What Is A Solo 401(k) Retirement Plan?

Self-employed individuals enjoy the freedom that comes with being their own boss. But without an employer, self-employed individuals miss out on the opportunity to contribute to an employer-sponsored retirement plan, like a 401(k). Luckily, the solo 401(k) presents a specialized option for self-employed workers to save for retirement without working a traditional 9 to 5.

Let’s explore what a solo 401(k) is and what to consider before setting one up.

What Is A Solo 401(k)?

A 401(k) is a retirement plan that your employer sponsors. As a traditional employee, you might have the option to make contributions that your employer matches. This type of defined-contribution plan has limitations on how much you can contribute each year.

A solo 401(k) is a type of individual 401(k) available to business owners who don’t have any employees. As a self-employed individual, you can only contribute to a solo 401(k) if you don’t have any full-time employees. The exception is that you can use the plan to cover your spouse in addition to yourself.

Solo 401(k)s are open to business owners of all kinds. Whether your business is your full-time commitment or just a side hustle, you can use the funds you earn through the business to contribute to a 401(k).

Solo 401(k) Vs. SEP IRA

A Simplified Employee Pension Individual Retirement Account (SEP IRA) is another option for small business owners to save for retirement. SEP IRAs and solo 401(k)s are both retirement accounts. But there are some key differences that set them apart. Here’s the breakdown of SEP IRA vs. solo 401(k):

• Contribution source: Solo 401(k)s allow you to make contributions as an ‘employer’ and an ‘employee.’ A SEP IRA only allows you to contribute as an employer.
• Contribution limits: A SEP IRA only allows you to contribute up to 25% of your net adjusted, self-employment income, up to a limit of $66,000 in 2023. A solo 401(k) allows you to contribute up to 100% of your self-employment income as an employee and up to 25% of your net adjusted self-employment income as an employer. Ultimately, you might be able to contribute more to a solo 401(k)
• Catch-up contributions: Anyone over the age of 50 can contribute an additional $7,500 as an employee in 2023 to their solo 401(k). Catch-up contributions aren’t an option for SEP IRAs.

Who Is Eligible For A Solo 401(k) Plan?

A solo 401(k) is only available to self-employed individuals, who have the opportunity to contribute both as an employer and an employee. You won’t encounter any income or age restrictions. However, you must be a business owner who operates without any full-time employees.

In terms of employees, there is one exception. If your spouse earns an income from the business, they can contribute to the solo 401(k) as an employee. As the business owner, you can make contributions to the solo 401(k) for your spouse as an employer.

Solo 401(k) Contribution Limits

As with most retirement accounts, there are contribution limits involved. Below is a breakdown of the contribution limits for 2022 and 2023.

Employee Limits

As the employee of your own business, you have the option to contribute up to 100% of your compensation with a limit of $22,500 in 2023. If you’re over the age of 50, you have the option to contribute an extra $7,500 per year.

Employer Limits

As the employer, you can contribute up to 25% of your net adjusted self-employed income. When the employee and employer contribution limits are combined, the total amount you can contribute $66,000 in 2023.

Taxes On Solo 401(k) Contributions

Like other 401(k) plans, a solo 401(k) comes with tax advantages.

You can choose the traditional 401(k) perk, which means the contributions will reduce your taxable income for the year. That’s because the contribution is taken out pretax. When you reach retirement, the funds you withdraw will be taxed as ordinary income.

The other option is to choose a Roth solo 401(k). With the Roth, the contributions you make will not impact your taxable income for the year you make them because they’re taken out post-tax. However, you won’t have to pay taxes on the distributions once in retirement.

Benefits Of A Solo 401(k)

If you’re considering a solo 401(k), here are some advantages to keep in mind:

• Tax benefits: Through a solo 401(k), you can make tax-free contributions with a traditional option or take tax-free distributions with a Roth option.
• High contribution limits: When compared to other plans, solo 401(k)s have relatively high contribution limits.
• Available to side hustlers: Your business doesn’t have to be your only source of income to open a solo 401(k).

Drawbacks Of A Solo 401(k)

Of course, there are also some disadvantages to consider:

• Penalties for early withdrawals: If you withdraw the funds in your solo 401(k) before age 59.5, you’ll get hit with a penalty.
• Paperwork: Unlike an employer-sponsored 401(k), you’ll be responsible for all of the paperwork tied to your solo 401(k).

How To Set Up A Solo 401(k)

Before setting up a solo 401(k), make sure it’s the right fit for your situation. When you’re ready to move forward, use the steps below as a guide.

1. Select A Plan Provider

You can open a solo 401(k) through most online brokers. But online brokerage platforms come with different fees and investment opportunities.

Take the time to look at what investment opportunities are available through a platform before signing up. For example, if you have a particular index fund in mind, make sure it’s offered before choosing to work with that provider.

2. Secure An Employer Identification Number (EIN)

You’ll need an employer identification number (EIN) to open your solo 401(k). Many business owners already hold an EIN, which acts as a tax identification number. But if you need one, you can apply though the IRS form SS-4.

3. Complete Your Application

With your EIN in hand, you can fill out an application for the solo 401(k) through the brokerage platform. Be prepared to complete a lot of paperwork. One of the forms you’ll encounter includes information about the plan adoption agreement, which outlines the rules of the plan.

4. Contribute To The Account

After the brokerage approves your account application, it’s time to make contributions. If possible, set up automatic contributions to put your retirement savings on autopilot.

Also, don’t forget to invest the funds you contribute to this account. Investing for retirement is a big undertaking. But with the right investment choices, you’ll be well on your way to a comfortable retirement.

How To Withdraw From A Solo 401(k)

When you reach age 59.5, you can withdraw funds for your solo 401(k) without running into any penalties. When you hit age 73, you’ll be required to start taking minimum distributions from your solo 401(k).

If you withdraw funds before age 59.5, you might get stuck with a 10% early withdrawal penalty. It may be possible to take out a loan from the plan to avoid the penalty. But the loaned funds must be repaid to the account.

Alternatives To A Solo 401(k) Plan

A solo 401(k) isn’t the only way to save for retirement. Here are some other options to consider:

• SEP: A Simplified Employee Pension (SEP) plan is available to businesses of all sizes, including one-person operations. As an employer, you must make equal contributions for all employees. But it’s easy to adjust your employer contributions each year.
• Traditional IRA: A traditional IRA is available to everyone, including traditional employees and self-employed individuals. The contribution limits for a traditional IRA are lower. But the contributions can be tax-deductible.
• Roth IRA: A Roth IRA is also open to traditional employees and self-employed individuals. The contribution limits for a Roth IRA match a traditional IRA. But the contributions aren’t tax deductible.

If you aren’t sure which type of retirement plan is right for you, consider consulting a financial professional.

The Bottom Line

A solo 401(k) offers a worthwhile way for self-employed individuals to build their retirement nest egg.

As you make progress toward your retirement goals, take advantage of the Rocket Money℠ mobile app. The app can help you track your net worth, including contributions to retirement accounts. If you want help monitoring your financial progress, download the Rocket Money app today.