What is a solo 401(k)?
A solo 401(k), also called an individual 401(k), is a retirement savings account created for folks who work for themselves and don’t have full-time employees (unless your spouse works for your business, in which case you both can contribute).
Think of it as similar to the 401(k) that regular employees get from their jobs, but with a special perk for self-employed individuals. Since you wear both the employee and employer hats, you can stash away more money in it each year.
Quick Facts about Solo 401(k)
| Eligibility rules | There are no age or income restrictions, but you must be a business owner without any employees. |
| Contribution limit | You can contribute a total of up to $66,000 in 2023, and if you’re 50 or older, you can make an additional catch-up contribution of $7,500. |
| Taxes on contributions | In a Traditional 401(k), your contributions are made with pre-tax dollars, which reduces your taxable income for the year. On the other hand, in a Roth 401(k), your contributions are made with after-tax dollars. |
| Taxes on qualified distributions in retirement | With a Traditional 401(k), qualified distributions are subject to taxation at ordinary income rates. In contrast, in a Roth 401(k), qualified distributions are entirely tax-free. |
| How to Set up | You can open a solo 401(k) with many online brokers as long as you have an employer identification number. Any of the brokers listed in our top picks for IRAs would also be suitable for a 401(k). |
Benefits of a solo 401(k)
A great thing about a solo 401(k) is that it lets you call the shots when it comes to your retirement plan and investments. Unlike folks with regular jobs who are stuck with their employer’s retirement options, you get to choose what works best for your money. As the boss of your retirement, you decide how to invest based on your comfort with risk, and you can pick the 401(k) type that gives you the best tax advantages.
Now, solo 401(k)s come in two flavors: traditional and Roth. Traditional solo 401(k)s are like a tax delay game. You put your money in with dollars that haven’t been taxed yet, which lowers your taxable income for the year. But down the road, when you take the money out in retirement, you’ll have to pay taxes on it. This makes sense if you think you’re making more money now than you’ll need during retirement. Delaying those taxes until your income drops can save you some cash.
On the flip side, Roth solo 401(k)s work the opposite way. You pay taxes on your contributions this year, but after that, your money grows without being taxed. When you take it out in retirement, it’s all yours without any taxes nibbling away at it. This is a better choice if you think your current income is about the same or lower than what you’ll spend each year in retirement. Paying taxes now will likely cost you less than waiting.
However, there’s a catch. The government usually won’t let you touch your solo 401(k) money before you turn 59 1/2, unless you have a really good reason like buying your first home or dealing with a hefty medical bill. Withdrawing money from a Roth solo 401(k) before that age is generally allowed, as long as your account has been around for at least five years. But if you take money out without a good reason before 59 1/2, you’ll face a 10% early withdrawal penalty.
Contribution limits for a solo 401(k)
If you’re self-employed, the good news is that you can put a significant amount of money into your solo 401(k) for your retirement. In 2023, you can contribute up to $66,000 (up from $61,000 in 2022), or if you’re 50 or older, as much as $73,500 ($67,500 in 2022). This is way more than what regular employees can save in a 401(k) because you, as a self-employed person, can make both employee and employer contributions.
Your employee contribution can go up to $22,500 in 2023 (up from $20,500 in 2022), or $30,000 if you’re 50 or older (up from $27,000 in 2022). This is the same limit that traditional employees have for their 401(k) savings.
The employer contribution part can be up to 25% of your employee contribution or roughly 20% of your net self-employment income. Net self-employment income means all the money you made from your self-employed work, minus business expenses, half of your self-employment tax, and the amount you already put into your solo 401(k) as an employee contribution. For example, if you earned $100,000 in net self-employment income, you could add up to approximately $20,000 to your solo 401(k) as an employer contribution.
Your maximum contribution is the smaller of the annual limit mentioned earlier or up to $22,500 of your income in 2023 ($20,500 in 2022), plus 25% of your income from the employer-side contribution. If you’re 50 or older, you can add an extra $7,500 in 2023 ($6,500 in 2022). If you’re under 50, even if your employer contribution would allow it, you can’t contribute more than $66,000 in 2023 ($61,000 in 2022). You can’t go over the maximum limit for both employee and employer contributions in a given year, even if you haven’t reached the annual limit.
