When you’re self-employed, it’s important to look for ways to boost your retirement savings and build wealth. Not building your nest egg can turn out to be a costly retirement mistake. One way to grow your savings and also enjoy the benefits of a tax-advantaged retirement account is to turn to the solo 401(k) plan.
So what is a solo 401(k), and how can you use it to build your retirement savings? Here’s what you need to know about how this account works and whether it should be part of your retirement planning.
What is a solo 401(k)?
A solo 401(k) plan is a tax-advantaged retirement account aimed at a small business or sole proprietorship that has no employees (other than a spouse). Sometimes, this small business retirement plan is also called an individual 401(k), a uni-401(k), or a one-participant 401(k) plan.
The point of a solo 401(k) is to allow those who are self-employed to make larger contributions than they could with an Individual Retirement Account (IRA). The Internal Revenue Service (IRS) limits the amount of money we can put into specific retirement accounts. Both the traditional and Roth IRAs limit your contributions to $6,000 a year (or $7,000 if you’re at least 50 and making catch-up contributions) as of tax year 2022.
As with IRAs, a solo 401(k) offers the opportunity for you to choose whether you contribute pre-tax or after-tax dollars. If you choose a Roth solo 401(k), you’ll contribute after-tax money and enjoy tax-free growth on your earnings. If you choose a regular solo 401(k), you receive a deduction on your taxable income in the year you make the contributions. Although a SEP IRA can also allow you to make higher contributions than regular IRAs, there is no Roth version of the SEP IRA, so a solo 401(k) can provide you access to larger Roth contributions.
However, it’s important to note you can’t have any employees beyond your spouse if you want to participate in an individual 401(k). Make sure you qualify for the plan before you move forward with it in your personal finance strategy.
Another perk of opening an individual 401(k) is that you can set up your plan to include loans. Just as you can access a 401(k) loan program through your employer, if you set up a uni-401(k) as a business owner, you can create your own loan program.
Pros of a solo 401(k)
- Potential to make higher contributions
- Ability to make Roth contributions if desired
- No income requirements for Roth accounts
- Easy to administer
- Possible ability to set up a 401(k) loan program
Cons of a solo 401(k)
- Required minimum distributions (RMDs) at age 72
- Can’t access without penalty until age 59 1/2
- Paperwork is more involved than IRAs or SEP IRAs
How solo 401(k) contributions work
Although you can make elective deferrals to a solo 401(k) plan up to 100% of your self-employment income, there are some 401(k) contribution limits that apply to the solo plans, just as with any other tax-advantaged retirement account. One advantage of the solo 401(k) plan is that you can make contributions both as an employee and an employer.
Here’s how much you can contribute to your solo 401(k) in 2022:
- Up to $20,500 as an employee (or up to $27,000 if you’re at least 50 years old)
- Up to 25% of your compensation as an employer
There is a combined maximum contribution limit on both employee and employer contributions of $61,000 in 2022, so you are eventually capped. You do end up with a slight advantage over a SEP IRA, though:
- With a SEP IRA, you’re capped at $61,000 for 2022, but you’re also subject to a limit of 25% of your income. If you make $75,000 per year, you’re limited to $18,750 total.
- With the solo 401(k) plan, your employer contribution alone can be 25% of your annual compensation, and you still have room to contribute an additional $20,500 through your employee deferral.
So you have the chance to contribute more to your retirement savings with the solo 401(k) plan.
Additionally, with a Roth solo 401(k), you don’t have to worry about income restrictions impacting how much you can contribute. A Roth IRA has an income threshold, so you can’t make contributions if your income is too high. The Roth solo 401(k) doesn’t have this drawback, so anyone can make contributions as long as they meet the other eligibility requirements.
You can also add your spouse to your solo 401(k) plan. They would have their own account, and you could make contributions to their account as long as they’re an employee. This can be a way to boost your household’s combined retirement savings. Your spouse is the only exception to the “no employees” rule associated with a solo or uni-401(k).
Finally, be aware that the employee portion of your 401(k) contributions are cumulative. So, if you have a regular job, as well as run your own business, you can make contributions to your traditional or Roth 401(k) at work and to your solo 401(k). However, your combined employee contributions in all your 401(k) accounts can’t exceed the annual total contribution limit (which is $20,500 for 2022). If you have more than one 401(k) plan, make sure you keep track of how much you’re contributing and also keep in mind any profit-sharing contributions your employer might make as well.
Traditional solo 401(k) vs. Roth solo 401(k)
The solo 401(k) has a Roth option, so it’s possible for you to make contributions that grow tax-free over time. As with any regular vs. Roth account, the main difference is the way the tax benefits are expressed.
With a traditional solo 401(k), your contributions are made with pre-tax dollars. You basically get an income tax deduction for the contributions you make to this account. Later, when you withdraw the money from your account, you will pay taxes at your regular tax rate.
