Being self-employed offers many perks, including freedom and flexibility. What it doesn’t offer is an employer-sponsored retirement plan. But when you don’t have access to a 401(k) at work, opening a solo 401(k) can make it easier to stay on track with retirement planning.
A solo 401(k) or one-participant 401(k) is a type of 401(k) that’s designed specifically with self-employed individuals in mind. This retirement savings option follows many of the same rules as workplace 401(k) plans, in terms of annual contribution limits, tax treatment and withdrawals. But it’s tailored to individuals who run a business solo or only employ their spouses.
It’s one of several self-employed retirement options you might consider when planning a long-term financial strategy. Before you establish a solo 401(k) for yourself, it’s important to understand how they work and the pros and cons that are involved.
What Is a Solo 401(k)?
A solo 401(k) is a tax-advantaged retirement account that’s designed for self-employed individuals and business owners who have zero employees, or no other employees than their spouses. This type of 401(k) plan is also known by a few other names:
• Solo-k
• Uni-k
• One-participant plan
Solo 401(k) contributions are made using pre-tax dollars, though it’s possible to make Roth contributions instead. In that case, you’d be able to withdraw money from a solo 401(k) tax-free in retirement.
A self-employed 401(k) plan works much the same as a regular 401(k), in that you may be able to take loans from your savings if needed. Catch-up contributions are also allowed. The biggest difference is that there is no matching contribution from an employer.
You can start investing in a solo 401(k) for yourself through an online brokerage. There’s some paperwork you’ll need to fill out to get the process started, but once your account is open you can make contributions year-round.
At the end of the year, the IRS requires solo 401(k) plan owners to file a Form 5500-EZ if the account has $250,000 or more in assets.
Solo 401(k) Contribution Limits
Much like a workplace 401(k), there are annual contribution limits that apply to solo 401(k) plans. The IRS caps total contributions to a solo 401(k) account at $58,000 for 2021 and $61,000 for 2022, not counting catch-up contributions for those age 50 and over.
As both the employee and employer of your own business, you can contribute both elective salary deferrals and employer nonelective contributions. Each has different contribution caps.
Elective Salary Deferrals
As an employee, you can contribute up to 100% of your earned income up to the annual contribution limit: $19,500 in 2021 and $20,500 in 2022, plus an additional $6,500 for those age 50+.
|
Solo 401(k) Contribution Limits by Age 2022 |
||
|---|---|---|
| Annual Contribution | Catch-Up Contribution | |
| Under Age 50 | $20,500 | N/a |
| 50 and Older | $20,500 | $6,500 |
Employer Nonelective Contributions
These contributions come directly from the “employer” (aka you) and are not deducted from the employee’s (your) salary. As an employer, you can contribute up to 25% of your self-employment income (business income – ½ self-employment tax and elective salary deferrals), in pre-tax dollars.
Pros and Cons of Solo 401(k)s
When considering retirement account options, it can be helpful to look at the pros and cons to determine what works best for your personal situation.
Pros of Solo 401(k)
There are different reasons why opening a 401(k) for self employed status could make sense.
• Bigger contributions. Compared to other types of self-employed retirement plans, such as SEP IRA or SIMPLE IRA, solo 401(k) contribution limits tend to be more generous. Neither a SEP IRA or SIMPLE IRA, for instance, allows for catch-up contributions.
• Roth contributions. You also have the option to make Roth contributions if you’re eligible. Whether you stick with pre-tax or after-tax contributions to a solo 401(k) can depend on your tax situation. Pre-tax contributions could yield an upfront tax benefit, in the form of a deduction. But if you anticipate being in a higher tax bracket when you retire, you may prefer being able to withdraw Roth contributions tax-free.
• Flexible withdrawal rules. A solo 401(k) can also offer more flexibility with regard to early withdrawals than a SEP IRA, SIMPLE IRA, traditional IRA or Roth IRA. If the brokerage offering your solo 401(k) allows it, you could take out a loan in place of an early withdrawal. This could help you to avoid early withdrawal penalties and taxes. An IRA-based plan wouldn’t allow for loans.
