Understanding Solo (Self-Employed) 401(k) Plans

Those who become self-employed often do it for the freedom, flexibility, and upside career potential. But it also comes with downsides, like losing out on employer-sponsored benefits such as health insurance or a 401(k) plan.

Retirement planning is essential for workers of all kinds—even self-employed individuals — and solo 401(k) plans are a popular option for solopreneurs looking to save for retirement.

This article will explore everything you need to know about solo 401(k) plans, including what they are, what advantages they have, and how to set one up.

What is a Solo (Self-Employed) 401(k) Plan?

A solo 401(k) plan, also called a solo-k, one-participant k, or uni-k, is a self-directed retirement account for self-employed individuals, sole proprietors, or small business owners with no employees. These accounts help self-employed individuals save for retirement. However, business owners with full-time employees are not eligible for this type of account.

A solo 401(k) can be either traditional, with tax-deferred contributions or Roth, with after-tax contributions. These accounts function similarly to the standard employer-sponsored 401(k) plan, but they allow self-employed individuals to make more significant contributions since they function as both the employee and employer with regard to their solo 401(k).

We’ll go further into detail about the contribution limits and role of self-employment tax with solo 401(k)s later in the article.

Advantages of a Solo 401(k) Plan

While a solo 401(k) plan isn’t the only type of retirement plan available to self-employed individuals, it is an option that brings unique benefits.

Three key features make the solo 401(k)a strategic idea for retirement savings:

1. Contribution limits: The total solo 401(k) contribution limit set by the IRS for 2023 is $66,000, which is the same as that for typical employer-sponsored 401(k) plans. With a solo 401(k), however, this includes your contributions as your own employee (your salary deferral contributions) and as your own employer (your profit-sharing contributions).
2. Tax advantages: With a solo 401(k), you can choose how to arrange your tax advantages. You can select either a traditional solo 401(k), where your contributions are tax-deductible to foster tax-deferred growth, or a Roth solo 401(k) option, where your contributions are made after tax.
   • If you contribute to a traditional solo 401(k), your elective-deferral contributions can reduce your taxable income for the year of contribution. The downside, though, is that your distributions will be taxed in retirement, and you’ll be subject to Required Minimum Distributions (RMDs).
3. Investment options: You may have greater flexibility in your investment options when you choose a solo 401(k) because you’ll have full control to pick your 401(k) plan administrator. Depending on your provider, you may be able to choose from more standard investment options and assets like ETFs, stocks, bonds, and mutual funds, in addition to alternative investments like real estate, cryptocurrency, precious metals, and private equity.

Solo 401(k) Contribution Limits

With an employer-sponsored 401(k) plan, the annual contribution limits are standardized and straightforward. With a solo 401(k) plan, figuring out your contribution limits will require some additional calculations.

Because you can contribute to these accounts through both elective employee contributions and employer profit-sharing contributions (as you’re your own employer), the character of your contributions may vary.

The IRS states that the maximum total solo contribution (employee + employer contributions) is $66,000 for 2023 if you’re under 50; if you’re 50 or older, you can make an additional catch-up contribution of $7,500.

Let’s break those numbers down a bit.

• As your own employee, your total contribution for 2023 cannot exceed $22,500, or up to 100% of your compensation for the year, whichever number is lower.
• But remember that you’re also your own employer, which means you can make an additional plan contribution of up to 25% of the compensation of your net self-employment income (your net profit minus half of your self-employment tax and contribution amount you made for yourself).
• The maximum income you can consider for these calculations is $330,000 for 2023.

You can use the IRS website to help you calculate your contribution limits.

Setting up a Solo 401(k) Plan

Each solo 401(k) plan provider will offer different online platforms and portals, customer service features, fees, and investment options. When choosing your plan administrator, be sure you have considered those qualities to select a brokerage that fits your needs.

Once you’ve chosen a plan, you’ll need to complete three steps:

1. Get an EIN (Employer Identification Number) from the IRS if you don’t have one already. You can apply for one here.
2. Fill out your plan documents with your brokerage, outlining your eligibility requirements.
3. Open the solo 401(k) account with your provider.

Then, you can begin making regular contributions from your earned income. Once you have a solo 401(k) account, you’ll need to fill out a form 5500-EZ at the end of the tax year if your plan assets exceed $250,000.

Be sure to remain up to date with tax reporting and compliance requirements from the IRS. Working with a tax professional can help you make the most of your tax return and ensure that you accurately calculate your earned income to determine your contribution limits.

How to make the most of your Solo 401(k)

A solo 401(k) is an excellent tool for reducing taxable income while saving for retirement. Here are three steps you can take to make the most of your retirement investments:

1. Maximize your contributions: Finding a stable and steady amount to contribute to your monthly retirement savings will help you build for your financial future and potentially reduce income tax burdens in the years leading up to retirement. Remember to strike a balance between your retirement savings and other financial goals.
2. Diversify your portfolio: Try not to invest in just one asset class, but use the various investment options available to balance out your portfolio. If you’re unsure, speak to a financial advisor to help you create the right asset allocation.
3. Monitor your plan and adjust accordingly: Review your investment performance regularly to make adjustments where necessary. But remember not to act in a short-sighted manner, as these many popular investment choices, like ETFs and mutual funds, aim to make returns in the long run. Also, be sure to adjust your contribution levels as your income changes.

FAQs

What is the downside of a Solo 401(k)?

Just like with any retirement account, there are downsides associated with a solo 401(k) plan.

Here are a few key factors to consider:

• Any withdrawal made before age 59 1/2 will be subject to potential income taxes (if you used a traditional solo 401(k) and made pre-tax contributions) and a 10% early withdrawal penalty.
• You cannot have employees with this plan, so if you hope to hire some employees in the future, it’s not the right option for you.
• Since there isn’t an employer, you’ll have to manage the plan independently, which can require more paperwork than other options like a SEP-IRA, Roth IRA, or traditional IRA.

Can I contribute 100% of my salary to my Solo 401(k)?

In 2023, as an employee, you can contribute up to $22,500 (or 100% of your net adjusted self-employed income, whichever number is less) to your solo 401(k).

For example, if your net adjusted self-employed income in 2023 is $50,000, your maximum contribution as an employee would be $22,500.

You would be able to contribute an additional $12,500 for the employer contribution piece ($50,000 * 25% = $12,500).

The total contribution available to a solo 401(k) in this case would be $35,000, assuming the employee is under 50 and does not qualify for a catch-up contribution.

Do I need a company to establish a Solo 401(k)?

You’ll need an Employer Identification Number (EIN) to establish a solo 401(k) plan. This works for individuals operating as a sole proprietor, a single-member LLC, a C corporation, or an S corporation with no employees. But you don’t need a separate legal entity to establish a solo 401(k) plan.

In Summary

If you’re self-employed, a solo 401(k) plan can help you build your retirement savings while creating tax advantages.

With high contribution limits and a range of investment options, a solo 401(k) can significantly benefit individuals without access to employer-matching contributions.

If you need help moving around previous retirement accounts or setting up a 401(k), Capitalize can be your trusted partner in the process.

Learn more about how we can help you build a financial future today.