What Is a Solo 401(k)?

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Saving for retirement might be a little simpler if you work a traditional job with an employer-sponsored 401(k). But things can get trickier for self-employed folks, especially those running a one-person operation. Just 13% of people in this group participate in a workplace retirement savings plan, according to a 2019 study from The Pew Charitable Trusts. What's more, those who do tend to have lower account balances when compared with other workers.

If you're a business owner with no employees, something called a solo 401(k) may be a good solution. In many ways, this type of retirement savings plan mirrors a traditional 401(k). Both provide attractive tax benefits and can help grow your nest egg over time. For a self-employed party of one, a solo 401(k) could make for a great retirement savings vehicle.

How a Solo 401(k) Works

This type of retirement account, also known as an individual 401(k) or one-participant 401(k), has the same rules and requirements that apply to traditional 401(k)s. The only difference is that it's designed specifically for business owners who don't have employees. With a traditional 401(k), the contributions you put in as an employee are tax-deductible. That means they reduce your taxable income today—a nice perk during your working years. Your employer may also choose to match some or all of your contributions. Solo 401(k)s are no different, but they are unique in that the business owner fulfils both roles—acting as both the employee and the employer.

You can make regular contributions to the solo 401(k) and, as the employer, you can also kick in a certain percentage of your total compensation. This sets the stage for higher contributions when compared with regular 401(k)s or individual retirement accounts (IRAs). But just like these accounts, you'll be taxed on the withdrawals you make in retirement. If you choose to tap your account balance prior to age 59½, you may also be hit with a 10% penalty.

How Much Can You Contribute to a Solo 401(k)?

Contribution limits for a solo 401(k) are unique since the business owner serves as both the employee and employer. If you have a one-participant 401(k) in 2021, you can contribute as follows:

  • As the employee: Up to $19,500 of earned income. Those who are 50 or over can contribute up to $26,000.
  • As the employer: 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 the following:
    • Half of your self-employment tax
    • Contributions for yourself

When taken together, total contributions to a solo 401(k) must not exceed $58,000 in 2021. That number jumps up to $64,500 for those 50 or older. This figure includes both the elective deferrals you make as the employee and contributions on the employer side.

Another distinctive feature of a solo 401(k) is that it extends to one other person besides the business owner. If your spouse also earns income from the business, they can enroll in the plan as well—potentially accelerating your family's retirement contributions in the process.

What Are the Tax Benefits of a Solo 401(k)?

A one-participant 401(k) has a number of tax advantages that make it an attractive retirement savings plan for self-employed workers.

  • Your contributions are tax-deductible. As previously mentioned, the money you put into a solo 401(k) as an employee will reduce your tax liability during your pre-retirement years. That money also enjoys tax-deferred growth. There are some tax benefits on the employer side as well. Profit-sharing contributions count as a deductible business expense for businesses that are incorporated. If not, they'll likely count as a personal income deduction.
  • You can opt for a Roth solo 401(k). Traditional 401(k)s are funded with pretax dollars; not so with Roth 401(k)s. These types of retirement accounts are funded with contributions that have already been taxed. While you'll miss out on the tax deduction today, you can enjoy tax-free distributions in retirement.

How to Open a Solo 401(k)

If you decide that a solo 401(k) is right for you, opening one isn't unlike opening an IRA. You can establish this type of account with many investment brokerages. Be prepared to provide an employer identification number (EIN) and appoint a plan administrator (most likely you). Once you've completed all the paperwork, you can choose your investment options. Some brokers provide additional assistance with this, so it's wise to review all fees and investment support before finalizing your plan.

Managing your solo 401(k) plan should be pretty straightforward since there are only one to two participants. Just keep in mind that the IRS will require you to file Form 5500-EZ annually once your plan exceeds $250,000 in assets. That said, another perk of a solo 401(k) is that it allows you to borrow against it. While taking out a 401(k) loan isn't generally advised because it can set back your retirement savings, it could serve as a last resort in a financial emergency.

The Bottom Line

A one-participant 401(k) is a retirement plan designed specifically for business owners with no employees. It can allow for larger contributions while providing notable tax benefits along the way. Consider it another financial resource to keep in your toolbox. The same can be said for monitoring your credit—something you can do for free with Experian. It's a simple move that can help detect potential fraud and keep your financial health going strong.

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