Financial Advisor in Raleigh NC: What Is a Solo 401(k)?
The perks of self-employment are plenty, but there’s at least one significant drawback: the lack of an employer-sponsored retirement plan like a 401(k). Enter the solo 401(k), or what the IRS calls a one-participant 401(k). Designed for self-employed workers, a solo 401(k) mimics many of the features of an employer-sponsored plan, without the drag of working for the man.
What is a Solo 401(k) Plan?
A solo 401(k) is an individual 401(k) designed for a business owner with no employees. In fact, IRS rules say you can’t contribute to a solo 401(k) if you have full-time employees, though you can use the plan to cover both you and your spouse.
The self-employed 401(k), or Solo 401(k), does come with one crucial difference. Because participants are acting as both employer and employee, they can set aside more money each year than they could under a traditional 401(k), IRA, or other small business retirement account.
Those high contribution limits, plus relatively easy plan administration, make the self-employed 401(k) an appealing option for business owners who meet the plan's requirements and want a significantly higher savings potential.
Solo 401(k) Contribution Limits
The total solo 401(k) contribution limit is up to $61,000 in 2022 and $66,000 in 2023. There is a catch-up contribution of an extra $6,500 for those 50 or older in 2022 and $7,500 in 2023.
To understand solo 401(k) contribution rules, you want to think of yourself as two people: an employer (of yourself) and an employee (yes, also of yourself). Within that overall, $61,000 contribution limit in 2022 and $66,000 in 2023, your contributions are subject to additional limits in each role:
As the employee, you can contribute up to $20,500 in 2022, $22,500 in 2023, or 100% of compensation, whichever is less. Those 50 or older get to contribute an additional $6,500 here in 2022 and $7,500 in 2023.
As the employer, you can make an additional profit-sharing contribution of up to 25% of your compensation or net self-employment income, which is your net profit less half your self-employment tax and the plan contributions you made for yourself. The limit on compensation that can be used to factor your contribution is $305,000 in 2022 and $330,000 in 2023
Keep in mind that if you’re side-gigging, employee 401(k) limits apply by person, rather than by plan. That means if you’re also participating in a 401(k) at your day job, the limit applies to contributions across all plans, not each individual plan.
Covering Your Spouse Under Your Solo 401(k)
The IRS allows one exception to the no-employees rule on the solo 401(k): your spouse, if he or she earns income from your business.
That could effectively double the amount you can contribute as a family, depending on your income. Your spouse would make elective deferrals as your employee, up to the $19,500 employee contribution limit (plus the 50-and-older catch-up provision, if applicable). As the employer, you can then make the plan’s profit-sharing contribution for your spouse, of up to 25% of compensation.
How to Start a Solo 401(k)
Follow these steps if you're interested in opening a solo 401(k):
Get an Employer Identification Number (EIN): You need an EIN to open a solo 401(k). You can apply for one of these on the IRS website.
Choose your broker: Explore different brokerages and look into their investment offerings, their fees, and their customer service.
Fill out the appropriate paperwork: Your financial advisor will send you a plan adoption agreement and an application to fill out before you can put money into your account.
Fund your account: You may put money into your solo 401(k) by sending a check or using direct deposit to fund the account.
Once you've done these four things, you can start choosing your investments and making regular contributions to your account. You can also roll over funds from other retirement accounts in your name if you choose.
You must make your solo 401(k) employee contributions by Dec. 31, but you have until the tax filing deadline for the year -- usually April 15 of the following year -- to make your employer contribution. If you have $250,000 or more in your solo 401(k) by the end of the year, you're required to submit a Form 5500-EZ information return to the IRS with your taxes for that year, so you don't run into trouble with the federal government.
Solo 401(k) Versus Other Retirement Plans
If you don’t think a solo 401(k) is a good fit for you, here are some other options you may want to consider:
Simplified Employee Pension (SEP) IRA: A SEP IRA is another popular option among self-employed individuals with no employees. You may contribute up to the lesser of $61,000 in 2022 or 25% of your net income. Contributions are tax-deferred, and there is no Roth option. You can use one of these accounts if you have employees, too, although you’ll have to make mandatory contributions to your employees’ accounts. This could limit how much you can afford to contribute to your own retirement.
Traditional or Roth IRA: Traditional IRAs and Roth IRAs are open to all workers, even those who aren’t self-employed. You can open them with most brokers, and you’re free to choose from many common investments. You may contribute up to $6,000 in 2022, or $7,000 if you’re 50 or older. These limits increase to $6,500 and $7,500, respectively, in 2023.
Self-directed IRA: Self-directed IRAs are traditional, Roth, or SEP IRAs that allow you to invest your money in real estate and other assets you can’t typically invest in with an IRA.
Each account has its pros and cons, so you’ll have to decide which is best for you. A SEP IRA might be a better fit if you don’t want to deal with the more complex reporting requirements of a solo 401(k). But solo 401(k)s let you choose between tax-deferred and Roth accounts and take out loans, while SEP IRAs don’t allow these things.
If you can’t decide on a single type of retirement account, you could always consider more than one. For example, a Roth IRA could be a smart complement to a tax-deferred solo 401(k) if you want to set aside some extra money above and beyond what the solo 401(k) allows.
Just make sure you understand the rules associated with the various accounts you use, particularly their contribution limits, so you don’t have problems with the IRS. You also need to keep in mind when you’ll owe taxes on the funds in each account so you know how to plan your withdrawals in retirement.
Bottom Line
A solo 401(k) is definitely worth considering, especially if you don’t have any employees and you’d like to set aside a lot of cash for retirement. But if you don’t think it’s the right fit for you, there are plenty of other options out there.
Focus on what makes the most sense for you right now. If that changes down the road, you can always do a rollover later. Check with your financial advisor or financial planner to decide what is right for you.
Sources
https://www.fool.com/retirement/plans/solo-401k/
https://www.forbes.com/advisor/retirement/solo-401k/
https://www.fidelity.com/retirement-ira/small-business/self-employed-401k/overview
https://www.fidelity.com/learning-center/personal-finance/retirement/self-employed-401k
https://www.nerdwallet.com/article/investing/what-is-a-solo-401k
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