A solo 401(k) is a retirement plan for the self-employed.
If you’re a business owner, a solo 401(k) is a way for you to access the same retirement benefits that you’d get as a corporate employee.
Table of Contents
What Is a Solo 401(k) and Who Is Eligible?
A solo 401(k) is an individual 401(k) designed for the self-employed and for business owners with no full-time employees.
Although it’s similar to a traditional 401(k) retirement account, a solo 401(k) is unique: You can contribute as an employer and as an employee. It also imposes fewer rules and requires less paperwork than a typical 401(k) plan.
The other brilliant thing about solo 401(k) plans is that, at least in theory, they offer a Roth option (more on that later). Unless you’re in a high tax bracket, Clark wants you to contribute your solo 401(k) funds into a Roth option.
If you’re a freelancer, you operate a side hustle or you own your own business, a solo 401(k) can be a great way to save and invest for retirement. The only requirements are:
- You must make self-employment income.
- You cannot have any “qualified” employees.
In this case, a “qualified” employee is someone who has worked for your company for at least one year and has worked at least 1,000 hours per year.
Once someone working for you reaches qualified employee status, you must incorporate a non-discrimination test. That involves more paperwork and tasks to meet legal compliance. At that point, it’s likely that a SEP IRA or a SIMPLE IRA are better options for you than a solo 401(k).
How Does a Solo 401(k) Work?
As a business owner, in terms of 401(k) contributions, you’re the employer as well as the employee.
As an employee, you can contribute up to a total of $19,500 of your income to your 401(k) accounts in 2021. If you’re at least 50 years old in 2021, you can add another $6,500 in catch-up contributions.
You can also make company (employer) contributions to yourself. I’ll go into more detail about how that works in the section on solo 401(k) contribution limits.
Other than yourself, the only people who can make or receive contributions within your solo 401(k) plan are:
- Your spouse. He or she must earn income from your business in order to qualify. By rule, your spouse must receive “employer” contributions as well.
- Your business partners. If you have a business with multiple owners and zero employees, all the owners can open a shared solo 401(k) plan.
The Two Types of Solo 401(k) Plans
The way your solo 401(k) works will depend on what type of plan you open. There are two main types:
- Brokerage based. You do business with an investment firm such as Fidelity, Schwab or Vanguard.
- Self-directed or “checkbook control.” You become your own trustee, either by working with a third-party company (typically not a brokerage) or simply by doing it all yourself.
Brokerage-Based Solo 401(k) Plans
Clark prefers the brokerage-based option because of the complexity of the do-it-yourself option. He’d rather you spend time on what’s making you money than on managing your solo 401(k).
Brokerage-based plans involve less paperwork for you, but they’re often limiting, even at the major investment firms.
For example, the solo 401(k) plans offered by Fidelity and Schwab don’t support Roth options or 401(k) loans.
“If you can’t find the Roth version of a solo 401(k) at your first choice of company, then you should maybe look at a different company that offers that as an option,” Clark says.
Vanguard’s solo 401(k) option happens to support a Roth option, but it doesn’t allow 401(k) loans and restricts investment options to Vanguard funds.
Brokerage-based solo 401(k) plans often are free or close to it. Vanguard charges $20 per year for every Vanguard fund that you invest in through your solo 401(k). If you invest in five different Vanguard funds, you’ll pay $100 annually. However, you can get those fees waived if you invest at least $50,000 with Vanguard.
Self-Directed Solo 401(k) Plans
With a self-directed plan, you agree to take on much more responsibility in terms of compliance, paperwork and bookkeeping. This is in exchange for more flexibility and features.
There are some third-party companies (not brokerages) that employ accountants that specialize in retirement plans for the self-employed. Those companies will offer guidance on the do-it-yourself version of a solo 401(k) plan for a fee.
Self-directed plans open up a world of investment possibilities. In addition to stocks, bonds, ETFs and mutual funds, your investment options can include real estate, private business investments, private loans, cryptocurrencies, precious metals — basically anything but collectibles.
With a self-directed solo 401(k) plan, you can typically take out a loan from your 401(k). You also usually get the option to make employee contributions to a Roth solo 401(k). Often, neither of those things are available through brokerage-based plans.
