When most people hear the term 401(k), they immediately think of it as a benefit that an employer provides to its employees. Many employers will make matching contributions to an employee’s 401(k) retirement account, effectively doubling the savings the employee puts away.
But what about those individuals who are self-employed or own their own company? Does that mean they cannot participate in a 401(k) plan and must save for retirement using other methods?
Not necessarily! This is where the “solo” or individual 401(k) comes into play. You must keep reading if you are a freelancer, contractor, or other self-employed individual!
We will explain exactly what a solo 401(k) is, how to start one, and what you need to know when contributing to that account.
What Is A Solo 401(k)?
As most people know, a traditional 401(k) is an employer-sponsored retirement plan administered by your employer or a third-party trustee.
The employer might match the funds you deposit into the account and set the rules regarding available investments, loans, withdrawals, and other administrative items. The IRS also recognizes these plans and allows for certain tax breaks when you contribute to these employer-sponsored plans.
So, what if you are both the employer and the employee? Many small business owners find themselves in this very situation. A 401(k) can offer many advantages over other retirement savings accounts like an IRA (the difference between an IRA and a 401(k) is another topic completely), so how do you participate if you do not work for a company?
- If you meet the criteria set forth by the IRS, you can still open and contribute to a 401(k) even if you work for yourself.
- You must own the business and be the only employee. There is an exception that covers your spouse working for the company, but we will address that later in this article.
This part of the criteria is usually easy to meet as almost all sole proprietors, contractors, and freelancers fall into this category. Many small business owners will also fit into this category if they do not have any hired staff.
- You must have earned income from the business. If you meet both of these criteria, then you will be allowed to open your self-directed 401(k).
Remember that a 401k is different from a pension which is fully funded by your employer. Keep reading to learn about the specifics of how you must open the account and the contribution limits placed on these accounts.
KEY TAKEAWAYS
- An individual or solo 401(k) is similar to a regular 401(k) but is designed specifically for self-employed business owners who don’t have employees.
- You can set up a traditional 401(k), a Roth 401(k), or both. Each offers different tax benefits, giving you flexibility in your retirement planning.
- One exception to the “no employee” rule is your spouse. Your spouse can work for the business and contribute to a solo 401(k) like the business owner.
Eligibility Requirements
The solo 401k rules state that you must meet a couple of requirements to be eligible to open this type of account. As mentioned above, you must be a business owner with no other employees. This can be a small business, sole proprietor, contractor, or freelancer.
Next, you must have earned income from the business. Those are the only two requirements for opening a solo or one-participant 401(k) account. There are no age limits or work history requirements to opening this type of account.
Similar to an employer-sponsored or group 401(k), these accounts have contribution limits and tax implications. The traditional 401(k) allows you to contribute pre-tax dollars to the account, but you pay taxes upon withdrawal.
Conversely, the Roth 401(k) allows you to contribute after-tax dollars and are entitled to tax-free withdrawals. Here is a chart that shows the major highlights of a solo 401(k) account.
| Solo 401(k) Plan Information | |
|---|---|
|
Eligibility |
Must own your own business and have no employees; otherwise, no age or income restrictions |
|
Contributions Limits |
In 2024, you can contribute upt to $23,000 individually, plus a “company match” up to 25% of your compensation for a total limit of $69,000
If you are 50 or older, you can contribute an additional $7,500 |
|
Contribution Taxes |
Traditional 401(k) contributions are tax deductable in the current tax year
Roth 401(k) contributions are made with after-tax dollars, so there are no tax benefits in the current tax year |
|
Taxes on Withdrawals at Retirement |
Qualified (traditional 401(k)) withdrawals are taxed as income in the year the wiethdrawal is made.
Withdrawals from a Roth 401(k) are not considered income and therefore are not taxed |
|
Steps to Open |
Contact a brokerage firm of your choice and provide them with your EIN
You must document the type of plan you wish to open, and you can begin making contributions imeediately |
Is A Solo 401(k) Tax Deductible?
The tax implications from a solo 401(k) are essentially the same as employer-sponsored accounts. Your contributions are not considered taxable income for that tax year, reducing the amount of money you are taxed.
However, when it comes time to withdraw your funds at retirement, you will be taxed at the current income tax rates. In some cases, it makes more sense to contribute to a Roth account instead. There are some critical differences between a traditional and a Roth 401k.
When you contribute to a Roth 401(k), your contributions are not tax deductible. You make those contributions using after-tax dollars. The advantage of the Roth plan is that you do not pay taxes on the withdrawals from your account.
This can be great for people who expect to have higher incomes during retirement, as they pay lower taxes while working and enjoy their retirement income tax-free.
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Adding Your Spouse Under Your Solo 401(k)
You have already learned that one of the biggest qualifications for a solo 401(k) is that your business must have no other full-time employees.
However, there is an exception for spouses. Just as your spouse can receive Social Security spousal benefits, they can also benefit from your 401(k).
