If you’re self-employed or you’re a small business owner with no employees other than a spouse, a Solo 401(k) or individual 401(k) can help you save considerably more for retirement than you could with just an IRA.
This type of account comes with astronomical contribution limits ($66,000 in 2023) when you consider both the employee and the employer contribution, and you don’t need a traditional employer or “boss” to open this account on your behalf.
The Solo 401(k) works just like it sounds like it would. Once you decide on an online brokerage firm, you take the initiative to open this account yourself.
There are a lot of online brokerage firms to consider for your Solo 401(k), and you’ll want to compare all the top options before you open this account.
This guide can help you understand exactly how Solo 401(k)s work and how much you can save. We’ll also provide insights into the best online brokerage firms to consider for your retirement planning needs.
What Is a Solo 401(k)?
Table of Contents
- What Is a Solo 401(k)?
- How Much Can You Contribute to a Solo 401(k)?
- How Does a Solo 401(k) Work?
- Solo 401(k) Rules You Need to Know
- When Is the Deadline to Fund a Solo 401k?
- When Does It Make Sense to Open a Solo 401(k)?
- Where to Get Help Opening an Account
- The Bottom Line on Starting a Solo 401(k)
A solo 401(k) is a type of employer-sponsored retirement plan that is specifically designed for self-employed individuals or business owners without any full-time employees other than their spouses.
It allows these individuals to make contributions to the plan for themselves and their spouse, with the money growing tax-deferred until it is withdrawn in retirement.
Like a traditional 401(k) plan, a solo 401(k) plan has a high contribution limit and offers the potential for tax-deferred growth on investment.
However, unlike a traditional 401(k) plan, a solo 401(k) does not require an employer match, and the employer and employee contribution limits are combined into one limit.
How Much Can You Contribute to a Solo 401(k)?
In 2023, individuals with a Solo 401(k) can contribute a maximum amount on the employee end and the employer side of the equation.
As an employee, individuals can defer all their compensation up to the annual contribution limit of $22,500 for 2023. The only exception is individuals ages 50 and older can contribute up to $30,000 as an employee of their company.
The rest of the contribution Solo 401(k) participants can make is on the employer side. Here, you can contribute up to 25 percent of your compensation “as defined by the plan” up to an annual limit of $66,000 total (up from $61,000 in 2022) or up to $73,500 if you’re 50 or older.
How does this actually work in practice? Consider this succinct example:
Solo 401(k) IRL Example
|Ashley, age 51, earned $50,000 in W-2 wages from her small business in 2020. She deferred $19,500 in regular elective deferrals plus $6,500 in catch-up contributions to the 401(k) plan. Ashley’s business contributed 25% of her compensation to the plan for the year, or $12,500. Total contributions to the plan for the 2023 tax season were $38,500.|
The above computation reflects the contributions the taxpayer can make if the business is established as a Subchapter S-corporation.
If operating as a sole proprietor, Ashley would be required to first deduct the $26,000 “employee” contributions, as well as half her self-employment tax from her net business income before calculating the 25% “employer” contribution.
This is why I strongly recommend using the services of a CPA when you have a Solo 401(k) plan or are contemplating establishing one.
The individual 401(k) lets you max that part out and contribute another 25 percent of your compensation on the employer side. The end result is the ability to save a ton for retirement and to reduce your taxable income in the process.
For reference, here’s how employee and employer contributions limits have changed for Solo 401(k) plans over the years for retirement savers under the age of 50.
|CONTRIBUTION YEAR||EMPLOYEE CONTRIBUTION LIMIT||TOTAL ANNUAL CONTRIBUTION LIMIT|
(EMPLOYEE + EMPLOYER)
How Does a Solo 401(k) Work?
As a reminder, a Solo 401(k) plan is nothing more than an individual retirement plan for self-employed people or small businesses without any employees.
As an employer, one of the main features of a Solo 401(k) is you’ll need to determine what your actual income is to determine your maximum employer contribution, which can be up to 25% of your compensation.
According to the IRS, your compensation is earned income, defined as..
“net earnings from self-employment after deducting one-half of your self-employment tax and contributions for yourself.”
But once again, this depends on the business structure of your company.
Solo 401(k) participants can open their account with any brokerage firm they want, although online providers have become extremely popular due to the fact you can get started at home and on your own time, and often with access to an array of helpful investing tools and resources.
Online brokerage firms also tend to come with low costs overall, which is another reason investors seek them out.
Solo 401(k) Rules You Need to Know
As you move closer to opening a Solo 401(k), there are some more details and rules you should know and understand. Here are some of the main Solo 401(k) rules that can help you figure out if this is the right plan for you.