Including Your Spouse in Your Solo 401(k) Plan
The IRS has a special rule for solo 401(k)s when it comes to employees – you can actually have one employee, and that’s your spouse, as long as they earn income from your business.
This can be a great benefit because it effectively allows you to potentially double your family’s contributions, depending on how much you both earn. Your spouse can contribute money to the 401(k) as if they were your employee, following the regular employee contribution limit (and the extra catch-up contribution if they’re 50 or older). As the employer, you can then make a profit-sharing contribution for your spouse, which can be up to 25% of their compensation.
How to start a solo 401(k)
If you’re thinking about setting up a solo 401(k), here’s a simple guide to get you started:
- Get an Employer Identification Number (EIN): To open a solo 401(k), you’ll need an EIN. You can apply for one easily on the IRS website.
- Choose Your Broker: Take some time to check out different brokerage options. Look at what they offer for investments, their fees, and how good their customer service is.
- Fill Out the Necessary Forms: Your chosen broker will send you some paperwork. You’ll need to complete a plan adoption agreement and an application before you can start adding money to your account.
- Fund Your Account: You can add money to your solo 401(k) by sending a check or using direct deposit to fund your account.
Once you’ve completed these four steps, you’re all set to start selecting your investments and making regular contributions to your account. If you want, you can also move funds from other retirement accounts in your name into your new solo 401(k).
Here’s an important timeline to remember for your solo 401(k):
- You need to make your solo 401(k) employee contributions by December 31st of the year.
- However, you have a bit more time for your employer contribution. You can wait until the tax filing deadline for the year, which is usually April 15th of the following year.
One more thing to keep in mind is that if you have $250,000 or more in your solo 401(k) by the end of the year, you’ll need to submit a Form 5500-EZ information return to the IRS along with your taxes for that year. This is to make sure everything is in order with the government.
Solo 401(k) versus other retirement plans
If a solo 401(k) doesn’t seem like the right choice for you, there are some other retirement savings options you might want to consider:
- Simplified Employee Pension (SEP) IRA: This is a popular choice for self-employed folks without employees. You can contribute up to the lesser of $61,000 in 2022 or 25% of your net income. Your contributions are tax-deferred, but there’s no Roth option. If you have employees, you’ll need to make mandatory contributions to their accounts, which might limit how much you can put into your own retirement fund.
- Traditional or Roth IRA: Traditional and Roth IRAs are available to all workers, not just the self-employed. You can open one with most brokers, and you have a variety of common investments to choose from. In 2022, you have the option to contribute either $6,000 or $7,000 if you’re 50 years of age or older. These limits go up to $6,500 and $7,500 in 2023.
- Self-directed IRA: Self-directed IRAs come in different types like traditional, Roth, or SEP IRAs. What makes them special is that they allow you to invest your money in things like real estate and other assets that you usually can’t invest in with a regular IRA. It gives you more flexibility in how you grow your retirement savings.
Each type of retirement account has its advantages and disadvantages, so you’ll need to figure out which one suits you best. If you prefer simplicity and want to avoid dealing with complex reporting requirements, a SEP IRA might be a better choice. But if you like having options, a solo 401(k) lets you pick between tax-deferred and Roth accounts, and you can even take out loans if needed—features not available with SEP IRAs.
If you can’t decide on just one retirement account, you could consider using more than one. For instance, you can pair a Roth IRA with a tax-deferred solo 401(k) if you want to save extra money beyond the solo 401(k) limits.
It’s crucial to understand the rules for each account you use, especially their contribution limits, to avoid any issues with the IRS. Additionally, keep track of when you’ll owe taxes on the funds in each account so you can plan your withdrawals during retirement accordingly.
A solo 401(k) is definitely worth exploring, especially if you’re self-employed without any employees and want to set aside a substantial sum for retirement. However, if it doesn’t align with your preferences, remember that there are numerous other options available. Focus on what suits your current situation best, and if your needs change in the future, you can always consider rolling over your funds into a different account.
