A solo 401(k) plan is the solution to a common problem for the self-employed: not having an employer-sponsored retirement plan. Also called a one-participant 401(k) by the IRS, this plan was designed with the self-employed in mind. You see, it mimics some of the features of an employer-sponsored plan, to ensure that you don’t miss out on retirement savings, while also giving you some added flexibility.
In this blog, we’ll cover everything you need to know about the solo 401(k), so that you can still ensure a comfortable retirement.
What Is a Solo 401(k)?
If you’re a freelancer or self-employed, you may be under the impression that you don’t have access to a tax-advantaged retirement savings plan like a 401(k). But with a solo 401(k), you do. These plans have no income or age restrictions, so it’s never too late to start one. In fact, unlike other plans, solo k contributions are not limited to a specific percentage of your salary. That way, you can minimize your tax liability – with the exception of self-employment taxes, of course.
A solo 401(k) works in pretty much the same way as other 401(k)s, depending on how it’s set up. Flexibility is one of the main advantages here – these funds can either function like traditional 401(k)s, or as Roth accounts. Because of this, they offer more advantages than other retirement options like a SEP IRA or SIMPLE IRA.
Who can establish a solo 401(k)?
The key to being eligible for these plans is to be self-employed – or to own an income-generating business without any other employees. One exception is that you may run your business with a spouse, and have them participate in the plan. That way, you have the option to save even more for retirement, as a couple.
If you have employees other than a spouse, you won’t be able to open a 401(k).
Contribution Limits
In 2024, the annual contribution limit to a solo 401(k) is $69,000. However, if you start the plan late, and are 50 years old or older, you’re allowed to make additional catch-up contributions of up to $7,500.
How this works is similar to other 401(k) plans – except here, you are the employer and the employee. As an employee, you can contribute up to 100% of your salary or $23,000 a year (whichever is less) to the plan, as well as the additional catch-up contribution, if eligible. These payments take the form of elective deferrals that are deducted from your paycheck, just like in employer-sponsored plans.
As an employer, you can make an extra profit-sharing contribution of up to 25% of your compensation or net income. In 2024, this is capped at $345,000.
As you can see, if you and your spouse contribute to the plan, there’s a potential for substantial retirement savings.
For instance, let’s say you’re both in your 30s and operate a business together. If you made $200,000 in income, you can contribute up to $23,000. So your total employee contribution could be as high as $46,000 for the year. But remember that you’re also business owners. So you could each contribute another 25% of your profits – or $25,000 each – for another $50,000 payment to your plan. That way, in a single year, you and your spouse would have put away $96,000 towards your retirement.
Not only does this significantly lower your tax liability, but you could also be eligible for other incentives.
Tax Benefits of Solo 401(k)s
As mentioned earlier, it’s possible to structure a solo 401(k) like a traditional 401(k), or like a Roth account. Each option impacts the tax benefits of your plan.
The traditional 401(k)
A solo 401(k) that’s structured like a traditional 401(k) gives you immediate tax benefits, because your tax liability is lowered for the year in which you make contributions. In other words, you will be paying lower taxes now, because you have less taxable income. However, this means that when you retire, and withdraw funds, these will be taxed as ordinary income. As such, the larger your withdrawal, the more tax you’ll pay on it. Also remember that if you need to make an early withdrawal, before the age of 59 ½, your money will also be subject to an extra 10% penalty.
The Roth option
Structuring your solo 401(k) as a Roth account defers your tax benefits. That means you’ll not have access to any tax breaks now, while making the payments, but your investment will grow tax-free as long as it’s in the account. And as an added bonus, you won’t be taxed when you make a withdrawal during retirement. Note that like a traditional option, you’ll be penalized if you make an early withdrawal.
The Roth option is usually more appealing for people who start their solo 401(k)s when they’re younger, and thus expect a higher income during retirement.
Tax incentives aren’t the only appealing feature of solo 401(k)s. Let’s look at a few other perks.
Additional Benefits
Solo 401(k) plans offer a variety of investment options, including cryptocurrency, stocks, bonds, mutual funds, exchange-traded funds and real estate. For instance, you can buy a property to rent it out, and any rental income will return to your 401(k).
This means that with a solo 401(k), it’s possible to easily diversify your retirement portfolio.
These plans also allow you to take a loan, to borrow funds from your account. Generally, this amount is limited to 50% of your funds, or a monetary value, depending on your provider. And while you will need to repay the loan with interest, like a normal loan, the interest is added to your funds!
These plans are also not exclusive – it is possible to have a normal retirement plan like an IRA, as well as a solo 401(k) if you have a side gig.
Finally, the solo 401(k) usually has less paperwork than other retirement plans, since it’s a single-participant plan. That means no business paperwork and asking employers for documents. All in all, this makes setting up and managing a solo 401(k) so much easier.
Establishing and Managing a Solo 401(k)
You can set up a solo 401(k) at any financial institution or broker that administers 401(k) plans. Be sure to check for any application or maintenance fees, as some providers may levy these. Once you have set your contribution levels and your plan is running, you’ll need to keep accurate records of any transactions, for tax reporting. This is particularly true if your fund has a balance of over $250,000, if you make a loan or withdrawal from it, or if you terminate it.
Remember that if you want to make a contribution for this year to lower your tax liability, you must establish your plan by December 31 and make your contribution by the end of the calendar year.
Contribution deadlines and reporting
Reporting your solo 401(k) contributions is done on your tax return, by the reporting deadline. You’ll need to ensure that you report these correctly. Both employee and employer contributions must be noted on Schedule 1, Line 16 of Form 1040.
To ensure compliance with IRS regulations, also make sure that you keep detailed records of your contribution types and amounts.
Proper planning will ensure that you stick to these deadlines and avoid potential issues with the IRS, so to maximize the benefits, make sure you have an effective tax strategy in place!
For help managing your taxes, or creating a strategy for your retirement savings, schedule a free Discovery Call with one of our CPAs today!
The information presented in this blog article is provided for informational purposes only. The information does not constitute legal, accounting, tax advice, or other professional services. We make no representations or warranties of any kind, express or implied, about the completeness, accuracy, reliability, suitability, or availability of the information contained herein. Use the information at your own risk. We disclaim all liability for any actions taken or not taken based on the contents of this blog. The use or interpretation of this information is solely at your discretion. For full guidance, consult with qualified professionals in the relevant fields.
