition, it can take more paperwork to open a solo 401(k), but it’s not especially onerous. You usually won’t be able to open the account completely online in 15 minutes, as you would a typical brokerage account. Plus, you’ll need to get a tax ID from the IRS, which you can do online quickly. On top of this, you’ll have to manage the plan, choose investments and ensure that you don’t exceed annual contribution limits.

Another wrinkle: Once you exceed $250,000 in assets in the plan at the end of the year, you’ll need to start filing a special form with the IRS each year.

These drawbacks aren’t especially burdensome, but you should be aware of them.

How to open a solo 401(k)

Many brokers, though not all, will allow you to set up a solo 401(k). The fees can vary substantially. Some brokers may charge a one-time setup fee, while others may charge an ongoing fee for overseeing the plan. However, two highly rated brokerages – Fidelity and Charles Schwab – offer fee-free plans, though you’ll still pay for other charges you incur.

Going with a broker has significant advantages over typical employer-sponsored 401(k) funds. The most obvious is that a worker can invest in a broader range of assets such as index funds, mutual funds, ETFs, stocks, bonds and certificates of deposit (CDs). In essence, you are not limited to only the funds offered by an employer-based plan. This feature of solo 401(k) plans gives you plenty of investment freedom.

However, this freedom means that small-business owners will typically have to manage the investments themselves. Many institutions offer free services like robo-advisors, online tools, in-person consultations and other options to help you choose the appropriate asset allocation if you need investment advice.

You’ll also want to check the specifics of each broker. Some may not provide solo 401(k) plans in both traditional and Roth varieties. Others may not offer the ability to borrow against your invested funds. If there’s a specific feature you need, be sure to check with the broker before opening an account.

Once your account is set up, there’s minimal maintenance work beyond determining your contribution levels, choosing your investments and staying on top of contribution deadlines.

For qualifying employee deferral contributions to take effect, a solo 401(k) plan must be established by Dec. 31 with the funds deposited by the end of the tax year. Employer profit-sharing contributions are usually extended until tax-filing deadlines.

Is a solo 401k worth it?

The flexibility around solo 401(k) contributions, investment options, and relatively low management requirements makes the plan an attractive alternative for small business owners or sole proprietors who want to save for retirement proactively.

Both the salary deferral and the income-sharing contributions are optional and can be adjusted at any time. You could contribute to your solo 401(k) using either method or not contribute at all in a given year based on the fluctuating profitability of your business.

Contributions to your solo 401(k) also allow you to leverage other tax incentives that could amount to significant savings in the long run.

Bottom line

The solo 401(k) offers one of the best options for the self-employed to save money quickly, and if your spouse is involved in your business, you can really take maximum advantage of the program. However, it can be useful even for smaller businesses because of the ability to save so much so quickly, and its complete flexibility makes it a great option for the self-employed.

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