You can also roll over a 401(k), 457(b), 403(b) or traditional IRA into your solo 401(k) plan if it’s self-directed. You can’t roll a Roth IRA into a solo 401(k). Many of the free brokerage-based plans restrict certain rollover options.
With a self-directed plan, you can also make voluntary after-tax contributions, which may not be the case with a brokerage-based plan.
However, a self-directed plan requires much more paperwork and bookkeeping. If you fund your solo 401(k) with money you’ve rolled over from another account and/or you have a Roth component to your plan, you’ll need to keep track of those separate money buckets.
Solo 401(k) Contribution Limits for 2021
*This limit applies across all 401(k) plans to which you have access. If you make less than $19,500 in self-employed income, your contribution limit is 100% of what you earn.
^This requires a calculation, which you can outsource to a tax specialist. If you want to do it on your own, you’ll need to use the rate table worksheet in Chapter 6 of IRS Publication 560. You can also make the calculation via another IRS document called “Calculating Your Own Retirement Plan Contribution.”
%You can use a maximum of $290,000 in compensation for these purposes. Anything you make beyond $290,000 isn’t eligible for additional employer contributions.
#Employer contribution limits aren’t comprehensive like employee limits. You can get up to $58,000 in total from multiple employers.
Solo 401(k) Employee Contribution Limits and Rules
As an employee, you can contribute up to $19,500 a year. If you’re 50 or older in 2021, you can contribute an additional $6,500 in what are called “catch-up contributions.”
Those amounts are total across all 401(k) plans. For example, if you run your own business and you’re a W-2 employee at another company, you don’t get to contribute $39,000. Your 401(k) employee contribution limit is still $19,500 total.
If your solo 401(k) plan rules allow, you can decide to make employee contributions to a Roth or a traditional solo 401(k).
If you have a spouse, he or she can contribute only up to the amount they earn from the business.
Employee contributions are due by Dec. 31 each year.
Solo 401(k) Employer Contribution Limits and Rules
You’ll calculate your employer contribution limit differently depending on whether your business is incorporated.
If you’re not incorporated, you’ll need to calculate your net income. It’s a good idea to consult with a tax specialist if you find that calculation to be challenging.
If you have a spouse, he or she must get the same contribution from the company that you do. In other words, if your employer (company) contribution is 15% per year and your spouse participates in your solo 401(k), you must give them 15% per year as well. The same is true for business partners: You must all get the same employer contribution percentage.
Employer contributions can be made only to a traditional solo 401(k). These contributions are tax deductible for your business.
Employer contributions are due by the time your business files its tax returns.
If your solo 401(k) account value exceeds $250,000, you’ll have to start filing Form 5500 EZ annually. That adds an extra layer of complexity to your solo 401(k). You can roll over some of your 401(k) funds into an IRA to avoid triggering that requirement.
How To Open and Set Up a Solo 401(k)
Here are the steps to open a solo 401(k):
- Make sure you’re eligible to open a solo 401(k). You need to make self-employment income and you can’t have any qualified employees.
- Make sure you have enough self-employment income to justify the administrative tasks of opening and maintaining a solo 401(k). “If you know you’re not going to put aside more than $6,000 a year for retirement, don’t worry about starting a solo 401(k). Just do a Roth IRA,” Clark says.
- Decide on a brokerage-based or self-directed solo 401(k) plan. Clark recommends brokerage-based plans. However, many brokerage-based plans don’t offer benefits such as a Roth option or broader investing options.
- Fill out the necessary paperwork and potentially start your own trust checking account. If you choose the self-directed option, you’ll do more work during this step.
- Determine whether you’ll make Roth or traditional employee contributions for the year. If you have the option and you’re not in one of the highest tax brackets, Clark advises you to contribute to a Roth solo 401(k).
- Fund your solo 401(k) through contributions and/or rollovers. You need to pay yourself self-employment income and make a contribution into your plan within the first year you open the account.
- Make your investments. Clark loves target date funds. He says you can put every dollar of your retirement portfolio into a target date fund. If you can’t bring yourself to do that, his next recommendation is to buy a mix of low-cost index funds: total stock market, international and bond.
