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 amount of savings that the employee puts away. But what about those individuals who are self-employed or own their own company? Does that mean that 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 401k comes into play. If you are a freelancer, contractor, or other self-employed individual, then you need to keep reading! We will explain exactly what a solo 401(k) is, how you can 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 that is administered by your employer or a third-party trustee. The employer might match the funds that you deposit into the account, and they also set the rules regarding available investment funds, loans, withdrawals, and other administrative items. The IRS also recognizes these plans and allows for certain tax breaks when you make a contribution 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.
First, 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 quite easy to meet as most all sole proprietors, contractors, and freelancers fall into this category. Many small business owners will fit into this category as well if they do not have any hired staff. Next, you must actually have earned income from the business. If you meet both of these criteria, then you will be allowed to open your self directed 401k. 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.
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 to 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), there are contribution limits and tax implications to these accounts. 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 then you are entitled to tax-free withdrawals. Here is a chart that shows the major highlights of a solo 401(k) account.
| Solo 401(k) Information | |
|---|---|
| Eligibility | Must own your own business and have no employees; otherwise, no age or income restrictions |
| Contribution Limits | In 2021, you can contribute up to $19,500 individually plus up to 25% of your compensation to the total limit of $58,000. If you are age 50 or older, you can contribute an additional $6,500. |
| Contribution Taxes | Tax deduction in current tax year for Traditional IRA contributions Contributions to Roth IRA are made with after-tax dollars, so no tax benefits in current tax year. |
| Taxes on Withdrawals at Retirement | Qualified withdrawals taxed as income during the year in which the withdrawal is made. No income taxes on withdrawals from Roth IRA. |
| Steps to Open | Simply contact your brokerage firm of choice and provide your EIN. You must document the type of plan you wish to open, and you can begin making contributions immediately. |
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, thereby reducing the amount of money on which 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 key differences between a traditional and 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 to 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 income during retirement, so they pay lower taxes while working and get to enjoy their retirement income tax-free.
Adding Your Spouse Under Your Solo 401(k)
You have already learned that one of the biggest qualifications for a solo 401(k) is the fact that your business can 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 receive benefits from your 401k. If your spouse earns money from the business, then he or she can take advantage of the plan as well. 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 into the plan. Essentially, this could double your individual contributions into your 401(k).
Benefits Of Opening Up A Solo 401(k)
So, why would you want to open this type of account as opposed to an IRA or other type of retirement planning account? The reason is that the solo 401k offers many advantages over other types of 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 difficult 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 end up saving 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 that usually means that the most they will ever contribute will not go higher than the employee contribution limit. Employer contribution limits are actually much higher than employee limits. As an employer, you can contribute up to 25% of your compensation into your 401(k) all the way to the limit of $58,000 in 2021. So, these profit-sharing contributions allow you to make much larger contributions into your retirement savings than by participating in an employer-sponsored plan.
Employee Contribution Limits
While there are limits on the amount that an employee can contribute to their 401(k), those limits are often much higher than the limits on other forms of retirement savings. In 2021, the solo 401k contribution limits for an employee are $19,500. If you are age 50 or older, then you can contribute an additional $6,500 in catch up contributions. Compare that to a traditional IRA where the total contribution limit is $6,000 for the year in most cases. While employers can also make contributions to an SEP IRA, the limits are still lower.
How To Open Your Solo 401(k)
Opening your account is fairly straightforward. You can open this type of account at most online brokerage firms or with your local financial planner if you prefer. 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 that you will have to write down the type of account you will be opening as well as the types of investments that will be 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 simply need your EIN and a decision on which brokerage you will be using 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 in which you open it, and you can decide how often to make contributions up to the maximum limit.
Roth 401(k)
Opening a Roth account is really no different from a traditional account. You will simply 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 that you are unable to 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, and in some cases, they can quickly grow their savings in these accounts. Since you are both the employee and the employer, you can max out your contributions from both perspectives. This would allow you to put away up to $64,500 in your account in a single year in some cases! You have the flexibility to choose either a traditional or Roth account, and you can even add your spouse to the account as well. These are great options for those who have their own business and are ready to grow their retirement savings!
Frequently Asked Questions (FAQs)
What is the difference between a Solo 401(k) and a regular 401(k)?
There are only a few differences between a regular 401(k) and a solo account. Traditionally, in a regular 401(k), you make contributions through salary deferrals. 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 manually make those plan contributions regularly. 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.
What does the Solo 401(k) allow me to invest in?
You have a wide range of flexibility when it comes to investment strategy with a solo 401(k). You may choose to invest in traditional stocks, bonds, or mutual funds. However, you might also choose other options like real estate, gold coins, tax liens, promissory notes, silver, or private equity. Your financial professional or tax advisor can help you if you have any questions.
How much does it cost to open a Solo 401(k)?
At many brokerages, there is no cost to open your solo 401k. Depending on the type of investments that you decide on, there may be some small maintenance fees for particular funds. However, the cost to maintain the account itself is usually quite low or even free. If you find a financial institution who wants to charge you a large fee for opening or maintaining this kind of account, then you should look elsewhere for better pricing.
Does a Solo 401(k) plan allow for Roth contributions?
Yes, you can choose to make Roth 401k contributions to your solo plan. Similar to a Roth IRA, you will contribute after-tax dollars and then enjoy tax-free withdrawals at retirement. Just be sure that you specify this designation when completing your opening paperwork. If you need the money early, make sure you know how to take an early withdrawal without a penalty.