Solo 401(k) Explained – What Is a Solo 401(k) Plan?
Self-employed individuals enjoy greater autonomy than most employees, but they also confront their own set of unique obstacles. Not having access to a 401(k) through one’s place of employment is a major drawback.
When you’re self-employed, it’s on you to save enough money, but a solo 401(k) can help. It’s like a 401(k), but it’s tailored to the needs of independent contractors. Here’s the lowdown on what you ought to know.
A solo 401(k), also called an individual 401(k), is a retirement plan option for self-employed people and sole proprietors who don’t employ any workers. If your firm employs your spouse, this rule does not apply to you. In that instance, you and your partner can open a separate 401(k) account.
The solo 401(k) differs from other retirement plans for the self-employed in that it allows contributors to put away 100% of their pay, up to the limit set by the IRS.
Users are not restricted to contributing a maximum of 25% of their pay, as is the case with several other plans. Although the self-employment tax can’t be avoided, this benefit can assist them to pay as little in taxes as possible.
Otherwise, a solo 401(k) is much like a regular or Roth 401(k) in terms of how it’s administered. Your solo 401(k) will function like a traditional 401(k) if you elect to make tax-deductible contributions to it. This will reduce your taxable income for the current year.
On the contrary, if you choose a Roth IRA, your contributions will be made after taxes are taken out, but your retirement withdrawal will be free of taxation.
Who Can Get a Solo 401(k)?
Self-employed people can obtain a Solo 401(k) plan. SEP IRAs and SIMPLE IRAs are two alternatives to traditional 401(k) plans that allow employers to offer tax breaks to their workers when contributing to their retirement savings. A SIMPLE 401(k) is a lesser-known concept that also enables employers to set up retirement plans.
An individual’s age or income level is not a factor in qualifying for a solo 401(k), but the participant must be a business owner without any other workers. In this regard, Uncle Sam is really rigorous. In order to participate in the 401(k) plan as a “solo,” you must not have any workers.
However, there is an exception to the rule that states a solo 401(k) plan can only be used by one-person businesses. The business owner’s spouse is eligible to join the retirement plan as well.
Your company’s retirement savings plan will grow exponentially if both you and your spouse participate. With catch-up contributions, a married couple might put away even more than the maximum of $114,000.
Benefits and Drawbacks of a Solo 401(k) Plan
If you are planning to take out a solo 401(k) Plan, consider the following benefits and drawbacks listed below:
Benefits
- You can customize your retirement savings plan to your needs by selecting the plan type and investment alternatives that suit you best. In addition, you get to choose whatever 401(k) plan offers you the most beneficial tax treatment.
- You can invest more than the typical maximum into a solo 401(k).
- There is no limit on the number of 401(k) plans to which a worker can contribute, but in 2022, that number is $20,500.
- The solo 401(k) enables you to save more thanks to the employer contribution, decreasing the business’s tax liability.
- Having a solo 401(k) doesn’t mean you have to forego other retirement plans like an Individual Retirement Account (IRA). The yearly maximum contribution is still in effect.
- A loan can be taken out against your solo 401(k) just like any other 401(k) plan.
Drawbacks
- If you cash out your solo 401(k) before reaching the retirement age of 59 ½ years old, you will be subject to taxes and penalties. You can get a loan or use a hardship withdrawal if you really need to, but these options should be considered emergency measures only.
- Paperwork for opening a solo 401(k) may be more extensive, but it’s still manageable.
- If the value of the plan at the end of the year is more than $250,000, you must begin filing a special form with the IRS.
What Are the Contribution Limits of a Solo 401(k)?
Like workers in a traditional 401(k) plan, sole proprietors can set up a 401(k) with a partnering brokerage and defer up to $20,500 per year (2022) in elective deferrals from their income.
Employer matching contributions are also welcome in the solo 401(k). Given that the worker also owns a stake in the company, he or she gets to decide how much of a stake to invest. A ceiling of $61,000 can be contributed to the solo 401(k) in 2022 from the company.
After subtracting 50% of your self-employment tax as well as any personal payments you’ve made to the plan, the remaining amount is what you can put toward your business’s profit-sharing contributions. In 2022, your yearly contribution cannot exceed $305,000 if it exceeds the maximum compensation limit.
Remember that when calculating your 401(k) contribution limit, the IRS includes both your and your employer’s contributions.
Similar to the catch-up contributions permitted in other 401(k) plans, individuals aged 50 and older can put away an extra $6,500 in 2022. For the year 2022, that implies that the total of both employee and employer contributions cannot be more than $67,500.
The joint contribution limitations for a solo 401(k) can lead to significant savings, especially for married couples, as we’ve shown.