On the other hand, with a Roth solo 401(k), you make your contributions with after-tax dollars. You don’t get a tax deduction today, but your money does grow tax-free. When you make withdrawals from your Roth individual 401(k) down the road, you don’t have to worry about paying taxes.
It’s important to note, however, that many of the other features of the traditional vs. Roth solo 401(k) are the same:
- You must wait until you’re 59 1/2 to take penalty-free withdrawals.
- There are required minimum distributions for Roth accounts as well as traditional accounts.
- There are no income limitations on the accounts.
Which type of account you choose will depend largely on your tax planning and your personal finance goals:
- If you believe your taxes are lower today than they will be in the future, then choosing a Roth account might make sense because you pay taxes now, and you won’t have to worry in the future because your distributions from the Roth account aren’t taxed.
- If you think your tax liability will be lower in the future, you might want to consider a traditional solo 401(k). You can get a tax break today by claiming a deduction for your contributions, and then later, when you withdraw the money and are taxed, your tax bill is lower than what it would have been.
It’s also possible to use both types of accounts to make the most of the potential tax advantages. You can have both a traditional and a Roth solo 401(k), depending on how you want to plan your retirement investing strategy. Consider consulting a financial professional or retirement specialist to figure out which accounts might work best for you. You’ll also want to work out a withdrawal schedule that provides you with the best tax efficiency and coordinates with your other tax-advantaged retirement accounts, taxable investment accounts, and Social Security benefits.
How to open a solo 401(k)
Opening a solo 401(k) is fairly straightforward once you find a financial institution to act as a custodian of your plan. Many of the major traditional investment firms offer access to an individual 401(k), including places like Fidelity, Vanguard, and Schwab. You need to meet their verification requirements, and then you can open your solo 401(k) and begin making plan contributions.
It’s harder to find robo-advisors willing to let you open a solo 401(k), however. Betterment does offer 401(k) plan administration possibilities for business owners, but you have to go through its particular setup process, and it’s a little different than just opening a solo 401(k).
Whichever solo 401(k) plan you choose, be sure to investigate the investment options it offers as well. Some plans may allow you to invest in a range of products like mutual funds, ETFs, stocks, and bonds; however, others may be more limited.
When opening a solo 401(k), you need to make sure you have the appropriate paperwork on hand. You’ll need your tax identification number, whether that’s your Social Security number or Employer Identification Number (or both) as well as other information, including your address, birth date, and email address.
Also, because you’re designating a plan administrator, you need to fill out the plan documents from the account provider. Make sure to read through the requirements ahead of time so you’re prepared and able to research any matters you aren’t sure about
Quick summary: Solo 401(k) facts
- Eligibility: Anyone who owns their own business or is self-employed and doesn’t have other employees other than a spouse. There are many eligible types of businesses, and you can even have an S Corporation.
- Annual contribution limit: Up to $20,500 for calendar year 2022. This is a combination of the ability to contribute up to $20,500 as an employee (or $27,000 if you’re at least 50) and up to 25% of your compensation as an employer.
- Taxes: With a traditional solo 401(k), you contribute with pre-tax money and pay taxes when you take distributions. With a Roth account, you contribute with after-tax money, but you don’t have to pay taxes when you take distributions.
- How to open: Find a brokerage that offers solo 401(k) accounts and follow their instructions.
Does a solo 401(k) need to file a 5500-ez?
You only need to file a Form 5500-ez if the total balance of your solo 401(k) plan is higher than $250,000 at the end of the year.
Do solo 401(k) contributions reduce self-employment tax?
In general, a solo 401(k) contribution won’t reduce your self-employment tax. Instead, the contribution is made after your self-employment tax is paid, which means you’ll get a deduction to reduce your taxable income, but it won’t reduce what you owe in self-employment tax.
How much does it cost to set up a solo 401(k)?
The cost of a solo 401(k) depends on where you set up your account. Some brokers will allow you to open a solo 401(k) for free, and won’t charge maintenance fees or other fees, though costs for trading within the account might still apply. Research your choices before opening an account, as both costs and benefits will vary.
A solo 401(k) can be a good choice when you want to save for retirement as a sole proprietor or small business owner, but it’s not your only option when you want to learn how to invest money. You have other choices, including setting up a traditional or Roth IRA, or opening a SEP IRA.
Depending on your situation, it might make more sense to set up some type of IRA to save for your retirement, as the paperwork is often easier to manage, and you can access these types of accounts through some of the best robo-advisors.
In many cases, you need to look into a more traditional broker to open a solo 401(k), and they usually have more paperwork requirements. This might be worth it, though, if it means you can qualify to contribute more overall to your retirement account.
Before you move forward, consider talking to a financial advisor. A financial professional can help you compare your retirement plan choices and make a decision that works best for you to build your retirement nest egg in a low-cost, low-fuss, and tax-efficient manner.
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