Understanding the Basics of a Solo 401(k)
A solo 401(k), also known as a one-participant 401(k) plan, is a retirement plan specifically crafted for sole proprietors and small business owners without full-time employees. It was built by the IRS to allow entrepreneurs who don’t have access to employer-sponsored plans the benefits of a 401(k) even without working for an employer.
While there are other types of retirement accounts available to people who don’t work for an employer—such as traditional IRAs, SEP (Simplified Employee Pension) IRAs, and Roth IRAs—solo 401(k)s have much higher contribution limits. To illustrate: in 2023, the contribution limit for IRAs is $6,500 ($7,500 for those eligible to make catch-up contributions), and the contribution limit for a solo 401(k) is $66,000 (with the same $7,500 available in catch-up contributions if you’re over 50).
This can augment your retirement savings more quickly—and also make for a bigger tax break in the short term, since traditional 401(k) funds are added to the account pre-tax and grow tax-deferred (that is to say, whatever salary deferrals you make into the account lower your total taxable income in the year of contribution).
There is also the option to make Roth solo 401(k) contributions, which allow you to make tax-free withdrawals later on in retirement—though contributions are taxed in the year they are made. As with other types of retirement plans, qualified distributions cannot be made until age 59 and a half without incuring penalties. Additionaly, a solo 401(k) offers a diverse range of investment options to help you meet your retirement goals on your terms.
Eligibility Criteria for Opening a Solo 401(k)
Opening a solo 401(k) can be an outstanding retirement savings option for self-employed individuals, freelancers, independent contractors, and small business owners. And fortunately, the IRS’s eligibility requirements are simple: you need only to be making earned income through self-employment and not have full-time employees. (An important caveat: your spouse doesn’t count as an employee and can be included in the plan, which is one of its biggest tax advantages.)
Another major tax benefit of a solo 401(k): you can essentially make both employee contributions and employer contributions, which is why the maximum contribution limit is so high. This makes solo 401(k)s powerful retirement savings vehicles: the contribution limit for an Individual Retirement Account, for comparison, is only $6,500, while for a Simple IRA it’s $15,500.
Solo 401(k)s are available from a wide range of providers. Once you open your brokerage account, you’ll have a diverse range of assets to invest in, like mutual funds and ETFs. Keep in mind that the tax deduction on your contribution will only apply if you make traditional, pre-tax contributions. With Roth 401(k)s, you’ll contribute after-tax dollars, which means you’ll still be liable for taxes on the money you contribute.
Step-by-Step Guide to Opening a 401(k) Without an Employer
Below is a detailed, step-by-step guide for opening a 401k without an employer.
1. Choose a Solo 401(k) Provider
Your journey begins with researching and comparing various solo 401(k) providers. Look for providers who offer low fees, a wide range of investment options, and outstanding customer support to ensure you select a provider that aligns with your financial needs and long-term goals. (For example: not all providers allow Roth contributions.)
2. Complete the Application Process
The next step involves gathering all necessary paperwork and documentation, such as proof of self-employment and identification, to apply for a your solo 401(k) account. Be prepared for any potential fees or minimum deposit requirements associated with opening an account. It’s crucial to read the fine print and fully understand the provider’s terms and conditions.
3. Set Up Contributions and Investment Options
After your account is established, set up your contribution amount—that is, how much of your earned income you’ll put into your solo 401(k)—and select from the available investment options. As always, it’s helpful to diversify your investment portfolio across different asset classes, such as stocks and bonds, to mitigate risk and potentially improve returns over time. Consider factors such as your risk tolerance, investment horizon (i.e. when you plan to retire), and long-term financial goals (i.e., how much you pln to spend each month during your retirement) when deciding on your investment strategy.
4. Understand the Tax Implications
No one likes a surprise at tax time—which is why it’s crucial to comprehend the tax implications of opening a solo 401(k). As discussed, traditional or pre-tax contributions lead to tax-deductions in the shrot term and tax-deferred growth in the long term, while after-tax Roth contributions mean you’ll be able to make tax-free withdrawals at retirement, but still be taxed today.