To qualify for a Solo 401(k) plan, you need to be self-employed or own your own small business. You cannot have any full-time employees except for a spouse.
You can have a part-time employee and still have this plan, provided your part-time worker puts in less than 1,000 hours per year or less than 20 hours per week.
When Do You Have to Take Distributions?
Where you were required to take Required Minimum Distributions (RMDs) at age 70 ½ until 2023, the recent passage of the Setting Every Community Up for Retirement Enhancement (SECURE) Act bumped that figure up to age 72.
In short, this means you’re required to begin taking distributions once you reach that age. This is unlike the Roth IRA, which doesn’t require distributions at any age.
Note you can take distributions without a penalty any time after you reach the age 59 ½.
When Does a Solo 401(k) Have to Be Established?
To make a contribution to a Solo 401(k) for 2023, you are required to establish your account before the end of the year or by December 31, 2023.
It’s possible to make contributions to a Solo 401(k) after the new year (and before your tax filing deadline, which is normally April 15), provided your business isn’t incorporated.
When Is the Deadline to Fund a Solo 401k?
The deadline to fund a solo 401(k), also known as an individual 401(k) or self-employed 401(k), for a given tax year is the tax-filing deadline for that year, which is typically April 15th of the following year.
However, if an extension is filed, the contribution deadline can be extended to October 15 of the following year.
It’s also worth noting contributions to a solo 401(k) can be made up until the employer’s tax-filing deadline, including extensions, even if the employee’s tax-filing deadline has passed.
This means contributions for a given year can be made as late as October 15th of the following year, which is the deadline for filing an extension.
The $250,000 Rule
You should also be aware of one more rule. Once your Solo 401(k) plan grows to over $250,000 in assets, you’re required to file an Annual Form 5500 EZ. You’re also required to file this form if you close your account.
When Does It Make Sense to Open a Solo 401(k)?
A Solo 401(k) isn’t the right investment strategy for everyone. Here are some scenarios when opening a Solo 401(k) makes sense:
- You’re a Business Owner and the Only Employee of Your Company: This might seem like a given since this is the exact person Solo 401(k)s are for, but it’s worth mentioning it’s also the only person Solo 401(k)s are for — if you’re not self-employed or if you have additional employees it won’t work to open a 401(k).
- You’re Self-Employed and Want a Retirement Plan Your Spouse Can Contribute To: Since you can add contributions from your spouse to a Solo 401(k), opening one could be a strong strategy if your spouse currently doesn’t have a retirement plan or if they haven’t maxed out other retirement contributions.
- You Want the Ability to Take Loans From the Plan: While taking a loan from your own retirement plan isn’t ideal, the realities of being a small business owner could mean you want or need that flexibility.
Where to Get Help Opening an Account
You can open a Solo 401(k) with any brokerage firm that supports this type of account — most do. However, some online brokerage accounts do offer more perks and benefits than others, which could make them ideal.
What Is a Brokerage Firm?
A brokerage firm is a company that helps buyers and sellers complete financial transactions.
They earn money based on fees or, in some cases, commissions involved with the transaction. In many cases, special licensing is required to buy and sell financial products, which is where brokers are necessary and helpful.
You might also find individual brokers who work independently, but typically, brokers are connected to a larger team (their firm) that can collaborate to help with transactions.
How Can Brokers Help?
When it comes to setting up a Solo 401(k), a broker can help you set up a plan and process stock trades. Even if you want to direct your own Solo 401(k), you will still need a broker with the appropriate credentials to set up your plan and complete your trades.
What to Expect When Working With a Broker?
Not all brokerage firms are created equal. You can find some that take a hands-on approach to managing your finances and others that will step back and allow you to do it yourself (if that is your preference).
You should expect that all brokers will charge a fee or commission. Some brokers might provide additional tools or resources, such as a mobile app or financial educational trading, that could make them a preferable option.
We compared some of the top providers to help you narrow down your list of potential options. There are lots of excellent brokerage firms out there with various pros and cons,
The Bottom Line on Starting a Solo 401(k)
Opening a Solo 401(k) comes with a ton of important benefits, the most important of which is your ability to save more money for retirement than you would otherwise.
Since contributions to a Solo 401(k) are tax-advantaged, you can also invest more to reduce your taxable income now, although you will pay income taxes on Solo (k) distributions once you begin taking them in retirement.
If you’re self-employed, you should absolutely consider opening a Solo 401(k), but you can also consider the SEP IRA, which works differently but comes with an annual limit of $66,000 for 2023.
Either way, make sure you compare all the top online brokerage firms to see which ones offer the internal investments you want with plenty of investing tools and resources.
Also, make sure to compare fees so you know how much you’ll pay for account administration and any trades you make throughout the year.