A solo 401(k) plan can be an excellent retirement plan option for those who are self-employed. They are easy to open and fund, and the contribution limits are high. Here are some details about these plans.
What Is a Solo 401(k)?
A solo 401(k) plan is designed for those who are self-employed or who are involved in a business with partners and/or a spouse. The IRS refers to these plans as one-participant 401(k) plans. They are also referred to as individual 401(k) plans in some cases.
A solo 401(k) plan allows solo business owners, their spouse who is involved in the business and any business partners the opportunity to contribute to a solo 401(k) account. The individual contribution limits are the same as for a 401(k) plan offered by a company to its employees. Additionally, the company can also make discretionary profit-sharing contributions on behalf of those covered by the plan.
Depending upon the plan custodian selected, a Roth account option may be available in addition to a traditional 401(k) account.
How Much Can You Contribute to a Solo 401(k) in 2019?
There are two components of solo 401(k) contributions.
Employee contribution: The first is the employee contribution which is made from net business income for a sole proprietor or as a salary deferral from those whose business is structured as an S-Corp, LLC, C-Corp, partnership or other type of entity whereby they are paid a salary from the business.
The limits for employee contributions are the same as for a regular company 401(k) plan in the amounts of $19,000 and, for those who are 50 and over, $25,000, at any point in the year for 2019. These limits change periodically and could go up in the future.
Profit-sharing contributions: In addition to the employee contributions, profit-sharing contributions can be made by the business. The maximum is 25% of compensation up to a maximum total contribution of $56,000, or $62,000 for those who are 50 or over. Profit-sharing contributions are a deductible expense of the business, while employee deferral contributions can be made on a pre-tax basis or after-tax into a Roth account (if available).
If you are employed but also have a side business, you can open and fund a solo 401(k). Note you cannot double up on contributions if your employer also has a 401(k) to which you contribute. The employee deferral limits would be a total of $19,000/$25,000 between the two plans. Even if you are already maxing your employee deferrals at your employer, you still may be able to make employer profit-sharing contributions to the solo 401(k) with income from your side gig. It is best to consult a qualified tax or financial professional to see how much your might be able to contribute to a solo 401(k) in this situation.
How Do You Qualify for a Solo 401(k)?
The IRS rules say that you cannot have a solo 401(k) if your business has employees other than the owner, their spouse and/or a business partner(s). The partners in a partnership are generally considered to be self-employed.
In order to be eligible to contribute to a solo 401(k):
- You must engage in some sort of self-employment activity that generates income for you.
- Your business cannot have employees other than the owner(s) and their spouse.
What Are the Types of Solo 401(k)s?
There are two types of solo 401(k)s: traditional and Roth. Employee contributions to traditional plan are made on a pre-tax basis, and money in the account grows on a tax-deferred basis until withdrawn. At that time, it is subject to taxes.
Many custodians also offer a Roth solo 401(k) account. This works like a Roth account in an employer 401(k). Contributions are made on an after-tax basis but the money in the account grows tax free. Withdrawals can be made on a tax-free basis as long as certain rules are followed.
Most major custodians offer solo 401(k) accounts. Investment options include stocks, bonds, mutual funds, ETFs closed-end funds and many others. There are a few items that are prohibited investments in 401(k) accounts, and these would be prohibited in a solo 401(k) as well.
There are also custodians who offer self-directed retirement plans that include solo 401(k) accounts. Self-directed accounts typically offer the opportunity to invest in non-traditional investments such as precious metals, real estate, crowdfunding, structured settlements, private debt and equity and a host of other alternative assets. In choosing one of these custodians be sure to find one with experience with these types of accounts. Also, be sure to consult your tax and financial adviser before going this route.
What Are the Benefits of a Solo 401(k)?
A solo 401(k) is a great way for someone who is self-employed to open a 401(k) account with most of the same features and benefits of a 401(k) offered by companies and employers. These benefits include:
- Higher contribution limits that some other plans. The ability to contribute the full employee contribution plus the employer profit sharing component provides self-employed individuals with a vehicle to save large amounts for their retirement each year. The tax benefits can be significant as well.
- Unlike a popular alternative, the SEP-IRA, the ability to contribute to a solo 401(k) does not fluctuate as greatly for varying levels of income from year to year. A solo 401(k) allows you to make the full employee contribution as long as your compensation from the business is at least $19,000 (or $25,000 if you're 50 and over.) A SEP-IRA only allows employer contributions based on a maximum of 25% of the compensation, a down year in income and owner compensation will translate to a very limited retirement contribution.
- Loans are available from a solo 401(k). There is typically a dollar limit and percentage of your account that can be borrowed. This feature provides a level of flexibility that is not available with other self-employed retirement saving options such as an IRA, SIMPLE IRA or a SEP-IRA.
- Until your account balance exceeds $250,000, the filing and paperwork requirements are minimal.
- A solo 401(k) can accept rollovers from other retirement accounts such as a 401(k) with a former employer. Likewise, money from a solo 401(k) can be rolled over to other retirement accounts like an IRA if so desired. Check the terms of your custodian's plan to determine how these options work.
A solo 401(k) can be an attractive retirement savings option for those who are self-employed. Be sure to consult with your financial or tax adviser to see if this type of plan is right for your situation.