One way to decide between which type of contribution to make is to consider your current tax bracket and future tax expectations. If you plan to be in a higher tax bracket at retirement, it probably makes more sense to pay your taxes today by using a Roth.
As always, it’s worth consulting with a tax professional or financial advisor to optimize your tax strategy and understand how your contributions and distributions will affect your tax liability.
Professional advice may come at a cost, but for most, it’s a lot better than sticker shock come tax time.
5. Make Regular Contributions and Monitor Your Account
To maximize your retirement savings, make regular contributions to your solo 401(k) account—while, of course, keeping the contribution limits in mind. Keep a close eye on your account’s performance, periodically rebalance your investment portfolio as per market conditions, and adjust your contributions over time based on your financial circumstances.
Additional Considerations for Solo 401(k) Account Holders
Balance Retirement Savings with Other Financial Goals
As important as retirement savings may be, funding your future retirement not the only worthwhile financial goal to consider. For example, if you don’t already have an emergency fund of three-to-six months’ worth of expenses sitting in an accessible savings account, it’s usually a good idea to set aside money each month to do so, even if it means lowering your overall retirement contributions.
You may also need to use your income to pay off high-interest debt, like credit card debt—or, as an entrepreneuer, to invest back into your business. As with all things personal finance, it’s about assessing your priorities and striking the unique balance that’s requried by your situation.
Consult with a Financial Advisor
It’s never a bad idea to seek the guidance of a qualified financial advisor to navigate the complexities of retirement planning, tax strategies, and investment decisions. Their expertise can prove invaluable in optimizing your retirement savings strategy and helping you achieve your financial goals more efficiently.
Explore Alternative Retirement Plans
While a solo 401(k) is a great option for entrepreneurs, there are alternative retirement plans worth exploring as well, such as SEP IRAs and SIMPLE IRAs—not to mention traditional and Roth IRAs, or a rollover IRA which can help you stash funds from an old 401(k) account in an up-to-date plan. Each plan has its unique features and potential benefits that might be better suited to your individual circumstances.
Alternative Retirement Plan Options
Let’s take a closer look at these alternative plans.
Traditional IRA and Roth IRA
Traditional and Roth IRAs are popular retirement account options for self-employed individuals and employed people alike—almost anyone can open one, regardless of employment status (though, Roth accounts come with income limits that disqualify some earners from contributing).
Understanding the differences between these two IRA types, including contribution limits, tax treatment of contributions and withdrawals, and eligibility criteria, is key. Evaluate your financial situation and future expectations to determine which type of IRA is more suitable for you.
SEP IRA
Another alternative is a SEP IRA. This retirement savings plan allows for higher contribution limits as well as tax-deductible contributions, making it a potentially attractive option for high-income, self-employed individuals and small business owners.
SIMPLE IRA
SIMPLE IRAs are another retirement savings option to consider. These plans are, as their name suggests, easy to set up and manage, making them an attractive option for small business owners and their employees. Understanding the key features of a SIMPLE IRA, including contribution limits, tax advantages, and eligibility requirements, can be beneficial for those weighing their retirement plan options.
Take Control of Your Retirement Savings Today
We all want to take control of our retirement savings—but doing so can be a bit more challenging for self-employed individuals, independent contractors, and small business owners. By fully understanding the nuances of solo 401(k)s and exploring other retirement account options, you can devise a bespoke strategy that aligns with your unique financial situation and retirement goals.
Navigating the retirement planning landscape can be challenging, but remember that you’re not alone. There are resources and professionals available to help you every step of the way. The team at Capitalize is well-equipped to assist you in finding and consolidating all your old retirement plans, helping to ensure a more secure and worry-free financial future.
Remember that the path to a secure retirement is a marathon, not a sprint. The steps you take now can make a significant difference in the future. So don’t wait—take control of your retirement savings today.
Reviewed by