If your spouse earns money from the business, he or she can also take advantage of the plan. Your spouse would be allowed to make the maximum contribution to the plan, and your business could also contribute up to 25% of the spouse’s salary. This could double your total contributions to your 401(k).
Benefits Of Opening Up A Solo 401(k)
So, why would you want to open this account instead of an IRA or other retirement planning account? The reason is that the solo 401(k) offers many advantages over other retirement accounts. Here are some of those advantages.
Flexibility To Choose Between Traditional & Roth
With an employer-sponsored plan, you are almost always stuck with a traditional plan. Many employers do not offer Roth plans because they are challenging to manage and maintain.
A traditional 401(k) might not be the best option for you, and with a solo plan, you can choose which type of account you open. You might save yourself thousands of dollars in tax benefits by having the flexibility to choose which type of account you open.
Employer Contribution Limits
To understand this benefit, it helps to remember that you are both the employee and the employer in this situation. Many employers will match your contribution to your 401(k), but typically only up to 4% of your income. This usually means the employer match will not exceed the employee contribution limit.
Employer contribution limits are much higher than employee limits. As an employer, you can contribute up to 25% of your compensation into your 401(k) to the limit of $69,000 in 2024.
So, these profit-sharing contributions allow you to make much more significant contributions to your retirement savings than participating in an employer-sponsored plan.
Employee Contribution Limits
While there are limits on the amount an employee can contribute to their 401(k), those limits are often much higher than those allowed in IRAs and other retirement plans. In 2024, an employee’s Solo 401(k) contribution limits are $23,000.
If you are 50 or older, you can contribute an additional $7,500 in catch-up contributions. Compare that to a traditional IRA, where the total contribution limit is usually $7,000 for the year. While employers can also contribute to a SEP IRA, the limits are still lower.
TIP
A solo 401(k) is an excellent plan for self-employed business owners to save for retirement. There is a unique option for high-income earners to make significant Roth contributions using a “Mega Backdoor Roth” option.
How To Open Your Solo 401(k)
Opening an account is pretty straightforward. You can open one at most online brokerage firms or with your local financial planner.
You must have your Employer Identification Number (EIN) handy, and you will be required to put the details of your plan in writing.
This means you must write down the type of account you will open and the investments included in the plan. This could include mutual funds, stocks, bonds, ETFs, or other investment avenues.
You will also be required to use the IRS Form 5500-EZ to report the returns from your plan each year before the tax filing deadline.
Traditional 401(k)
As mentioned above, you will need your EIN to decide which brokerage to open your account. The firm will likely require an application and some paperwork to be completed, and then you will be ready to start making contributions.
You can contribute to this account in the same calendar year you open it and decide how often to make contributions up to the maximum limit.
Roth 401(k)
Opening a Roth account is no different from a traditional account. You will elect the Roth account type when discussing the account with your brokerage firm. You will still need your EIN and written documentation of your plan.
The Bottom Line
If you rely on self-employment income, you might think you cannot participate in a 401(k) program. However, that is not the case!
Even self-employed individuals can contribute to a solo or self-employed 401k; in some cases, they can quickly grow their savings in these accounts.
Since you are both the employee and the employer, you can maximize your contributions from both perspectives. In some cases, this would allow you to put away up to $69,000 in your account in a single year!
You can choose either a traditional or Roth account and add your spouse to the account. These are great options for those who own their own businesses and are ready to grow their retirement savings!
Frequently Asked Questions
There are only a few differences between a regular 401(k) and a solo account. Traditionally, you make contributions through salary deferrals in a regular 401(k). These deferral contributions are automatically deducted from your paycheck and placed into your account. This helps you save for retirement without even thinking about it.
However, these elective deferrals are a little different for a solo account. Since you are the employee and the employer, those contributions are not automatically withdrawn from your paycheck. You will need to make those plan contributions manually.
In addition, a rollover will work much the same way. If you leave the corporate world to start your own business, you can roll your regular 401(k) over into a solo account.
With a solo 401 (k), you have a wide range of flexibility regarding investment strategy. You may invest in traditional stocks, bonds, or mutual funds.
However, you might also choose other options, such as real estate, gold coins, tax liens, promissory notes, silver, or private equity.
Your financial professional or tax advisor can help you with any questions.
At many brokerages, opening your solo 401(k) is not expensive. Depending on the type of investments that you decide on, there may be some small maintenance fees for particular funds.
However, the cost of maintaining the account itself is usually relatively low or even free. If you find a financial institution wanting to charge you a hefty fee for opening or maintaining this kind of account, you should look elsewhere for better pricing.
You can choose to make Roth 401k contributions to your solo plan. Like a Roth IRA, you will contribute after-tax dollars and then enjoy tax-free withdrawals at retirement.
Please specify this designation when completing your opening paperwork. If you need the money early, you should know how to make an early withdrawal without a penalty.
Yes, you can move your solo 401(k) to another company.
This can be done without tax implications if you initiate a direct rollover to another custodian.
Contacting both providers to inform them of the request will help streamline the transfer process.
Reviewing the different fees and investment options before rolling over your solo 401(k) is essential.
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