Cons of Solo 401(k)
There are also a few potential downsides of investing in a solo 401(k).
• Eligibility restrictions. If you run a small business and you have at least one employee other than a spouse, you won’t be able to open a solo 401(k) at all.
• Complicated reporting. Calculating contributions and filing can be more complicated with a solo 401(k) vs. a SEP IRA or SIMPLE IRA. If your plan has more than $250,000 in assets you’ll need to file Form 5500-EZ with the IRS each year.
• Administrative costs. Depending on where you open a solo 401(k) plan, the cost of maintaining it year to year may be higher compared to other self employed retirement plans. And an early 401(k) withdrawal can trigger taxes and penalties.
It’s important to consider the range of investment options offered through a solo 401(k). What you can invest in at one brokerage may be very different from another. The individual cost of those investments can also vary if some mutual funds or exchange-traded funds offered come with higher expense ratios than others.
| Solo 401(k) Pros | Solo 401(k) Cons |
|---|---|
| Catch-up contributions may allow older investors to save more for retirement versus a SEP IRA or SIMPLE IRA | Only self-employed individuals who have no employees or just employee their spouses can contribute |
| It’s possible to choose between a traditional solo 401(k) or Roth solo 401(k), based on your investing goals and tax situation | Annual reporting requirements may be more complicated for a solo 401(k) compared to other self employed retirement plans |
| Solo 401(k) plans can allow for loans, similar to workplace plans | Early withdrawals from a solo 401(k) are still subject to taxes and penalties |
Opening Your Own Solo 401(k)
If you’re interested in setting up a solo 401(k) for yourself, you can do so through an online brokerage. Opening a retirement savings account isn’t that complicated. Here’s a step-by-step guide for how to start a solo 401(k).
1. Choose a Plan Administrator
A plan administrator is the person responsible for managing your solo 401(k). It’s their job to make sure the plan is meeting reporting and other requirements established by the IRS. If you’re self-employed, you can act as your own plan administrator or you could choose your accountant instead.
2. Choose a Brokerage
Once you know who’s going to manage the plan, the next step is deciding where to open it. A number of brokerages offer solo 401(k) plans so you may want to spend some time comparing things like:
• Account setup process
• Investment options
• Fees
You may be able to start the solo 401(k) account setup process online, though some brokerages require you to call and speak to a representative first. And you may need to finalize your account opening by mailing or faxing in any supporting documents the brokerage needs to complete the application.
3. Fill Out a Solo 401(k) Application
Before you can start a 401(k) account for yourself, you’ll need to give your brokerage some information about your business. A typical solo 401(k) application may ask for your:
• First and last name
• Employer Taxpayer ID number
• Plan administrator’s name and contact information
• Social Security number
• Mailing address
• Citizenship status
• Income information
You’ll also need to disclose any professional associations or affiliations that might result in a conflict of interest with the brokerage. In completing the application, you’ll be asked to name one or more beneficiaries. You may also be asked to provide bank account information that will be used to make your initial contribution to the plan.
4. Choose Your Investments
Once you’ve returned your solo 401(k) account application and it’s been approved, you can choose your investments. The type of investments offered can depend on the brokerage and the plan. But typically, you may be able to choose from:
• Target-date funds
• Actively managed funds
• Exchange-traded funds (ETFs)
Whether you have access to individual stocks, bonds, CDs, or alternative investments such as cryptocurrency can depend on the platform that’s offering the plan.
5. Decide How Much to Contribute
You may choose to schedule automatic investments or make them manually according to a schedule that works for you. If you’re opening a self employed 401(k) just for yourself, you’ll have until the annual April tax filing deadline to make contributions for the previous year.
The Takeaway
A solo 401(k) can be a worthwhile investment vehicle for self-employed people who want to save for retirement. It has more generous contribution limits than some other options, and also offers flexibility in terms of early withdrawals.
If you’re ready to start saving for retirement, you can open a Traditional or Roth IRA online with SoFi Invest® and have a plan designed to fit your needs and goals.
Photo credit: iStock/visualspace
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