For instance, a married couple in their thirties who own a business and bring in $200,000 in W-2 salaries in 2022 would be eligible to make employee contributions of up to the maximum of $40,000.
They may pool their earnings as business owners and each put in an extra $25,000, for a total of $50,000. They would have been able to save $91,000 for retirement in a single year.
Keep in mind that there are maximum contribution limits for all 401(k) plans. Therefore, if you have a traditional 401(k) at work and a solo 401(k) as well, your total retirement savings will be limited to the maximum allowable amount.
In addition to these rewards, the legal form of your business may entitle you to further tax breaks if you contribute to a solo 401(k).
How to Open a Solo 401(k) Plan
If you want to open a 401(k) for yourself, follow these instructions.
- Obtain an Employer Identification Number (EIN). Opening a solo 401(k) plan imposes an EIN. Those interested can submit an application for one through the IRS website.
- Select a Broker. Numerous brokers, yet not all, authorize a solo 401(k). Fees vary since several brokers demand a one-time service fee, whereas others supervise the plan on a continuous basis. Fidelity and Charles Schwab offer free programs, but you’ll pay extra charges.
When compared to the standard employer-sponsored 401(k), the benefits of using a broker are substantial. Workers can invest in index funds, mutual funds, ETFs, equities, bonds, and CDs (CDs).
Therefore, you are not restricted to using only the money provided by your company’s plan. With a single 401(k), you can choose from a wide variety of investment options.
Examine each broker’s details. Compare the investment options, costs, and quality of service provided by various brokerages.
- Complete the necessary forms. Before you may fund your account, your broker will give you an application and a plan adoption agreement.
- Put money into your account. A check or direct deposit can be used to add funds to your solo 401(k).
After you have completed these four steps, you will be able to start selecting investments as well as executing regular deposits into your account. Your existing retirement savings can be rolled over into this plan if you so want.
Worker payments to a solo 401(k) plan must be made by December 31, while employer contributions can be made until the tax filing date for the year, which is often April 15.
Last but not least, if you expect to have $250,000 or greater in your solo 401(k) at the end of the year, you must file a Form 5500-EZ information return with the IRS along with your taxes for that calendar year.
Is a Solo 401(k) Plan Worth It?
Solo 401(k)s are a viable option for sole proprietors or small business owners who desire to save for retirement in a proactive manner due to their contribution and investment flexibility and low administrative obligations.
One’s salary deferral and income-sharing contributions are both flexible and open to change. Depending on the year’s profitability, you may choose to make a 401(k) contribution in one of two ways, or you may opt not to make a contribution at all.
Your solo 401(k) contribution could net you additional tax breaks that add up to big savings.
Solo 401(k) Plan Alternatives
Your retirement plan options do not consist solely of a solo 401(k). There are a few more additional alternatives for retirement savings that you might look into. You can supplement your solo 401(k) with other retirement savings vehicles.
Sole proprietors also have the choice between the following retirement programs:
- Simplified Employee Pension Plan (SEP). To help your workers save for retirement, consider setting up a SEP plan so that you, the employer, can make contributions to their individual retirement accounts (IRAs). You can start a SEP regardless of the number of workers you employ.
- Traditional Individual Retirement Accounts (IRA). The tax benefits of retirement savings with a traditional IRA are substantial. You may be able to reduce your taxable income by the amount contributed to your traditional IRA. In addition, you won’t have to pay taxes on your contributions until you begin withdrawing money from your account in retirement.
- Roth IRA. It’s an Individual Retirement Account (IRA) with certain modifications from the standard plan. Roth IRA contributions are not tax-deductible, but qualified withdrawals from the account are exempt from federal income tax.
You can continue executing contributions to your Roth IRA even after you reach age 70 ½. Moreover, your Roth IRA contributions will remain there for as long as you would like.
Final Thoughts
If you’re self-employed and don’t employ any other workers, you may be eligible for a solo 401(k) plan. This is a great way for self-employed individuals to put away cash quickly.
You can get the most out of the program if your partner helps run the firm alongside you. Its flexibility makes it a fantastic choice for the self-employed, but its rapid savings potential may be valuable even for little firms.
With a solo 401(k), you can pick the investment alternatives and plan structures that best suit your necessities. If you cash out your single 401(k) before you are 59 ½ years old, you will be subject to taxes and penalties.
If you’re self-employed but still desire to keep substantially for retirement, a solo 401(k) is a great choice to explore. There are other choices if you feel you need to find a better fit. Pay attention to the things that make the most sense at the moment. Rollovers can be done in the future if circumstances change.
