What Is a Solo 401(k)?
Just because you are a one-person outfit, a freelancer, or an independent contractor doesn't mean you have to do without a retirement savings plan or the tax benefits that accompany them.
One option If you are self-employed is the solo 401(k), also known as an independent 401(k) plan. In fact, the Solo 401(k) has some benefits over other types of retirement accounts available to the self-employed.
Key Takeaways
- If you're self-employed and don't employ others, you are eligible to open a solo 401(k).
- A couple running a business together also qualifies.
- You can contribute to your solo 401(k) as both employer and employee.
- For 2023, you can contribute a combined total of $66,000 (rising to $69,000 in 2024). If you're age 50 or over, you can add another $7,500 in both years.
- You can choose between a traditional plan or a Roth plan. Each has its own tax advantages.
Eligibility Requirements
There are a few eligibility requirements to invest in a solo 401(k). You must produce your income from your own business. And the business must be run by you alone, or you and your spouse.
Sole proprietors, small business owners without employees (except for a spouse), independent contractors, and freelancers typically fit this description. The business must also produce income. This is verified through your tax records.
If you meet these criteria, you can open a solo 401(k) plan.
If you make a living as a one-person business operator, a freelancer, or an independent operator, the solo 401(k) may be the best choice for you. Any business form with no employees can adopt such a plan, whether it is a sole proprietorship, LLC, corporation, or partnership.
How to Set up a Solo 401(k)
There are specific steps that must be taken to properly open a solo 401(k) plan, according to the Internal Revenue Service (IRS).
First,you have to adopt a plan in writing, making a written declaration of the type of plan you intend to fund. The choices are the same as those given to an employee opening a 401(k) plan: you can choose a traditional 401(k) or a Roth 401(k). Each has distinct tax benefits.
A solo 401(k) must be set up by Dec. 31 in the tax year for which you are making contributions.
You can open a solo 401(k) at most online brokers and traditional brokers or directly through a financial services company. You'll want to do some research ahead of time to identify the best solo 401(k) company for you.
You'll need an employer identification number (EIN) to get started with the enrollment process. If you don't have one already, you can apply online directly to the IRS.
The rest of the documentation will be provided by the broker or financial services company you choose for the account.
The Traditional 401(k)
If you have a traditional 401(k) plan, you're investing in pretax dollars. That is, you're effectively claiming an immediate tax break for your contributions as you make them throughout your working years.
When you reach retirement age, you owe income taxes on the funds as you withdraw them. You'll pay taxes on your initial deposits as well as on the money your investments have earned over the years.
Keep in mind that most people are in a lower tax bracket after retiring than they were during their working years. If you anticipate being in a higher tax bracket, you might wind up paying a hefty extra amount in taxes down the road.
The Roth 401(k)
Roth plans are funded with after-tax dollars. Since you've already given the IRS its cut, your withdrawals are tax-free after you retire. That's totally tax-free, including the money you paid in and the investment returns the account earned.
This could add up to a nice fat bank account for your retirement years. However, keep in mind that it's a bigger hit to your spending power during your working years.
Getting Your Solo 401(k) Started
Once you have established the type of plan you want, you will need to create a trust that will hold the funds until you need them or you reach retirement age. You can select an investment firm, online brokerage, or insurance company to administer the plan for you.
You also need to establish a record-keeping system, so that your investments are accounted for properly.
Benefits of a Solo 401(k)
Solo 401(k)s provide some advantages over other types of retirement accounts available to you. One big advantage is the availability of the Roth option as well as the traditional version. Only the traditional option can be used by those who invest using the SEP IRA, a Keogh plan, or a SIMPLE IRA. The plain-vanilla IRA that is available to all who have earned income is available in Roth or traditional versions but the annual contribution limits are far lower.
One of the main advantages of the solo 401(k) is that it can accept contributions from both an employee and an employer. That is, if you have a solo 401(k), you wear both hats and can make contributions in both roles.
Contribution Limit as an Employee
The contribution limits are adjusted for inflation every year by the IRS.
For 2023, the maximum contribution limit for a 401(k)—as an employee—is $22,500. If you are 50 or older, you can make an additional catch-up contribution of $7,500 as well. For 2024, these numbers are $23,000 and $7,500, respectively.
Contribution Limit as an Employer
Wearing the employer hat, you can contribute up to 25% of your compensation.
The total contribution limit for a solo 401(k) as both employer and employee is $66,000 for 2023, and $69,000 for 2024, or 25% of your adjusted gross income, whichever is lower.
People ages 50 and above can add an extra $7,500 a year as a "catch-up contribution" in 2023 and 2024. In other words, in 2023 you can contribute a total of $66,000 ($22,500 as an employee + $43,500 as an employer) along with a $7,500 catch-up contribution if applicable for a maximum of $73,500 for the year.