Solo 401(k) Withdrawal Rules
When we’re young, 16 (driver’s license), 18 (voting age) and 21 (drinking age) are milestone ages within the legal system.
But if you’re older than 21, you’ve still got some special ages worth celebrating.
One of those is 59½. At that age, you’re allowed to withdraw from any retirement account without paying a 10% early withdrawal penalty to the IRS. That includes a solo 401(k).
The only exception: If you have a Roth account of any kind, you must wait five years from the day you open it before you can make penalty-free withdrawals even after you’re 59½.
If you don’t take any money out of your solo 401(k) into your 70s, the government starts to wonder if it will get any tax revenue, especially from your traditional 401(k) funds.
Whether you contributed to a Roth 401(k), a traditional 401(k) or both, when you’re 72 years old, you’ll need to start taking what are called Required Minimum Distributions (RMDs). There are rules that determine exactly how much you need to withdraw each year after your 72nd birthday.
If you’re still working at 72 years old, you can delay taking RMDs from your current 401(k).
Advantages of a Solo 401(k)
Here are some of the top benefits of a solo 401(k) plan:
- Access to a 401(k) retirement plan if you’re self-employed. You don’t have to be a W-2 employee at a large company to get access to a 401(k). If you’re self-employed, a solo 401(k) gives you another option.
- Can make employee and employer contributions. A SEP IRA, which is the biggest alternative to a solo 401(k) for the self-employed, allows only employer contributions.
- Much higher contribution limits than an IRA. If you contribute to an Individual Retirement Account, you’re allowed to put in a maximum of $6,000 per year ($7,000 if you’re at least 50 years old). With a solo 401(k), you can set aside up to $58,000 per year in a tax-advantaged retirement account.
- Potential for a range of attractive features. Depending on the specifics of your solo 401(k) plan, you may be able to contribute to a Roth solo 401(k), access a huge range of investment options and take out a loan from your 401(k). Clark strongly advises against taking out a loan against your 401(k).
Disadvantages of a Solo 401(k)
Here are some of the drawbacks of a solo 401(k) plan:
- No employees allowed. If you have an employee who has worked for your company for at least one year (12 months and 1,000 hours), you’re no longer eligible to maintain a solo 401(k) plan — unless that employee is your spouse.
- Can create significant administrative work. A solo 401(k) plan isn’t as time-consuming as a full-scale corporate 401(k). But it can be a significant resource drain. This is especially true if you select the do-it-yourself option and open an account on your own, outside of a brokerage firm.
- Need decent income before it becomes worthwhile. If you’re not planning to set aside more than $6,000 per year into a retirement account — perhaps a decent amount more than $6,000 — opening a solo 401(k) probably isn’t worth the effort.
- Some of the nuances and rules are especially dense. Personally, I find that solo 401(k) plans to be one of the most complex types of retirement accounts.
Solo 401(k) vs. SEP IRA
If you’re self-employed and you want access to a tax-advantaged retirement account, you have three options:
- Solo 401(k)
- SEP IRA
- SIMPLE IRA
“There’s nothing simple about a SIMPLE IRA,” Clark says.
“The paperwork is brutal. It’s straight-jacketed with a lot of inflexible rules. I never, ever recommend a SIMPLE to anybody. So in my opinion, which could be wrong, I think it really is a choice between the SEP and the solo 401(k).”
Here’s a look at some of the similarities and differences between solo 401(k) and SEP IRA plans:
Solo 401(k) plans can offer many more features. But if you open a solo 401(k) with a brokerage, as Clark suggests, you may not get access to all those features.
However, the brokerage version of solo 401(k) plans is not as much of an administrative undertaking as the do-it-yourself version.
At any rate, a SEP IRA — Simplified Employee Pension Individual Retirement Account — is “simpler.” You can also operate a SEP IRA even if you have employees, in theory, although that can get expensive quickly.
If you operate your own business and don’t have any employees, a solo 401(k) can help you stash a lot of money into a tax-advantaged retirement account.
Solo 401(k) plans probably should be more popular than they already are, but researching how they work and digging into the rules can be tedious.
However, it’s worth taking the time to set up a solo 401(k) plan if you’re eligible and make enough self-employed income to justify it.