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A solo 401(k) is a retirement savings plan for business owners with no employees. It can be a powerful long-term saving tool if you're self-employed or a career freelancer. In many ways, this type of retirement plan mirrors a traditional 401(k). Both provide attractive tax benefits and can help you grow your nest egg over time. Understanding how a solo 401(k) plan works can help you decide if it is right for you.
How a Solo 401(k) Works
A solo 401(k) is available to business owners who have no employees. If your spouse earns income from the business, they can also participate.
| What to Know About Solo 401(k)s | |
|---|---|
| Eligibility | Available to those who are self-employed or own a business that has no employees (other than a spouse). The business must have an employer identification number. |
| 2023 Contribution limits | As the employee, you can contribute up to $22,500. Those who are 50 or older can contribute an extra $7,500. As the employer, you can put in an extra 25% of earned income. |
| Taxes on contributions | Funds grow tax-deferred, but you'll be taxed on distributions. |
| Withdrawal rules | Withdrawing funds before age 59½ typically results in a 10% early withdrawal penalty, plus being taxed as regular income. Required minimum distributions (RMDs) begin at age 73. |
With a solo 401(k), business owners can contribute as both the employee and the employer, which can help supercharge your savings. The money you put in as an employee is also tax-deductible. Just like a traditional 401(k), you won't owe taxes until you make withdrawals in retirement. Keep in mind that tapping funds prior to age 59½ usually triggers a 10% early withdrawal penalty. Once you reach age 73, you must begin taking required minimum distributions (RMDs), and you will have to pay taxes on these RMDs.
Solo 401(k) Contribution Limits
Solo 401(k) contribution limits for 2023 are as follows:
- As the employee: You can contribute up to $22,500 of earned income. Those who are 50 or older can kick in an extra $7,500.
- As the employer: You can contribute up to 25% of your compensation. If you're self-employed and your business isn't structured as a corporation, you can calculate your earned income by taking your net earnings and subtracting half of your self-employment tax and contributions for yourself.
All together, total contributions can't exceed $66,000 in 2023 (excluding catch-up contributions from those who are 50 or older). That includes the elective deferrals you make as the employee and your contributions on the employer side.
Tax Advantages of a Solo 401(k)
- Employee contributions are tax-deductible. When you file your personal income tax return, contributions you made as an employee will be tax-deductible. That reduces your taxable income during your working years.
- Employer contributions count as a business expense. The money you put in as an employer is considered a deductible business expense for businesses that are not incorporated. If your business is structured differently, these contributions will likely qualify as a personal tax deduction.
- Your money grows on a tax-deferred basis. You won't owe taxes on solo 401(k) funds until you begin taking distributions. That means you'll avoid paying taxes on investment gains along the way.
- You can consider a solo Roth 401(k). Roth 401(k)s are funded with after-tax dollars. Contributions are not tax-deductible, but you can make tax-free withdrawals in retirement. Early withdrawal penalties also apply. Beginning in April 2024, Roth 401(k)s will be exempt from required minimum distributions.
Is a Solo 401(k) a Good Idea?
If you're self-employed and looking for a tax-friendly way to save for retirement, a solo 401(k) is worth considering—especially if your spouse also earns income from the business. If you both participate, it could help accelerate your family's nest egg. Participants are able to contribute more when compared to a traditional 401(k). The tax benefits offer another incentive.
Not all business owners can contribute to a solo 401(k) plan. If you have employees who aren't contract workers, you may need another way to save for the future. Some options include:
- Traditional individual retirement account (IRA): Traditional IRAs share some of the same characteristics of 401(k)s, though contribution limits are lower. Contributions may also be tax-deductible. Early withdrawal penalties and required minimum distributions apply.
- Roth IRA: With this type of retirement account, you'll enjoy tax-free distributions in retirement, and there are no required minimum distributions. You can withdraw your contributions at any time, as long as you've had the account for at least five years.
- SIMPLE 401(k): SIMPLE is shorthand for Savings Incentive Match Plan for Employees. These 401(k)s are geared toward small businesses that have fewer than 100 employees.
How to Open a Solo 401(k)
- Compare solo 401(k) providers. Many investment brokerages offer solo 401(k)s. Shop around to see which provider feels like the right fit. Comparing fees, investment choices and investor support resources can help guide you.
- Decide on the right type of solo 401(k). Decide if you prefer the tax benefits of a traditional solo 401(k) or a Roth. The latter might make sense if you expect your tax bracket to be higher in retirement than it is now.
- Open your account and select your investments. You'll likely choose from a variety of mutual funds and exchange-traded funds (ETFs). If you aren't sure where to start, a financial advisor can provide personalized investment guidance. Some solo 401(k) providers also provide investment support.
- Comply with IRS rules. Be sure to stay within the annual contribution limits. Employee contributions generally must be made by December 31 of a given tax year. The deadline for employer contributions is usually the tax filing deadline, which is typically in mid-April of the following year. If your plan exceeds $250,000 in assets, you'll likely need to file Form 5500-EZ annually.
The Bottom Line
A solo 401(k) plan can help self-employed workers maximize their retirement savings. They offer several tax advantages and have generous contribution limits. It can be especially attractive if your spouse also earns income from the business.
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