You can have a solo 401(k) even if you're moonlighting. If you have a 401(k) plan at both jobs, the total employee contribution limits must be within the maximum for the year, but the employer contribution is not limited. If you're one of these lucky folks with two retirement savings plans, talk to a tax adviser to make sure you follow the IRS rules.
Added Flexibility
The SEP IRA is an alternative retirement plan that is often recommended for small business owners. But the solo 401(k) has an advantage over the SEP: you can take loans from the plan before retiring. In general, it's not advisable to borrow from your retirement fund, but it's an option if you must.
The solo 401(k) has another advantage over the SEP IRA: you get to choose between a Roth and a traditional account. The SEP IRA can only be a traditional account.
Other Benefits
The IRS is not known for making paperwork disappear, but the Solo 401(k) is designed for use by sole proprietors, freelancers, and contractors. As such, it eliminates much of the paperwork and bureaucracy that go along with setting up and managing a 401(k) in a corporation.
As a solo operator, you also have a world of options to choose from in selecting how to invest your money for retirement. Most companies offer their employees a limited selection of funds from a single financial services firm. You have no limits except for a few that the IRS imposes. You can't play the derivatives market or invest in stamps or comics, for example.
Otherwise, you can invest in stocks, bonds, mutual funds, exchange-traded funds, and many other types of investments.
Alternatives to a Solo 401(k)
There are basically two options in addition to the solo 401(k) for freelancers and independent contractors who want to save for retirement and get the tax advantages that go with these IRS-approved choices:
- The SEP IRA, for Simplified Employee Pension, is designed to be an easy, flexible option for small businesses with employees. It works much like a traditional IRA but has higher contribution limits. The limits are the same as for the Solo 401(k): $66,000 for 2023 and $69,000 for 2024; however, your contribution cannot exceed 25% of your net adjusted income. You may not find that adequate for your goals. No catch-up contribution is allowed for those aged 50 and older. No Roth option is available. A SEP IRA can be opened through any brokerage or bank.
- The Keogh Plan is open to sole proprietors, partnerships, and limited liability companies and is often used as a profit-sharing vehicle for professional practices such as doctors' and lawyers' groups. It has the same contribution limits as the SEP IRA and the Simple 401(k) but poses a greater administrative burden. There is no Roth option.
Another option, the SIMPLE IRA, is designed for businesses with 100 or fewer employees. It is open to sole proprietors but has a lower contribution limit than the Solo 401(k) or the SEP IRA. The maximum contribution is up to 3% of the salary plus $15,500 in 2023 and $16,000 in 2024. There is no Roth option.
All of these options have higher contribution limits than the plain-vanilla IRA available to all earners. The limit there is $6,500 for 2023 and $7,000 for 2024. If you are 50 and older, you are allowed a catch-up contribution of $1,000 in each year.
Who Qualifies for a Solo 401(k)?
You're eligible to open a Solo 401(k) if you are self-employed and have no employees. A couple running a business jointly also qualifies.
What Are the Benefits of a Solo 401(k)?
Unlike other options, a Solo 401(k) account holder can choose between a traditional option and a Roth option. The traditional option allows you to deduct the amount you pay from your income for that year, giving you an immediate tax break. With the Roth option, the income taxes on that money are paid immediately and you owe no taxes when you withdraw the funds.
The Solo 401(k) has far higher annual contribution limits than a plain-vanilla IRA, although that is also true for the SEP IRA and the Keogh plan.
The Solo 401(k) allows you to take loans from your account before you retire. This is not an option with many other retirement plans.
Finally, the Solo 401(k) is relatively straightforward in terms of paperwork, as it is designed for one-person shops, not corporations.
How Much Can I Contribute to a Solo 401(k)?
The total contributions to a Solo 401(k) for a person under age 50 is $66,000 for 2023 and $69,000 for 2024. People ages 50 and above can add an extra $7,500 in both years as a "catch-up contribution." Those numbers all include the person's combined contributions as employer and employee.
How Much Does It Cost to Open a Solo 401(k)?
There is no cost to open a 401(k) account but watch out for those fees later on. While you're researching your options, check for account maintenance fees, transaction fees, commissions, mutual fund expense ratios, and sales loads.
A fractionally higher fee can mean a big hit to a retirement portfolio. If you make the right choices you can minimize the fees you pay.
The Bottom Line
If you are self-employed, you have several options for saving for retirement while saving on your taxes. You don't have to settle for the plain-vanilla IRA, which is available to anyone with earned income but sets the maximum annual contribution at a comparatively low level.
Instead, you can opt for one of several types of retirement plans that have much more generous limits with similarly generous tax benefits. The solo 401(k), the SEP IRA, the Keogh plan, and the SIMPLE IRA all are possibilities.
However, the solo 401(k) is the only option that offers you a choice of a Roth account or a traditional account, while still allowing for the maximum yearly contribution available among tax-advantaged retirement plans.
