Also known as the individual or self-employed plan, the solo 401(k) dates back to the Employment Retirement Income Security Act, passed in 1974. ERISA established bedrock standards for employer-sponsored health and retirement plans.
The idea of a self-employed retirement plan took flight when the Economic Growth and Tax Relief Reconciliation Act of 2001 greatly expanded annual retirement plan contribution limits for the self-employed. With the advent of digital commerce, more Americans have opted for the self-employed life and a solo 401(k) plan to help them retire comfortably.
So what is a solo 401(k) plan, and how can self-employed business owners take full advantage? Here’s an inside look.
[Related:Guide to Retirement Planning for the Self-Employed]
What Is a Solo 401(k) Plan?
A solo 401(k) plan is a variation of a traditional employer 401(k) plan but specifically for self-employed individuals. “It’s a great vehicle for business owners looking to save more than the allowed limits in a (Savings Incentive Match Plan for Employees or SIMPLE) IRA or simplified employee pension IRA,” said Brendan Halleron, a Minneapolis-based certified financial planner with Affiance Financial, in an email.
Solo 401(k) plans can be a lifesaver for small business owners. Many have poured substantial financial assets into their businesses without prioritizing their retirements.
“Clearly, the long-term benefits of saving as much as possible for retirement can be incredible, especially with years to let compounding work its magic,” said Gina P. Slayton, a wealth advisor at Bartlett Wealth Management in Cincinnati, in an email. “Many business owners focus solely on the growth of their business to the detriment of their personal financial plans. Having the foresight to create wealth outside of the value of the business itself can be life-changing for owners, their families and communities.
“Additional perks of the solo 401(k) plan include “expanded opportunities to save Roth IRA dollars, potential loans from the plan and employer deductibility of the employer contribution portion,” Slayton added.
Administering a solo 401(k) can be complex, so working with experienced professionals is a must.
“In addition to keeping contributions within the IRS limits, the owner and their team must maintain a plan document by current tax law, make sure not to hire any employees other than their spouse and monitor the need to file form 5500-EZ if their plan assets exceed $250,000,” Slayton noted.
Choosing a retirement plan as a solo entrepreneur can be confusing and requires a little homework. “They must consider many factors, including contribution limits, ease of administration, tax savings and flexibility,” Slayton said. “Ultimately, having a retirement plan is one of the best tools to ensure financial stability in the future.”
Who Qualifies for a Solo 401(k)?
Generally, any sole proprietor, freelancer, independent contractor, franchisee and small business owner qualifies for a solo 401(k) plan. A small business that classifies itself as a sole proprietorship, limited liability company, limited partnership or “S” and “C” corporation can access a solo 401(k) plan.
[Read: 401(k) Mistakes Job Hoppers Make.]
Solo 401(k) Contribution Limits
The current solo 401(k) contribution limit is the same as an employer 401(k) plan: $23,000 as an employee contribution and $30,500 for those over 50. “But solo 401(k) participants can also contribute up to 25% of their compensation — or 20% if self-employed — as an employer contribution,” Halleron said. “The total limit between both employee and employer contributions is $69,000, or $76,500 if over age 50. This offers a significant tax-advantaged savings opportunity for business owners.”
Setting Up a Solo 401(k) Plan
Business owners and the self-employed can set up a solo 401(k) with any of the larger financial retirement plan custodians like Schwab, Vanguard or Fidelity. “You’ll be required to provide some information about your business and answer some general questions in addition to signing paperwork to open the account,” Halleron said.
The account features offered by each firm vary slightly, so check plan details. “For example, some brokerage firms offer a Roth option for your solo 401(k) while others don’t,” Lei Deng, a certified financial planner with Savor Financial in St. Louis, said in an email.
Specialty services can help, too. “There are companies like Solo401k.com that can help you set up your plan,” Kristine Stevenson, a money coach and tax resolution specialist in Austin, Texas, said in an email.
Expect to complete a consent form before starting to use the plan. “You’ll need an employer identification number — think of it as your company’s Social Security number,” said Shawn Carpenter, CEO of Stock Alarm in Chicago, in an email. “Once the plan is implemented, you can start investing and choose how to invest your money, whether in stocks, bonds or mutual funds.”
Generally, you can expect a one-time account setup fee plus monthly management fees.
One item of particular importance is understanding when to file form 5500-EZ with the IRS. “This is for so-called ‘one participant’ 401(k) plans that cover the owner or spouse; one or more partners; and doesn’t provide any benefits for the owner, spouse, or one or more partners,” Stevenson noted. “If you otherwise meet plan criteria but the plan assets are less than $250,000 at year-end, the requirement to file the form is waived.”
Stevenson advises checking the IRS instructions for Form 5500-EZ for more information.
Pros of a Solo 401(k) Plan
— Tax benefits. Tax-deductible contributions can reduce your tax bill now.
— Roth option. Some programs allow you to contribute after-tax dollars with a Roth option. “This means you don’t pay taxes when you withdraw the money later,” Carpenter said.
— Credit availability. If you need a loan, you can borrow from your individual 401(k). “Be careful,” Carpenter advised. “Borrowing from yourself through a solo 401(k) can be risky.”
Cons of a Solo 401(k) Plan
— Ample paperwork. A solo 401(k) requires a lot of administrative work, especially if your plan balance is over $250,000. “Here, you’ll need to file an additional tax form,” Carpenter said.
— You may outgrow it. If your business is growing and hiring full-time employees, “you may want to switch to some type of traditional retirement plan,” Carpenter noted.
— Watch for penalties. Since this is a qualified plan, “it also has more strict rules of distribution, so your money in your solo 401(k) might not be accessible to you before you reach 59 1/2 without penalty,” Deng noted.
[Related:How to Save for Retirement If You Work Part-Time]
Solo 401(k) Management Tips
To help you get the most out of your solo 401(k), follow these guidelines:
— Maximize your investments. Pour as much cash as possible into your solo 401(k) plan. “You’ll gain maximum benefit from plan-related tax breaks, tax benefits and long-term growth,” Carpenter said.
— Consider the Roth option. If you think you’ll be in a higher tax bracket when you retire, a Roth option may be a viable alternative.
— Plan for required minimum distributions. RMDs are the minimum amounts you must withdraw from your retirement accounts each year after turning 73. To find the best strategy to minimize your tax obligations, begin planning several years in advance.
— Diversify your investments. Don’t put all your products in one basket. “Spread your investments across different assets to manage risk,” Carpenter added.
— Review regularly. Review your retirement plan annually to make sure it’s still aligned with your long-term goals and tweak your investments as needed.
— Be consistent. You don’t need to be a savvy investor to become wealthy with a solo 401(k) plan, but you do need to be consistent. “An easy way to establish this habit is by saving every time you are paid or on a consistent schedule,” Halleron said. “Do that, and a solo 401(k) can allow you and your spouse a flexible, tax-advantaged vehicle for consistent retirement savings.”
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What Is a Solo 401(k) Plan? originally appeared on usnews.com
Update 09/11/24: This story was previously published at an earlier date and has been updated with new information.
